- Markets are driven by more than just economic trends.
- Geopolitical and other events can influence investor sentiment and appetite for risk, and consequently, the capital markets.
- Global developments could influence 2019 investment returns.
Among the first things investment strategists typically consider when forecasting capital market returns are forward-looking expectations for the economy. These can factor in such elements as the pace of economic growth, corporate earnings growth, inflation and monetary policy. While those factors play a central role in investment returns, politics and geopolitical developments can also exert an impact, with some influencing returns more than others. For 2019, four considerations in particular warrant attention.
Can D.C. legislators find common ground?
Perhaps the most significant domestic political development to watch in the new year is the recent Democratic Party takeover of the U.S. House of Representatives. Once the federal government is fully funded and reopens from its pre-Christmas partial shutdown, we can expect the usual political rancor with the now-divided Congress, making the legislative process even more challenging than it normally is.
Yet, several areas of possible compromise exist. There is general bipartisan agreement on issues such as increased expenditure on the nation’s infrastructure, paid family leave, lower prescription drug prices and other healthcare reforms, immigration reform and even potential changes to the tax code. Collectively, the success or failure of these legislative initiatives have implications for industrial and materials companies, pharmaceutical and biotechnology companies, employers in general who offer healthcare benefits, as well as consumers and investors.
The “Brexit” dilemma
There is no shortage of issues overseas, and U.S. investors should keep an eye on one European development in particular: Brexit. In the European Union (EU), the March 2019 deadline for the United Kingdom (UK) to officially leave the EU is rapidly approaching. Theresa May’s Government has reached an agreement with the EU on the outline of a deal, but its prospects remain uncertain. This raises the possibility that the deadline arrives with no deal, causing widespread uncertainty in terms of trade, travel and politics, most notably in Ireland concerning the border with Northern Ireland. There is even increasing talk of a second referendum, although that seems unlikely. The bottom line is that the outcome—and its potential impact on investment returns—remain uncertain at this late date.
It bears mentioning that UK economic growth has been steady, if less than robust, since the Brexit vote in June 2016, but one legacy of the vote has been the devaluation of the pound. Britain’s currency is down 14% against the dollar as of year-end 2018, turning a 6% gain in the FTSE 100 Index, generally a beneficiary of a weaker currency, into a loss of 9% for U.S. dollar-based investors. During the same interim the S&P 500 gained 19%. As reported by the Financial Times, investors have withdrawn money from UK equity markets every week since the referendum, totaling more than $1 trillion, due to the uncertain economic impact of Brexit.
Italy’s budget challenges
The other major political standoff in Europe resides in Italy, the Eurozone’s third largest economy, where a new populist government proposed a budget that targets a deficit larger than permitted by EU rules. Already saddled with the second-highest debt burden as a percent of Gross Domestic Product (GDP) in the Eurozone, Italy’s proposed increase in spending only threatens to make matters worse, raising concerns among investors of a banking crisis, or even a possible exit from the Eurozone, although the latter seems unlikely. The European Commission has threatened to fine Italy for breaching the budget rules, but negotiations have continued, and more recently, volatile markets have calmed down amid signs of progress.
U.S./China Trade tensions persist
Perhaps the most potentially impactful geopolitical situation is the U.S. trade dispute with China. To compel China to pursue what the U.S. considers more fair trade policies, the U.S. government imposed a series of tariffs on Chinese exports to our country, and China retaliated. To increase the negotiating pressure on China, the U.S subsequently threatened to impose tariffs on all of China’s exports to the U.S. and to raise the current 10% tariff to 25%. In early December 2018, the two countries agreed to a temporary ceasefire with a March 1 deadline while negotiations continue, but progress towards resolving the countries’ trade imbalances remains uncertain.
The U.S. business community has generally been supportive of tariffs but using them as a negotiating device is risky. Furthermore, the longer this trade dispute continues, the greater the potential negative economic impact to both countries and other trading partners. A study sponsored by Koch Industries on the impact of tariffs already imposed (as well as threatened) on China and other countries concluded that U.S. economic growth would be reduced by 1.8% in 2019 and result in significant job losses. If the damage is to this scale, we would likely see further negative impact on the markets. However, given recent developments, this is an issue that would need to evolve further to fully assess potential impacts.
What to do in an uncertain environment
Given the uncertainties that could alter the economic landscape, the challenge is to navigate the tradeoff between possible worst-case outcomes that result in further market declines, and potentially favorable resolutions that could take markets higher. Being aware of political and geopolitical risks and opportunities, coupled with an understanding of economic fundamentals, is all part of being an informed investor.
Speak with your financial advisor to understand how these considerations align with your own risk tolerance and goals, and how best to factor them into the ongoing management of your portfolio.