A void where the government used to be

Just when you think you have seen it all in the Brexit debate, we always find something interesting around the corner. Brexit Secretary Stephen Barclay said yesterday: "The vote is going ahead and that's because it's a good deal and it's the only deal." This morning, Downing Street was telling us that the “meaningful vote” that parliament had been promised on the terms of the Brexit deal was definitely going ahead. This afternoon, the prime minister informed us: “We will … defer the vote scheduled for tomorrow.”

Obviously, the fact that there was a snowball-in-hell’s chance of the deal being ratified would have put the prime minister in an impossible position and called what is left of her authority into question. On only three occasions in the last 100 years has a government been defeated by more than 100 votes and it is pretty easy to construct a scenario in which the Withdrawal Agreement would have been rejected by a majority of around 125. Recall that the 139 vote defeat suffered by Tony Blair’s government in 2003 on the question of involvement in the Iraq War arguably marked the beginning of the end for the prime minister as his authority began to leach away. Theresa May is in a far weaker position and it is questionable whether she would survive such a crushing blow. May’s future, however, is a subject for another day. At issue is where does the UK go from here? 

The PM has made it clear that she intends to meet with other EU leaders to discuss the concerns surrounding the backstop which threatens to leave the UK permanently tied to the EU. However, it is difficult to imagine any circumstances in which the EU will make any concessions. The Commission’s view is likely to be something along the lines of “we gave you a reasonable deal which you can take or leave as you see fit. In any case, you haven’t voted on it yet. Come back and see us when you have.” So May could be forced to put the Withdrawal Agreement to a parliamentary vote, and of course it will be heavily rejected. In this case the prime minister goes to Brussels to repeat her request and the EU27 merely repeats the first part of its answer.

Under these circumstances, the UK would have no option but to request an extension to the Article 50 process. The question is how the UK would then use the extra time made available? Probably the first option it would pursue is a Norway Plus arrangement in which the UK joins EFTA and applies to join the EEA (an option only available to EFTA or EU members). Whilst this would minimise the economic costs, the UK would still be subject to the four freedoms of goods, services, capital and labour. In essence it would be a rule-taker. Indeed, as I noted six years ago in response to the FT’s year-ahead 2013 questionnaire “Anyone with notions that we can negotiate a Swiss or Norwegian-style existence on the fringes of the EU is dreaming. Such an existence would still mean that we are subject to large parts of EU legislation but without any power to change it – something which the euro sceptics would like even less than the system they have now.”

What is worrying is that many politicians still don’t understand this point and they have had six whole years to think about it and a whole lot of information put in front of them to demonstrate it. Maybe, just maybe, they will eventually get it in which case the UK would be mad to pursue such a course of action. I suspect that the other alternatives involve either a general election or – and whisper it quietly – a second EU referendum. An election does not do anything to resolve the Brexit question and should be viewed as a side effect of the current political impasse rather than an attempt to resolve it. With regard to a second referendum, I agree with the PM when she says “if you want a second referendum to overturn the result of the first, be honest that this risks dividing the country again” (as I hope I made clear here). But if politicians cannot agree what form of Brexit they want, they may have no choice but to put the question back to the people.

The reason we might end up in this position is primarily due to the fact the government failed to manage the process. The referendum result was never legally binding but May did all she could to make it sound like it was. She was far too late to face down the Brexit ultras who promised unicorns and cakes and indeed pandered to their prejudices (remember “citizens of nowhere” and “queue jumpers”). Perhaps most damningly, the referendum was treated as a winner-take-all outcome in which the near-half of voters who opposed Brexit were completely marginalised. For those who express sympathy with the PM for the near-impossibility of her task, remember that she made it far harder for herself than it needed to be.

I would not like to predict the outcome of a second referendum (I wouldn’t even like to predict the question on the ballot paper). But if it is a choice of “Remain” or “Accept the current deal” the likelihood is that the UK might not even leave the EU (some polling data here, for what it is worth). Further support for this option comes from today’s ECJ ruling that the UK can unilaterally rescind its Article 50 notification, for it suggests that the EU is giving the UK room for manoeuvre if it changes its mind on Brexit.

