Power to the Populists

Emily Nicol
Chris Scicluna

Financial markets are back in risk-on mode, with the investor mood buoyed by the actions of the populist leaders on both sides of the Atlantic.

Closest to home, Boris Johnson’s Conservatives won a landslide election victory – the party’s biggest since Margaret Thatcher – that removes near-term Brexit uncertainty, guaranteeing that the UK will leave the EU at end-January albeit leaving a distinct lack of clarity about what will follow after that. So, sterling has locked in its 3 cent gain against the USD (currently close to $1.345) triggered last night upon release of the UK election exit poll, whose findings were subsequently corroborated as results from individual constituencies were released.

And with reports suggesting that Trump has endorsed a first-phase trade deal with China, cancelling the tariff hikes set to go ahead this weekend and seemingly raising the possibility of cuts to existing tariff rates on Chinese goods by up to 50%, Asian financial markets were inevitably upbeat. So, after yesterday’s 0.9% gain in the S&P500, China’s CSI300 closed up 2.0%. And despite a rather mixed BoJ Tankan survey (see the detail below), which pointed to near-term Japanese economic weakness but a still-positive trend in business capex, the Nikkei 225 closed up 2.6%, given impetus by a weakening in the yen back to ¥109.6/$.

In the bond markets, however, USTs were little changed in Asian time, having already sold off yesterday in the wake of Trump tweeting that he’s “Getting VERY close to a BIG DEAL with China”. JGBs opened lower but reversed the initial losses (10Y yields back to -0.03%), with reports of extra issuance to come to fund next year’s fiscal stimulus. Euro are govvies, however, have opened significantly lower (10Y Bunds up about 4bps to -0.24%) and Gilts are inevitably weaker too (10Y yields are also up about 4bps higher at 0.85%.)

So, Johnson’s Conservatives have romped to a landslide victory in the UK’s general election. With distinct echoes of Trump in 2016, Johnson won large swathes of seats in the traditional ‘red wall’ of the Labour heartlands. The Scottish National Party won most seats North of the Border to open a new Constitutional can of worms. But with a couple of results still to declare, the Tories are currently set for a House of Commons majority of 78, their best result since Thatcher. And this blonde-wash gives Johnson carte blanche to set policy ahead.

First and foremost, of course, the large Conservative majority means that Parliament will swiftly pass the legislation required to ensure that the UK leaves the EU on 31 January. That, however, will merely conclude the first phase of Brexit, with the UK then entering a transition/implementation phase during which nothing will change in the country’s trading and financial relationship with the EU (bar the removal of its say in decision-making). Negotiations to determine the UK’s future relationship with the EU should, however, commence in the early spring, with an emphasis on putting in place a new Free Trade Agreement as soon as is logistically feasible.

According to Johnson’s Withdrawal Agreement, the transition period could be extended for one or two years, as long as that extension is agreed before July next year. But during his election campaign, Johnson insisted that it would not be extended. He also insisted that the UK should be allowed to diverge significantly from EU rules, including on labour and environmental rights. But it is hard to believe that a new Free Trade Agreement allowing for such divergence – which would also see the EU add extra barriers to trade to protect itself from the intensified competition from the UK – could be agreed between the UK and EU and ratified in national (and some regional) parliaments by the end of next year.

As such, the Conservative victory would appear to bring with it a significant risk that the UK ends its current trading relationship with the EU at end-2020 on WTO terms, implying the disruptive imposition of tariffs and non-tariff barriers to trade (including, for example, the loss of EU market access for UK financial services firms). The large scale of Johnson’s majority, however, means that he will be less reliant on the hardline nationalist Brexiters in his party’s ERG grouping. As such, he might well choose to pivot towards a softer form of Brexit, with a high level of alignment with EU rules, simply to be able to secure a quick deal. Just as he went back on his previous pledge to avoid a hard border down the Irish Sea, he might also renege on his commitment not to extend the transition period beyond the end of next year.

