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It would be easy to react to the string of Brexit supporters belatedly admitting that leaving the EU’s single market and customs union was bad for the British economy by saying “told you so”. So here goes: told you so.
Inexorably, year by year, evidence accumulates of the damage done. Not just did the fall in the exchange rate after the referendum inflict a painful shock, but overall trade has lagged behind that of similar economies, and business investment has been strikingly weak.
Is there a way to undo this damage in the short to medium term? Unfortunately, the political toxicity of the UK’s relationship with the EU, and the Labour opposition’s tactic of being at least half as mule-headed as the government at all times, means any dismantling of barriers with the single market will be slow and piecemeal. A Horizon Europe research programme here, a labour mobility agreement there, a veterinary deal somewhere down the line. And all subject to the EU’s unhelpful aversion to smudging the hard line between the easy market access afforded to member states inside its legal order and the tough border bureaucracy for those without.
The maddening thing is it’s not as if the UK has given in to mindlessly constructing trade barriers across the board. So far, the rest of Britain’s trade policy (the prince-free parts of Hamlet, you might say) is pretty sensible and for the most part fairly well executed.
The UK’s ability to run two trade policies animated by different philosophies under one government is startling. At a World Trade Organization summit last week, British ministers and officials paraded their progressive free-trade internationalist credentials. Anne-Marie Trevelyan, the UK trade secretary, told the FT that other (unnamed) governments at the meeting had told her “how important UK leadership is in support of the values of free and fair trade in the rules-based order”.
At one point, the UK made a big show of its independence of mind by being the last government to hold out against a proposal to override a WTO agreement on intellectual property rights regarding Covid vaccines. In this way it struck the somewhat paradoxical pose of being a lone fighter for multilateralist principles.
Outside the WTO, the UK’s preferred gang in world trade is the Asia-Pacific, where its attitudes and conduct are pretty sound. On top of its bilateral deals with Australia and New Zealand, a digital agreement with Singapore has just gone into force and the UK is closing in on an agreement with India.
In some areas, such as its willingness to embrace agricultural liberalisation and address digital issues such as data flow in trade deals, its activities mark a constructive change from EU trade policy. In others, including its eagerness to accept a weak trade deal from India rather than emulate the EU’s determination to hold out for something more substantive from New Delhi, it’s a sign of geostrategic expedience driving commercial policy.
But, either way, the UK in its non-EU dealings is proving, broadly speaking, a competent negotiator and constructive participant in line with the country’s internationalist free-trade tradition. By contrast, its dealings with Brussels since Brexit have been reactionary and damaging. The commitment to the international rule of law on which it prides itself in the WTO is entirely absent in its threats against the Northern Ireland protocol. Its neurotic aversion to co-operation is childish and self-destructive.
A common Brexiter argument was that opportunities elsewhere would offset and ultimately outweigh the shock to trade with the EU. It’s theoretically possible that this could still happen, or that the government’s hunt for domestic deregulatory Brexit dividends will at some point bag some substantive game. But so far, the net effect of the UK leaving the customs union and single market is very clearly negative.
The Asia-Pacific remains far away, however hard you squint. The UK’s dysfunctional relationship with its largest and closest trading partner greatly outweighs anything constructive it is doing elsewhere, including at a multilateral level. Again: told you so.
The broad weakness in UK business investment, including by domestic companies, and of trade with non-EU economies, is particularly striking. It suggests that it isn’t just border frictions with the continent that have hurt the economy, but a general uncertainty among companies and a sense that economic policy is in the hands of a government that doesn’t know or care what it’s doing.
A digital partnership with Singapore — which in any case needn’t be incompatible with EU single market membership — is fine. But it’s not a substitute for an open and constructive relationship with the trading area the UK so recklessly left.
The Biden administration has placed five Chinese companies on an export blacklist for violating sanctions by allegedly providing support to Russia’s military and defence companies before and during the invasion of Ukraine.