Nothing that has happened today has helped markets, with sterling falling to its lowest since April 2017. Although markets fear that today’s events have raised the likelihood that the UK will leave the EU without a deal, I don’t buy it. Nonetheless, there is major uncertainty regarding the nature of the UK’s future relationship with the EU which has put sterling under great pressure and 3-month GBP option volatility is on a par with what we saw around the time of the 2016 referendum (chart). Like nature, markets abhor a vacuum and today’s decision to withdraw the parliamentary vote has exposed a major void where the government used to be.

Predicting nine of the last five recessions

The equity market white knuckle ride continued this week as tech stocks came into the line of fire. At the start of this year I suggested that global stock markets would end the year higher than they began and wrote “I’ll stick my neck out by predicting a rise of 5-10% in the major US and European indices.” That call is not looking good at the present time with European equities well into negative territory and US markets also now in the red, having held up well until this week. However I did point out that “it might pay to reduce the degree of risk exposure – perhaps by switching the top 10% of risky assets in the portfolio for something less risky” and that “a market which is so dependent on tech stocks is clearly vulnerable to a shift in sentiment.”

Despite my apparent over-optimism, I have generally been pretty cautious on stock markets in recent years particularly since the 10-year trailing P/E ratio on the S&P500, as popularised by Robert Shiller, continued to point to a market that was running out of line with fundamentals (chart above). And the higher tech stocks drove up the market, so it was inevitable they would also lead it down. As the chart below (taken from Bloomberg) shows, over the last 12 months the so-called FAANG stocks have outperformed the S&P500 by 14% and have contributed all the increase in the index market cap. At mid-year, the outperformance index was at 37% and it has been hard for some time to avoid the sense that tech stocks have been somewhat bubbly given their stellar rise. Yet the valuations of tech stocks have not been too far out of line. Apple, for example, is trading at a P/E multiple of just below 20x earnings and the Alphabet ratio (the company formerly known as Google) of around 26x is high, but not crazy. This is testimony to the extent to which the FAANG companies have been able to generate exceptional earnings growth.

But some cracks in the façade are beginning to show. Amazon’s narrow miss relative to Q3 expectations, and guidance suggesting that the Q4 earnings season may be weaker than the consensus currently expects, have dampened enthusiasm. Yet Amazon and Alphabet recorded earnings numbers that were 30% and 21% higher respectively than a year ago. So maybe things are not as bad as painted but when they are seen as invulnerable to bad news, any negatives can have a bigger-than-expected impact. I thus tend to view the moves in tech stocks as a catalyst for selling in a market that has become rattled by other issues in the global economy.

The number one concern is the ongoing trade spat between the US and China which is now beginning to impact on corporate America if this week’s Beige Book evidence is anything to go by. We also have to add the fact that the tax cuts implemented at the beginning of this year have given corporate earnings a big lift which will not be repeated next year. As investors look ahead to 2019, they see an earnings outlook that is far less rosy. Looking further afield, Brexit issues; the ongoing dispute between the Italian government and the European Commission, and the diplomatic spat between Turkey and Saudi Arabia add to the sense that all is not well in the wider macro world. Global investors have good reasons to be nervous. 

Then there is the Fed’s rates policy, which looks set to drive interest rates still higher. There are those who believe that the recent market wobble is a good reason for the Fed to pause. I do not see why. After all, if low interest rates were responsible for driving the market up, so higher rates might be necessary to get it back into line with fair value. In any case, it has been slightly puzzling that the market has continued to go up despite the Fed’s tightening, which can only be attributable to the one-off tax cut. A pause that refreshes can only be a good thing. Putting all the pieces together and it is hard to escape the suspicion that in the equity world at least this is as good as it is going to get. This does not mean to say that it is all over. As was the case in autumn 1999, when US markets also wobbled badly, it is possible that there may be a rebound before the final reckoning. 

