Korea – a new political uncertainty
Just when you thought political risk was disappearing from the markets, up pops the political class to not disappoint, this time the US and North Korea. Last week, bombastic rhetoric from US President, Donald Trump, and his North Korean equivalent, Kim Jong-un, increased tensions, which resulted in North Korea threatening to nuke, Guam. It is not the first time of threatening behaviour from North Korea, but it is the first time for such a response by a US President. Although there are some doubts that North Korea has developed nuclear weapons, as well as the missiles capable of delivering them, the threat exists. The traditional defensive assets such as gold and the Yen have benefited from this risk.
Apart from North Korea, there is another Donald Trump concern, and that is the lack of policy making at the White House, combined with the ongoing power struggles amongst the staff. There is a risk that the tax reforms, which should benefit markets, may be delayed indefinitely. The lack of economic momentum remains a real risk. There is a danger that the US government will breach its agreed debt ceiling sometime later this year, threatening a shutdown, if no new agreement is reached. What normally happens in this situation is that something is thrashed out in the end, as it always has been during previous episodes. The political difficulties Donald Trump faces may mean that the US could again be peering over a fiscal cliff.
On the positive, the US economy is continuing to make progress, with the non-farm payroll figures revealing that US businesses and non-profit organisations created 209,000 jobs in July, compared with the 183,000 expected. The US unemployment rate also fell to 4.3%, which is a 16-year low that was matched in May. There still seems to be a vast number of jobless Americans that it should be possible to entice back into the labour force, after years of discouragement.
Wage growth remains subdued, however, there are signs that it is picking up. In July, US retail sales rose 0.6%, which is the biggest increase since December 2016. In addition, US retail sales figures for June were revised to show a rise 0.3%, instead of the previous estimate of a 0.2% drop.
US inflation, as measured by the Consumer Price Index (CPI) rose by 1.7%, in the 12 months, to July 2017, which follows a 1.6% gain in June. Janet Yellen, the Federal Reserve (Fed) Chairwoman commented that the 2% inflation target is within reach within the next 2 years. The market expects that the Fed will raise interest rates one further time in 2017.
It is expected that the Fed will announce the start of its quantitative easing being unwound before the end of this year.
UK inflation, as measured by the CPI, rose 2.6% in the 12 months to July 2017, which is unchanged from June’s figure and beat market expectations. Higher inflation in clothing, food and utilities was offset by lower fuel costs. The impact of the weakness in Sterling appears to have peaked, which should mean lower inflation in 2018.
Given the uncertainty over the Brexit negotiations, the market expects UK interest rates to rise in late 2018.
Although there are economic concerns regarding consumers due to inflation being higher than wage rises, there are signs that wages are starting to increase. The Office of National Statistics figures have revealed that earnings growth in the 3 months to June 2017 was 2.1% higher than the same period in 2016, and up from 2% in the 3 months to May and 1.8% in the three months to April.
Unemployment has also fallen in the quarter ending in June, falling 57,000 on the previous 3 months, to 1,482,000. The jobless rate has fallen to a 42-year low of 4.4%. Employment was up 125,000 at 32.1 million, which is the highest rate (75.1%) since modern records began.
UK retail sales increased in July by 0.3%, as strong spending on food offset falls in the purchase of other goods, with all the other main sectors falling. Ruth Gregory, UK economist at Capital Economics, said the retail figures were “fairly encouraging given the recent intensification of the squeeze on consumers’ real incomes and that talk of a sharp consumer slowdown has been overdone”.
The Eurozone economy continues to show proof of the ongoing recovery. GDP growth in the 2nd quarter in the Eurozone rose 2.1% year-on-year, which was marginally ahead of market expectations. Private sector activity surveys continue to indicate robust growth across the manufacturing, services and composite sectors of the economy.
Not surprisingly, the European Central Bank (ECB) is becoming more upbeat on the Eurozone’s economic outlook. The mere speculation that the ECB will pursue less expansionary monetary policy has led to the Euro strengthening. However, the ECB President, Mario Draghi, still maintains that an accommodative monetary policy is required, emphasising the subdued outlook for underlying inflation. Inflation, as measured by CPI, rose 1.3% in the 12 months to July 2017. In April, the rate of ECB asset purchases were reduced from 80 billion Euros per month to 60 billion Euros and this is expected to be maintained for the time being.
The Bank of Japan’s quarterly economic survey indicates that manufacturers are seeing improving business conditions. Economic data shows a virtuous cycle unfolding between gradually rising incomes and consumer spending, supported by labour market tightness (i.e. low unemployment). Japan’s central bank has improved its monthly assessment citing resilient consumption, solid overseas demand and increases in business investment. The Japanese unemployment rate fell to 2.8% in June 2017, down from 3.1% in the previous month. This is the lowest unemployment rate for more than 20 years. However, while economic growth is above trend, inflation remains weak and the Bank of Japan has cut its forecast and pushed back the date for when it expects to achieve its 2% inflation target to around 2019.
China has had encouraging data with GDP growing 6.9% year-on-year in the second quarter of 2017. Industrial production increased 6.4% year-on-year, but this was below market expectations of 7.2%. It is the weakest gain since January this year.
In July, the Chinese economy saw retail sales up 10.4% year-on-year and industrial production up 6.4% year-on-year.
The IMF is forecasting China will grow by 6.7% in 2017 and achieve 6.4% growth per annum between 2018 and 2020; however, the IMF has issued a warning that the level of debt in China is a key risk. Total debt has quadrupled since the financial crisis to stand at $28 trillion, at the end of last year.
The developing economies have benefited from stronger commodity prices, particularly the Latin American economies. Commodity prices are benefiting from Dollar weakness, together with strong economic growth in China.
Brazil should start to benefit from the government passing labour reforms, together with falling inflation. The CPI for Brazil during 2017 has so far averaged 4.01%, whilst the CPI for the 12 months to July 2017 was only 2.71%.
Although, in the last month, North Korea has taken most of the political headlines for the markets, investors must not forget that there are other political risks that are likely to resurface. So far these political risks have had limited impact on the markets, and at worst they have only had a temporary impact before normal service has been resumed.
Although there are political risks, economic data is still supporting the economic growth story and, thereby, markets. Global economic growth is continuing to pick up and this is being seen in the economic data from Europe, Japan and China. There are two economic risks, the first is Donald Trump being unable to implement his economic policies and tax reforms and the second is the level of debt. Not only is the level of debt excessively high in the developed world, but it is becoming excessively high in China. With interest rates at extremely low levels, it is unlikely that the high level of debt will be a problem in the immediate future, but it may store problems down the road.