US political divisions, its changing relationship with China and “major insurrections” within the EU are the key geopolitical challenges that investors will have to consider in 2019, according to Brooks Macdonald’s Jon Gumpel.
Gumpel, manager of the five FE Crown-rated Brooks Macdonald Defensive Capital fund, said that while markets will have to consider the ongoing impact of the withdrawal of liquidity from markets, there are several political challenges that could also take a toll.
It is the political issues often discounted by investors that pose a greater threat to markets in 2019, he said, identifying three key themes that should be on everybody’s radar.
The first of these themes is an increasingly divided US government. President Donald Trump’s Republican Party lost control of the House of Representatives – the lower chamber of US government with the ability to issue bills relating to raising revenue and impeachment of senior officials – to the Democrats during the midterm elections in November.
The two sides came to a stand-off just before Christmas as Trump placed the government in shutdown after failing to get amendments to a budget bill apportioning $5.7bn in federal funds for a US-Mexico border wall, a key election promise during his campaign.
“The US is beset by internal divisions,” said Brooks Macdonald’s Gumpel. “What does that actually mean? I think it means that there is scope for greater volatility.”
Performance of index over 1yr
Source: FE Analytics
As can be seen above, the CBOE SPX Volatility VIX index – Wall Street’s so-called ‘fear gauge’ and a measure of US equity market volatility – spiked over the Christmas period.
“You’ve got a president who is – well, let’s be generous – ‘forthright and front footed’, with a similarly aggressive House of Representatives led by the opposition party,” Gumpel explained. “Now you have the potential for conflict in the US, which I think we’re already seeing.”
He added: “People say politics doesn’t matter but it absolutely does: it’s now having a major impact on the US. Does the shutdown aid either the general economy or general sentiment? No and no.”
The second geopolitical theme – and another hangover from 2018 – is the changing relationship between the US and China.
Markets were shaken last year by the levying of tit-for-tat tariffs by the US and China, as Trump took a more aggressive approach to perceived ‘unfairness’ over trade between the two, intellectual property theft and security concerns.
US trade in goods with China 2000-2018 ($m)
Source: US Census Bureau
However, what many commentators have overlooked, according to Gumpel, is the changing internal politics of China and how that could have serious consequences for its relationship with the US.
“If China is on the path to gradually becoming a member of the world’s enlightened nations then the US can be happy in a partnership that is not necessarily tied to its economic advantage,” the Brooks Macdonald Defensive Capital manager said.
“But if China is a dictatorship – and by which we mean a Chinese premier who has removed the means by which he is replaced and is effectively a longer-term dictator – then that does lead to greater volatility.
“Why? Because it changes the relationship with the US and, also, it changes relations internally in China.”
Gumpel added: “Does Xi Jinping have a whole range of enemies that he might not have had? Yes, he has the power, but he also has a whole range of people to stick the knife in if the opportunity comes up because their progress up the chain is shortened.”
More importantly, he said, the US-China relationship that has been in place since the late 1970s and driven the global disinflationary growth of the past 30-40 year is “not just ending, but even reversing into a political hot war and economic cold war”.
“That is actually not just a risk to markets and volatility but a structural risk,” he said. “What you will see is not just greater volatility but also reduced longer-term growth and shorter-term growth.”
The manager said Chinese manufacturers had boosted orders during the latter part of last year to beat the next round of tariffs but that the economy might slow this year, this could lead to deflation and have a significant impact on the US economy.
“In our view equity markets might bounce around but as more people get it and get that the world is very different, we think that is going to be a change going forward,” he added.
Gumpel’s third geopolitical issue is the “major insurrections” that the EU is facing on two fronts: Italy’s budget problems and Brexit.
“The shorter-term major issue is Italy unless there is a ‘no-deal’ Brexit in which case Europe has a major problem,” he said. “And I think Europe is probably a bit less well-prepared for it than the UK. But who knows what’s happening.
“For us the only thing about Brexit is in an environment where political risks are growing globally the only thing is that Brexit has the potential to be a trigger and who know where that is going to go.”
Given the ongoing challenges of normalising interest rates and withdrawing liquidity from the market, Gumpel said geopolitics is a real concern.
“If you look, a lot of the global economy politics is causing real economic damage and that is definitely a headwind to markets in a situation where people are saying that we’re overdue a recession,” he said.
“In order for markets to improve further from these levels we need to see a proper cessation of the US-China issue and I’m not convinced we’re going to.
“If we do that would great, but the reality is that the US no longer sees that it is in their longer-term strategic interest to develop and maintain China for China’s benefit.
“If you look at the things the US requires [of China], it would be a humiliation for Xi Jinping and I don’t think they’re quite ready for that.”
Gumpel concluded: “Our view is that we don’t think this is going to be a particularly easy year: it may well be that we get a very nice, strong relief rally or it may well be that central banks and politicians decide to reduce their quantitative tightening, in which case who knows [what will happen]?
“The reality is the trajectory of economies is probably – in the medium and longer term – lower.”
Performance of fund vs sector since fund strategy change
Source: FE Analytics
Since its strategy was changed in March 2010, Brooks Macdonald Defensive Capital has made a total return of 61.50 per cent compared with a 21.10 per cent gain for the average IA Targeted Absolute Return peer, although it should be noted that the sector is home to a wide range of strategies.
The fund has an ongoing charges figure (OCF) of 0.81 per cent.