Focus on fundamentals: Politicians and policies come and go, but it is the economy that drives the stock market – and nothing else, says Russell Taylor
Set against a backdrop of a renewed fall in sterling, the first week of October saw the FTSE 100 index near a record high. Sterling then plunged sharply in Asian markets on 7 October – a faulty algorithm according to some sources, a misreading of the Conservative policy on Brexit according to others.
Politics or economics
Whatever the cause, the episode shows the eagerness of dealers – whether robots or humans – and their difference from regular investors. Stock markets are not moved by politics, only money. The pound’s fall from 1.30 to 1.10 against the euro is bad news for skiers preparing for their holidays, but good news for business.
Nissan manufacturing cars in Sunderland is immediately better off compared to VW in Wolfsburg, while small and medium-sized enterprises will find that their continental competitors’ products are now more expensive than their own.
This is one of the benefits of floating exchange rates, whereby currencies can adjust to the movement of competitive forces. We no longer live in the world of old-style devaluations encapsulated by Harold Wilson’s infamous ‘pound in your pocket’ comment during the sterling crisis of 1967.
It is a short-term tonic, one that allows economies and politicians to adjust smoothly and quickly – and very welcome because of the profound changes now facing the British economy.
Preparing for change
It is the economy that will determine the course of the FTSE 100 and other, related, indices. Companies will either make good profits, so pay dividends to their shareholders, or they cannot. Despite the increasingly global focus of our largest indices, to a large extent this is still determined by demand within the domestic economy.
Brexit is the end of the UK as the preferred choice of foreign inward direct investment – the advantages of English law and language plus full, unfettered access to the EU.
What that will mean in terms of employment and economic growth will not be known for some years yet. In addition, business must adjust to a very different style of government. The new prime minister has made it clear that the Blair-Cameron era, when the UK could cosy up to international business, is over.
This is going to be a more authoritarian government, imposing its wishes on companies – whether that be immigration, workers’ rights, minimum wages, payment of tax – and even, perhaps on the Bank of England’s (BoE) monetary policy.
A change in government policy is desirable in principle, but the Conservative party conference in Birmingham gave little evidence that ministers or the party faithful had much idea of what they were doing.
Most still believe in a simple world of business, where a product is made in Britain and exported to a foreign market. However, globalisation has turned that simple model into a cat’s cradle of worldwide supply chains. That domestically made product is actually a complex integration of different electronic and mechanical parts, each of which must satisfy regulations concerning rules of origin and quality standards.
This ignorance is dangerous, for the UK is dependent on foreign-owned business for its success, and especially so the City of London. These firms import staff because they cannot find the skills they need in Britain.
Neither at the conference itself nor in the media was there any discussion of why immigration is so high – the skills shortage is not due to the lack of grammar schools, but of the technical schools for the manually and technically gifted that were promised in the 1944 Education Act, but never provided. The classics are all very well, but not in a world of robots.
Hard slog
The government has stated that it will trigger Article 50 by the end of March 2017, and most readings of the runes suggest that it will be a hard Brexit – that is, an end to freedom of movement of labour, as well as a denial of any rights to the European courts. This also means leaving the single market. But much the government is committed to negotiating a free trade agreement between the EU and the newly sovereign UK, and this is a process that will take years.
It will be a war on two fronts. The new prime minister does not like it, but Brexit has finally propelled constitutional reform to the forefront of British politics. Theresa May must keep the Scots happy, but also needs to be aware of the growing interest of the Welsh and Irish assemblies in these talks, as well as that of London.
On the other side, she has to deal with 27 separate European countries, disunited in the Council of Ministers, but united on one thing only. Whatever deal is struck, it must discourage any other country from daring to follow the UK out of the EU. Should the Council falter under pressure from national business interests, then the Commission itself can object, while the famously disputatious European Parliament is only awaiting the opportunity to flaunt its power of veto.
Mad central bankers
These challenges must be faced despite UK growth proving insufficient to reduce the heavy burden of government and personal debt: the main cause of the 2007/08 crises. Meanwhile the pressure on central banks from governments that are terrified of voter reaction to the supply side reforms that should be implemented has sent them mad.
During 350 years of complicated history, the BoE decided that the real cost of money was about 2 per cent plus or minus inflation and deflation. Monetary policy was the setting of a cost of money that prioritised the best investments and discouraged those that could not meet the interest bill.
Since the banking crisis the BoE, together with other central banks, has decided that quantitative easing is essential to the health of the economy. The supply of money has been stepped up and interest rates reduced to nothing. The theory is that if the rich are made richer, through asset price inflation, then a few crumbs will drop from their table to make us better off.
An interesting theory, but as Winston Churchill said “however beautiful the strategy, you should occasionally look at the results”. These results have seen Western economies fail to gain economic traction; bond prices in a bubble; and a financial crisis threatening insurance companies and banks that can no longer earn enough from government securities to meet their liabilities for pension and annuity payments.
Inflation is the answer
The only answer is inflation, although central bankers will need to change their policies to bring that about. That may come about anyway: monetary systems never last forever. The gold standard died in 1931, to be replaced by a system devised in part by John Maynard Keynes. The current system has lasted 45 years, since Mr Keynes’ Bretton Woods agreement collapsed in the 1970s.
Therefore investors need to concentrate on not losing what they have. Cash is safer than government bonds, even though no return can be captured and it will be hurt by inflation. Equities at least produce a return, but will endure capital losses once markets adjust to the loss of control by central banks, or even the loss of confidence in paper money.
However, economic demand has fled the Western world, and is only found among the developing middle classes of Asia. And technology is making business more efficient, even as it is threatening mass unemployment.
Equities are not homogenous, for there is a world of difference between conservative and racy shares. What is needed is not index trackers, nor common- or garden managers, but investors with vision, passion and courage. They exist, and can be found, albeit with some difficulty.