The commerce department put the Chinese firms on the “entity list”, which effectively bars US companies from exporting to them. The companies, which are not globally recognised names, are Connec Electronic, King Pai Technology, Sinno Electronics, Winninc Electronic, and World Jetta (HK) Logistics.
“Today’s action sends a powerful message to entities and individuals across the globe that if they seek to support Russia, the US will cut them off,” said Alan Estevez, under-secretary of commerce.
The blacklisting was announced as the US grows increasingly worried about strengthening ties between Beijing and Moscow, particularly after Xi Jinping and Vladimir Putin in February signed a statement that described the China-Russia partnership as having “no limits”.
The Financial Times reported in March that China had signalled a willingness to provide military assistance to Russia, which set off alarm bells in Washington.
Over the past two months, Jake Sullivan, US national security adviser, and Lloyd Austin, secretary of defence, have warned their Chinese counterparts that Washington would take strong action if China gave Russia any military equipment or assistance. US officials said there was no evidence that China has provided military assistance.
The commerce department did not accuse the Chinese government or military on Tuesday of supplying equipment to the Russian army. “We have not seen China provide Russia with military equipment or systematic evasion of sanctions,” said a White House official.
But the decision to place the companies on the entity list emphasised the broader concern about ties between China and Russia. It also marked the first time that President Joe Biden’s administration has penalised Chinese entities for helping the Russian military since Putin launched the invasion of Ukraine in February.
Chinese and Russian nuclear bombers flew over the Sea of Japan last month while Joe Biden was in Tokyo, further stoking US anxieties. Experts said the exercise highlighted how Beijing was co-operating with Moscow even as Russian forces waged their assault on Ukraine.
The Chinese embassy in the US said Beijing was playing a “constructive role” in promoting peace talks and had not provided military assistance to Russia.
“China and Russia maintain normal energy and trade co-operation, and the legitimate interests of Chinese companies should not be harmed,” said an embassy spokesperson, who criticised Washington for imposing unilateral sanctions under its “long-arm jurisdiction”.
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Good morning. Ugly day for stocks yesterday. The blame was pinned on a bad reading on the Conference Board’s consumer confidence index. Feels more like a market looking for an excuse to sell, though. And for good or bad, the market half-life of economic data is measured in hours at this point. Email us with measured, sensible, long-term views: firstname.lastname@example.org and email@example.com.
Working on yesterday’s letter about long-maturity corporate credit, I chatted with Jim Sarni, a principal at Payden & Rygel, a good friend of Unhedged. He pounded the table a bit, saying that I had things backwards: the real opportunity was in the short to middle bit of the curve.
“It’s appealing from the simple standpoint of, where the hell do I put my money right now, whether as an institution or a private investor,” Jim says. “And it can appeal no matter what view a person has — that we are facing Armageddon, or we are going to be fine.”
The argument goes like this. A portfolio of investment-grade corporates with an average duration around 2.5 years provides a yield of up to 4 to 4.5 per cent. “Doing the math on the back of a napkin,” Sarni says, “that means Treasury yields can move up another 180 basis points or so before total return to the investor turns negative.”
The two-year Treasury, roughly mirroring the expected peak for the fed funds rate, is yielding 3.1 per cent. Suppose that does move up to, say, 4.6 per cent. Now your basket of mid-duration corporates are barely at break even. But under those circumstances, equities and longer-duration bonds will probably be doing a lot worse than break even. Losing only a little money might have you feeling pretty good. And if rates fall (or spreads tighten), there will be bonus returns along the way.
CPI, of course, is running at 8 per cent or so, which makes a yield of half a lot less enticing. Sarni is undeterred: “You’ve gotta be somewhere. Eight per cent is not a long-term number. It’s 8 per cent coming down. Over the duration of this portfolio inflation won’t be close to 8 per cent — north of 3, south of 4, maybe?” Sarni thinks that, given the palpable slowing in the economy when the Fed is only halfway to its anticipated destination, the bet is tilted towards lower inflation and rates. And if the Fed pushes the economy into a hard landing, you could do worse than owning the debt of companies “that are going to weather the storm just fine”.
