3rd October 2017

Rathbones weekly review: Balancing power

About 170 years ago, the Conservative Party was split by a bitter battle between the countryside and the cities. Using hefty tariffs on imports, the Corn Laws kept grain prices – and therefore bread and food prices – high and ensured the dominance of landowning aristocrats over the manufacturing mogul and their workers.

Today, the Conservatives are split again. How open should the UK’s borders be? What society should Britain strive to be? Who should control the balance of power, the cities or Middle England? Prime Minister Theresa May, like David Cameron before her, is trying to steer a path between the Eurosceptics and the moderates in her party. But it is becoming ever harder to bring the two camps together, particularly in the face of a cold and uncompromising trading bloc.

Mrs May’s appetite for heavy rhetoric with the EU has faded recently. She has conceded on immigration, the Brexit bill and how long the break-up will take. So it is about the right time for today’s Benjamin Disraeli to emerge. Boris Johnson quickly ruled himself out of a leadership bid in the post-referendum chaos after getting double-crossed by supposed ally Michael Gove. Mr Johnson was emphatic. And yet the unspoken understanding seemed to be: come the opportunity, come the man. Mr Johnson, now Foreign Minister, has kicked off the week of the Conservative Party conference with another article all but attacking his Prime Minister by advocating for a hard Brexit and for better working class pay.

The repeal of the Corn Laws was pushed through by powerful industrialists arguing that they had the plight of the working man in their heart. It led to a mass migration of redundant farm labourers, many of whom were relatively well-paid, to factories. It lowered the wage costs of British manufacturers and helped boost the revolution that was stirring in the towns and cities. It unleashed modern Britain and split the Conservatives down the middle.

Is a similar thing happening today? 

Source: FE Analytics, data sterling total return to 29 September

Debt and prayers

After warning for some time on the amount of consumer debt racked up by Britons, the Bank of England is now talking about tightening interest rates.

Whether it’s a bluff or not is difficult to say. Several times in the past Governor Mark Carney has turned hawkish in phrase without following up with action. Still, this time round inflation is running hot and the market is inclined to take him seriously. A 0.25-basis-point rise in November has an 83% probability according to the swaps market. If rates do rise next month, we believe it would have a limited effect on the economy. Monetary conditions would remain much looser than before the referendum, because quantitative easing and the term for lending scheme remain in place.

Meanwhile, on the other side of the Atlantic the debate is about just how many increases the Federal Reserve will implement in 2018 (it forecasts three). We all know the uncertainties of “data-dependent” central bank actions, but there is a chance that events will overtake the Fed’s plodding cautiousness. President Donald Trump’s tax reform has landed. Well, some of it – there are plenty of details that are yet to be finalised. At the moment, it aims to simplify the tax code to the size of a postcard, streamline deductions, drop many loopholes and create a few more to encourage investment. An admirable, if Herculean, goal.

Despite Republicans controlling both houses of Congress and the White House, there will be a few fights over this. Like everything, it comes down to money and votes. The tax plan would cut Federal taxes by $5.8tn and raise an extra $3.6tn elsewhere. That $2.2tn hole has to be funded by greater borrowing. That’s awkward for a party that has lambasted the fiscal profligacy of its opponents for the better part of decade. Some say this void would be filled by extra revenue garnered from significantly higher growth spurred by the reduction in taxes. History hasn’t been kind to this theory. Others say they should balance the budget by slashing entitlement programmes. The 2016 federal budget was $3.9tn, half of that was defence spending, social security and healthcare for the old. There are no votes to be had messing with these programmes. If the tax plan is passed, expect a fudge. The tax reductions will have to be pared down or there will be a lot more debt and prayers for higher growth issued by the Republican caucus.

Easier fiscal policy of this magnitude, if it comes, would force the Federal Reserve to tighten its policy to combat potentially runaway inflation.

A shadow of authority

The Spanish government’s brutal repression of the Catalonian independence referendum dominated headlines at the weekend.

Police raided polling stations armed with batons and fired rubber bullets into crowds, injuring hundreds of citizens. Separatists are claiming victory because roughly 90% of the vote was in favour of independence. Common sense tells you that those braving the melee of a banned referendum are probably planning to vote Si. Only 40% of Catalonia cast a ballot, with many people saying they would boycott the vote because they didn’t agree with the independence movement. Still, the heavy-handed response by the government plays into the hands of those who argue Catalonia was annexed 300 years ago by a Spain it wanted no part of.

Catalonia, with its capital Barcelona, is one of the richest regions of Iberia. Its pursuit of independence stems partly from a belief that Spain is milking the region with taxes while giving it nothing in return. Flooding the streets with Guardia Civil bussed in from other regions can only increase the feeling of occupation.

In Germany, Chancellor Angela Merkel is having to be much more conciliatory as she negotiates a three-way coalition to stay in power. We believe her discussions will be successful, but they will take a few months yet. It will also likely water down her agenda and force her to be less audacious in her foreign affairs. She is helped by robust, if traditionally Teutonic, economic data. Germans are not known as riotous consumers, but an unexpected fall in retail sales is still disappointing. Despite that, economic growth is expanding, manufacturing output is booming and the unemployment rate is at the lowest level since reunification.

The engine room of Europe appears to be in rude health.

Bonds

UK 10-Year yield @ 1.36%
US 10-Year yield @ 2.34%
Germany 10-Year yield @ 0.46%
Italy 10-Year yield @ 2.17%
Spain 10-Year yield @ 1.61%

Julian Chillingworth
Chief Investment Officer

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