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As the third quarter comes to an end, there have been two seismic shifts in global markets. It has been 30 months since interest rates began to climb to 5.5%, and 10 months since the US Federal Reserve announced it had halted any further increases. We finally witnessed the long-awaited first cut in interest rates. It is surely no coincidence that shortly afterward, the People’s Bank of China unleashed its equally long-anticipated monetary “bazooka,” reminiscent of its actions during the Credit Crunch in 2008. Is the Fed too late? Is a recession finally on the horizon? Is the Chinese stimulus sufficient? Will Labour tax away all potential economic growth? What on earth is the ECB doing? These are all valid questions, but none of them will significantly impact the long-term outlook. As we have repeatedly stated, the direction of interest rates, inflation, and corporate earnings is what truly matters; globally (excluding Japan), all these factors have turned positive for markets. As we enter the final quarter of 2024, there has been a marked shift in market sentiment. Since Microsoft’s substantial investment in OpenAI and the launch of ChatGPT, technology stocks, especially dominant American companies like Microsoft, Facebook, and Nvidia, have driven investment returns, often at the expense of other sectors. UK-based investors also saw returns bolstered by a strong dollar, but this trend has changed. The dollar has weakened, as expected when cash returns (interest rates) decline and “the rest” of the market has begun to rise in the performance rankings. In the last quarter, bonds, mid and small-sized companies and property have moved to the top of the performance table, while technology stocks have fallen to the bottom. These early stages are typically the most volatile, with calls for a “double dip recession” common and many commentators caught on the wrong side of the market, refusing or unable to change their stance. Historically, these are classic signs that a new cycle is now fully underway.
Forthcoming UK Budget
The UK is gearing up for its first Rachel Reeves Budget on October 30, 2024. This will coincide with a period of economic growth, as the UK continues to outperform its European competitors. However, whispers, leaks, and actions such as cutting infrastructure spending, halting R&D for supercomputers and AI and restricting the Winter Fuel Allowance all suggest the onset of a new age of austerity. The last period of austerity under George Osborne was, with the benefit of hindsight, economically flawed. Currently, the justification for these cuts stems from a reported £22 billion shortfall in public finances. This shortfall represents the government’s overdraft, not its mortgage (national debt). There is always a desire for a “balanced budget,” but this almost never materializes, as shown in this chart dating back to the 1950s. The political trick is to promise that it is improving and decreasing. This chart also illustrates just how costly the Covid-19 lockdown periods were for government finances. A reduction in tax revenue and direct cash transfers to individuals significantly shifted the chart “off the scale.” Nevertheless, it was returning to “normal” levels. The additional £22 billion of “unbudgeted government expenditure” adds 1.8% to the deficit.
While the new government has ruled out increases in VAT, income tax, and National Insurance, it seems likely that Capital Gains Tax (CGT), Inheritance Tax (IHT), and pension relief may be targeted. The financial risk associated with increasing these types of taxes is that they are elastic; often, there is a choice about whether to pay them or not. Historically, when these taxes have been increased, the actual tax revenue received has often declined. There is a fine art to levying taxes, sometimes, a cut can raise more revenue. A comparison of tax rates in Germany and France, along with a review of CGT and IHT rates and pension relief under the last Labour government of Blair and Brown, suggests there may be some headroom in tax rates. Nevertheless, the scale and breadth of the negativity leading up to the event is concerning. However, this situation may set up markets to be modestly surprised when the details are finally released.
The promise in the Labour Manifesto was to reduce the “overdraft” by growing the GDP side of the equation and not raising taxes. While the Winter Fuel Payment has taken all the headlines, the reduction in infrastructure and R&D spending is actually more concerning from an economic standpoint. The new Industrial Strategy, which is due to be announced on the same day as the Budget, might be the more important document.
German Manufacturing
In marked contrast to the UK, the German economy and the manufacturing sector in particular continues to struggle. The latest PMI data paints a gloomy picture for Germany’s manufacturing sector, as a significant drop in new orders has been a primary contributor to the index’s downturn. August experienced the sharpest decline in new contracts since November 2023. Surprisingly, power generation and electronics saw the biggest falls in production, despite a boom in green energy projects. The troubles at Volkswagen are a high-profile example of the malaise in German manufacturing. Despite the overall negative trend, there were signs of improvement in demand from China and the USA. Indeed, manufacturers’ optimism about growth opportunities has been growing, reaching its highest level since February 2022. These improvements in business outlook and export demand provide a glimmer of hope for the sector’s eventual recovery. Much depends on the ECB and major customer, China.
China
The Chinese maintained COVID-19 lockdowns for far longer than Western nations. This has had severe long-term economic consequences, especially since the widely expected substantial post-lockdown stimulus never materialised. At the same time, President Xi appointed himself for a longer term and promptly cracked down on the fast-growing Chinese tech sector. This has all hindered the Chinese economy and ultimately led to property developers defaulting on their debt and growth stalling. Growth targets were cut from 7% to 5% and even this lower level now seems unlikely to be achieved. There were fears that the ruling Communist Party was trying to push back against capitalism. However, with Chinese youth unemployment rising to 19%, it seems the Party has reached an inflection point. They have finally unleashed the “economic bazooka,” just as they did in 2008. Interest rate cuts, reduced bank reserve requirements, and a stock market stability fund are all back. Investors who had grown tired of waiting are now rushing back in. With U.S. interest rates coming down, this adds to the global positive bias.
Markets
October is often the most volatile month of the year, as political developments tend to concentrate in this month. 2024 will be no exception, with the U.S. Presidential Election dominating the news cycle. Harris is ahead in the polls, but Trump is leading in crucial swing states. The risk for markets lies not in who wins, but in the possibility of a contested election result. A repeat of the 2000 election, where the outcome was decided by the U.S. Supreme Court, would not be welcome. Typically, traders take positions off the table ahead of such binary events. In the UK, the first full Labour Party budget has been preceded by a series of negative briefings and warnings of “difficult choices,” “pain,” and a “recalculation” of this year’s potential budget deficit. This seems to be classic political preparation for significant tax increases. While this may be acceptable for the gilt market, it raises concerns for some parts of the equity market (AIM) and for the private equity sector that now dominates the City of London. For the main UK equity market, the Industrial Strategy Document and house building/green energy stimulus will be of most interest. The key aspect is that, while taxes will undoubtedly increase, they will do so in an improving economic environment, just as valuations (excluding technology) are low. Interest rates globally are coming down, and crucially, central banks have shifted from being a drag on markets to being a source of stimulus. As the market adage goes, “don’t fight the Fed.”
October 2024