For a proxy of the kind of portfolio that Sarni is talking about, you can look at, for example, the Ice BofA 1-5 year corporate ex-144a index (yield to worst 4.25 per cent, average duration 2.7 years); or the Bloomberg US corporate bond 1-5 year index (yield 4.33 per cent, duration three years). Here is the price and spread of the latter over the past year:
Keen to hear from our readers in the bond business whether they also see value in this bit of the curve.
We’ve been asking around these parts what the next 60/40 portfolio — 60 per cent stocks for growth, 40 per cent bonds for stability — should look like if we are moving into a world of persistently higher inflation. In such a world, the glorious negative correlation of bonds and stocks of the last 30 years or so may be nothing but a memory.
We call this replacement, affectionately, the dumb portfolio. It has to generate decent returns over a long horizon, require little active oversight and can’t be too complex. There also have to be enough assets for a broad swath of investors to pile in. Inflation-linked I-bonds, for example, have less than $60bn in circulation. They don’t fit.
We noted last time that commodities looked better as an inflation hedge than as a way to grow capital. A few readers pointed out that we used an index that understates how well commodities have done by focusing only on raw price performance. They rightly suggested we try a total return index instead, which includes the extra yield earned by the collateral, usually Treasury bills, that must be held against commodity futures. The difference is noticeable:
Still, this is not a resounding growth story. The latest rally puts us back to early 2000s levels. The last sustained period of appreciation before that, from the early 1980s to early 2000s, saw commodities grow 531 per cent, versus over 2,000 per cent for the S&P 500. Unless you believe a commodity supercycle is coming (lots of people do!), expect a growth trade-off for the diversification benefit.
Another possibility is publicly listed infrastructure projects. Tim Robson, spooked by inflation a year ago, wrote that he cut out his 35 per cent bond allocation to add infrastructure and has liked the results:
This construct has performed as I hoped with significant gains and yield from this infra allocation offsetting my equity losses since the turn of the year.
In the UK this shift was relatively easy to achieve by buying a selection of UK listed infrastructure investment trusts.
Several readers suggested getting exposure to factors such as value or momentum. Here’s Caleb Johnson, formerly at AQR and now at Harbor Macro Strategies:
Investors don’t just need exposure to more asset classes, like commodities, they need exposure to factor and style premia. Yes, this has typically been available mainly through private investments . . . but they are also available through “liquid alts” in the form of mutual funds and [exchange traded funds] that non-accredited investors can access as well.
Consider a style factor like momentum. A commodities ETF treats an entire asset class like a monolith and is only going to give an investor passive exposure to it. But a factor-oriented fund is going to do more than offer long-only exposure, allowing investors to profit from exposure to individual markets across asset classes even when they are going down in price.
Along similar lines, Philip Seager at Capital Fund Management wrote that trend following, factor investing’s close cousin, looks promising:
Not only is it a diversifier (on average zero correlated with equities) but also has mechanical features that make it a hedge against long, drawn out, protracted moves down in equities (see the 2008 crisis for example). We have also shown recently that TF as applied to commodities provides an effective hedge against inflation (end 2021 and 2022 year-to-date demonstrate this). On top of all this because of its long term nature and exposure coming from very liquid futures contracts it also scales very well.
We don’t deny the proven power of trend following and factor investing (when done right) but wondered whether the underlying concept might be too complex, even if you can buy it in an ETF. In general, the point of the dumb portfolio is maximum returns given minimum trust in your fund manager. Factor investing asks for a lot of trust.
Paul O’Brien, a 60/40 optimist, suggested a simpler change:
The key premise of the 60/40 is not the negative correlation of stocks and bonds. It is the low covariance of stocks and bonds. Bonds are less volatile than stocks and so will diversify a stock portfolio (lower portfolio volatility) even if the correlation is [positive].
