Investors are currently enjoying a period of relative calm. The S&P500 has enjoyed two successive weeks of gains. Bond investors are less fearful of inflation than they were a month ago, so yields have stabilised. Future interest rate hikes appear priced in.
But November may see two themes emerge that upset this.
First, U.S tech stocks appear over-valued even after the 30% year-to-date decline in the NASDAQ index. Last week’s share price falls in the sector, after disappointing third-quarter results from most of the major companies, may well persist.
Second, in the U.K., new Prime Minister Rishi Sunak must keep the gilt market and sterling on side to ensure borrowing costs don’t spike again. This could prove very tricky over the coming weeks.
Of course, in addition to these issues are ongoing geopolitical issues such as the war in Ukraine, China’s designs on Taiwan, hawkish central banks and the strong dollar. And what will be the impact on U.S government policies if Republicans do well at the coming mid-term elections?
U.S big tech
Last week saw some headline-grabbing falls in earnings, and share prices, from big U.S. tech companies (e.g., Meta and Amazon). Further disappointment seems inevitable.
Investors have widespread suspicion that bottom-up analysts, who follow individual companies’ earnings outlooks, are too optimistic in their guidance. Their forecasts do not fit with forecasts of recession in the U.S and Europe, as inflation and rising interest rates and unemployment weaken demand.
Optimism in earnings leads to elevated valuations in the tech sector. Despite the share price falling last week and the particularly heavy fall for social media companies’ stock prices, the NASDAQ index is still on a price/earnings ratio of 26. This is in the middle of its range over the past five years.
Meanwhile, the cost of capital, which is a key factor in valuing long-duration assets such as tech, has risen sharply.
U.S. tech faces an unpleasant mix of a strong dollar, ‘higher for longer’ interest rates on borrowed capital, weaker consumer and business demand growth, and falls in advertising revenue.
Meanwhile, growing geo-political tensions with China, a significant supplier and market, complicate the outlook for costs and revenue. President Xi of China has made it clear he wants China to be self-sufficient in technology. This will mean state subsidies going to China’s tech sectors that will, inevitably, reduce Chinese demand for U.S equivalents.
Against this background, Elon Musk’s $44bn acquisition of Twitter last week, financed with $13bn of bank borrowing and based on a valuation made in April, looks…brave.
U.K. politics, gilts and sterling
U.K. Prime Minister Rishi Sunak must be seen as a master of his government for the fall in gilt yields over the past fortnight and the rally in sterling to be maintained.
This will be difficult to do as he tries to push through Parliament £40bn of tax hikes and public spending cuts, to be announced in a Medium-Term Financial Statement on November 17. Conservative Party Members simply do not have the appetite to explain to their constituents why these are necessary at a time when real incomes are falling because of high inflation.
A rebellion of just 36 Conservative MPs would mean the legislation falls at its first hurdle. And the party is deeply divided.
Internal party opposition to Sunak comes largely from two sources: loyalists to Boris Johnson, who considers Sunak a traitor for resigning as Chancellor in the summer, precipitating Johnson’s downfall. The second group are hard line-Brexiters, who are always watchful in case a pragmatic approach to the problems Brexit has thrown up fails to pass their test of ideological purity.
The Brexit lobby has two pieces of legislation they wish to safeguard, both antipathetical to stable government and economic growth. Investors will hope they wither away, but Sunak is pressing on with them to keep his party together.
First is the Retained EU Law (Revocation and Reform) bill, which puts a sunset clause on all EU-derived legislation currently in the UK statute book, which must be either ‘revoked or reformed’ by the end of 2023. It cleared its second reading in the House of Commons, so it appears set to become legislation.
Business fears many of the regulations it operates under will be changed, creating uncertainty and hindering investment spending for little practical gain.
The second is the Northern Ireland Protocol Bill, initially drafted by Liz Truss when she was Foreign Secretary earlier this year. It has just entered the House of Lords.
Sunak has told the hard line-Brexit supporters that he is ‘committed’ to this bill, which will unilaterally override the Protocol terms agreed upon with the E.U. This is despite having blocked it last October, when Chancellor, because of the risk of retaliation by the E.U.
Brussels has threatened to give a year’s notice before tearing up all Brexit-related agreements, as it is entitled to do if the bill is passed. Exports to the E.U. have recovered much slower than expected after the pandemic, largely due to the administration and costs associated with Brexit. If existing trade arrangements are torn up, with nothing to replace them, the E.U. will be able to apply quotas and -effectively- ban imports from the U.K.
In addition, the U.K. government has been warned by President Biden that a trade deal with the U.S. will be off the table.
Juggling party unity with the demands of the gilt market and sterling will be difficult for Sunak. Expect a return to volatility in both markets if he fails to find the thin line in the middle.
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