Nevertheless, from an economic perspective, among other things this persisting uncertainty surrounding the transition and the risk of new barriers to trade being imposed at end-2020 would seem likely to continue to weigh on business investment in the UK, which has flat-lined since the 2016 referendum. So, although the new Government will pass a Budget early next year offering a small National Insurance giveaway to households and providing for extra public investment in future, we expect UK GDP growth to remain very subdued over coming quarters, meriting an easing of monetary policy. As such, we expect sterling in due course to give up some of its gain, and Gilts to outperform in the first half of next year.

Given October’s consumption tax increase and disruption caused by the super Typhoon, business conditions at Japanese firms were inevitably anticipated to have deteriorated sharply in the final quarter of the year. But the overnight release of the BoJ’s Tankan survey provided somewhat mixed messages about recent developments. While it flagged further divergence between manufacturers and non-manufacturers, and signalled that firms are less optimistic about likely conditions in the New Year, overall the survey was arguably not as bad as some had feared.

Admittedly, the Tankan did suggest a widespread deterioration in business conditions over the past quarter. And the survey further highlighted the significant challenges facing Japanese manufacturers, with the headline DI for large firms in the sector declining for the seventh quarter out of the past eight in Q4 and by a larger-than-expected 5pts to 0, the lowest since the start of Abenomics. (This weakness tallied with today’s revised IP data, which suggested a steeper pace of decline than initially estimated in October with the 4.5%M/M drop leaving output down a whopping 7.7%Y/Y.)

Perhaps unsurprisingly given persistent weakness in global demand, the Tankan implied the most significant worsening of sentiment in Q4 was seen in key export-oriented sectors – i.e. the business oriented machinery manufacturer DI fell 16pts to 0, while the autos index was down 13pts to -11, the weakest since the post-2011 quake slump. Unusually, medium-sized firms were marginally less downbeat than their large counterparts, although small-sized manufacturers were predictably more gloomy. And manufacturers of all sizes forecast a further deterioration in Q1 too.

While the headline DI for large non-manufacturers also slipped back in Q4, the 1pt drop to +20 was smaller than had been expected and smaller than the declines seen after the tax hikes in 1997 and 2014 (-6pts and -5pts respectively). Nevertheless, the index in Q4 still stood at its lowest for almost three years, with an inevitable slump in sentiment among retailers – the equivalent DI fell 7pts to -3, the first negative reading for five years. Construction firms also saw a softening in conditions in Q4. And overall, non-manufacturers forecast a further deterioration in conditions in Q1, with SMEs predictably anticipating the worsening to be slightly greater. Nevertheless, the respective indices would still remain significantly higher than their long-run average, in marked contrast to the manufacturing sector.

The greater optimism among non-manufacturers compared with manufacturers perhaps in part reflects their improved expectations for profits growth this year, which saw the overall expected decline revised down by 1.6ppts to -3.0%Y/Y. In contrast, manufacturers were notably more downbeat about their expected profit growth, with firms now forecasting a double-digit decline in overall profits in FY19 for the first time in more than a decade.

This notwithstanding, manufacturing firms were only marginally less upbeat about their capex plans this year, still forecasting growth of 6.8%Y/Y in FY19, with a double-digit rise at large manufacturers. And with non-manufacturers having nudged slightly higher their full-year forecast, overall firms were more upbeat about their investment intentions over the fiscal year as a whole, forecasting growth of 3.3%Y/Y, albeit half the pace recorded in FY18.

Other detail from today’s Tankan suggested that while firms on the whole continue to have insufficient capacity, the constraints were little changed from three months ago, and not quite so acute for manufacturers, therefore suggesting a lack of fresh upward pressure on inflation. Certainly, the Tankan’s inflation indicators again pointed to a very weak pricing environment. While large manufacturers reported a marginal increase in input price pressures in Q4, they continued to report a steeper decline in output prices last quarter – indeed, the relevant index fell 2pts to -6, the lowest for three years. And while non-manufacturers suggested that prices moved broadly sideways in Q4, firms in both sectors indicated that they expect to face further downward pressure on their output prices in the New Year.

In the US, today will bring retail sales figures for November. A reportedly strong start to the holiday shopping period and a pickup in sales of new vehicles is expected to have boosted overall retail sales. Following the consumer and producer price reports published earlier this week, export and import price indices for November, as well as business inventories figures for October, are also scheduled for release.


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