Rather than ditching the 60/40, investors may want to hold lower-duration bonds, or [Treasury inflation-protected securities].
Could building the inflation-proofed dumb portfolio be as easy as take 60/40, sprinkle in some Tips and small caps, and call it a day? (Ethan Wu)
Is the Fed tightening faster than it thinks?
The writer is president of Queens’ College, Cambridge, and an adviser to Allianz and Gramercy
The markets are evolving their minds about US economic prospects just as the Federal Reserve has been scrambling again to catch up to developments on the ground.
This risks yet another round of undue economic damage, financial volatility and greater inequality. It also increases the probability of a return to the “stop-go” policymaking of the 1970s and 1980s that exacerbates growth and inflation challenges rather than addressing them.
Good central bank policymaking calls for the Fed to lead markets rather than lag behind them, and for good reasons. A well-informed Fed with a credible vision for the future minimises the risk of disruptive financial market overshoots, strengthens the potency of forward guidance on policy and provides an anchor of stability that facilitates productive physical investment and improves the functioning of the real economy.
Coming into the second half of June, the Fed had already lagged behind markets twice in the past 12 months and in a consequential manner. First it stubbornly held on to its “transitory” mischaracterisation of inflation until the end of November, thereby enabling the drivers of inflation to broaden and become more embedded. Second, having belatedly course-corrected on the characterisation, it failed to act in a timely and decisive manner — so much so that it was still injecting exceptional liquidity into the economy in the week in March when the US printed a 7 per cent-plus inflation print.
These two missteps have resulted in persistently high inflation that, at 8.6 per cent in May, is hindering economic activity, imposing a particularly heavy burden on the most vulnerable segments of the population, and has contributed to significant market losses on both stocks and government bonds. Now a third mis-step may be in the making as indicated by developments last week.
Having rightly worried about the Fed both underestimating the threat of inflation and failing to evolve its policy stance in a timely manner, markets now feel that a late central bank scrambling to play catch-up risks sending the US economy into recession. This contributed to sharply lower yields on government bonds last week just as the Fed chair, Jay Powell, appeared in Congress with the newly-found conviction that the battle against inflation is “unconditional”.
The markets are right to worry about a higher risk of recession. While the US labour market remains strong, consumer sentiment has been falling. With indicators of business confidence also turning down there is growing doubt about the ability of the private sector to power the US economy through the major uncertainties caused by this phase of high inflation.
Other drivers of demand are also under threat. The fiscal policy impetus has shifted from an expansionary to contractionary stance and exports are battling a weakening global economy. With all this, it is not hard to see why so many worry about another Fed mis-step tipping the economy into a recession.
In addition to undermining socio-economic wellbeing and fuelling unsettling financial instability, such a mis-step would erode the institutional credibility that is so crucial for future policy effectiveness. And it is not as if Fed credibility has not been damaged already.
In addition to lagging behind economic developments, the central bank has been repeatedly criticised for its forecasts for both inflation and employment — the two components of its dual mandate. A recent illustration of this was the sceptical reaction to the Fed’s update on monetary policy released on June 15.
The scenario that worries the market — the Fed aggressively hiking rates only to be forced to reverse by the end of this year due to the threat of recession — is certainly a possibility, and it is not a comforting one.
There is another equally possible alternative, if not more likely and more damaging economically and socially: A multi-round flip-flopping Fed.
In this scenario, a Fed lacking credibility and sound forecasts would fall in the classic “stop-go” trap that haunted many western central banks in the 1970s and 1980s and remains a problem for some developing countries today lacking policy conviction and commitment. This is a world in which policy measures are whipsawed, seemingly alternating between targeting lower inflation and higher growth, but with little success on either. It is a world in which the US enters 2023 with both problems fuelling more disruption to economic prosperity and higher inequality.
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