Yet it does not feel like a rerun of the late-1990s. For one thing, the tech companies are delivering real products that generate earnings rather than the hype which characterised the tech bubble. The global economy is far less frothy – particularly in Europe – and investors are a lot more cautious. Nonetheless, many people I speak to are concerned that the US is setting itself up for a recession on an 18-24 month horizon. Maybe! Or there again maybe not! At times like this, it is always worth recalling Paul Samuelson’s famous phrase that the stock market has predicted nine of the last five recessions.

Will markets feel so brave without central bank protection?

Perhaps one of the more surprising aspects of markets in recent weeks has been the extent to which they have remained resilient in the face of what might be termed extreme provocation. Admittedly there was something of a wobble around the time President Trump decided to end US participation in the Iran nuclear deal, but on the whole they have remained remarkably quiet. Add in the prospect of unrest on Israel’s borders and the ongoing situation in North Korea, and it is clear that there are plenty of geopolitical threats to worry about (not to mention the very fact that Donald Trump occupies 1600 Pennsylvania Avenue).

Not so many years ago, these were the kinds of issues that would have investors running for cover. But equity option volatility continues to ease back and is well below the levels achieved in early February which is a sign of reduced tension. Indeed, the FTSE100 yesterday hit an all-time high, although this was primarily the result of a weaker pound that boosts the sterling value of foreign currency earnings in a market which generates 70% of its revenue abroad. Nonetheless, it does raise a question of why markets can continue to remain steady in the face of numerous headwinds.

One reason is that central banks in Europe and Japan continue to provide huge amounts of liquidity. In European bond markets, the central bank remains a huge buyer and it is almost impossible to get hold of certain bonds – particularly corporate securities – due to the ECB’s actions. Against this backdrop there is little reason for markets to panic in the face of events that may – or may not – cause prices to fall. This is entirely rational behaviour. If investors believe there may be a small dip in prices that will subsequently be reversed as the central bank backstop kicks in, it makes sense to hold onto positions and thus save the trading costs associated with closing them and reopening them again. In other words, markets can be afford to be brave in the face of these threats. But how long might such behaviour persist?

In the US, the Fed has raised rates six times since December 2015, by a total of 150 bps, and it is winding down its balance sheet, so the degree of support which it once provided is being slowly eroded. We are starting to see bond yields creep up with many investors concerned by the fact that the US 10-year yield has hit a new multiyear high, returning to a level not seen since 2011 (3.128%). It is hard to say why rates have edged up so quickly of late but then it was equally difficult to explain why the long end of the curve did not respond as monetary policy was tightened. They are probably now where they should be. In the process, the differential with German Bunds has widened out to around 260 bps – a spread last seen in the late-1980s. So long as the ECB is still engaged in buying Emu bonds, there is little prospect of a substantial narrowing. But before too long – perhaps once the ECB buying programme ends – European yields will also begin to rise. Indeed, Italian yields are already edging up as political concerns mount regarding the formation of a new coalition government.

It currently feels as though we are in the midst of a phoney war as markets digest the implications of Fed tightening. They don’t want to sell because a strategy of shorting the market has not paid off over the past nine years. But as the Fed increasingly normalises monetary policy and the ECB contemplates an end to its QE programme, the special conditions which have supported valuations, and prompted a divergence in asset prices from fundamentals, may well force investors to take a closer interest in some of the global threats which are bubbling up. And they may not like what they see.

A shot across the bows

It is now eleven years since the first indications of the looming financial crisis began appearing on our radar screens. In the summer of 2007, banks began to curtail redemptions from funds which were heavily invested in collateralised debt obligations and subprime bonds. This set in train a series of events that culminated in the bankruptcy of Lehman’s in September 2008, which triggered the biggest economic and financial crash in 80 years. A decade on, and we are only now beginning to see indications that the scars inflicted upon the industrialised world are healing.

The IMF’s World Economic Outlook, released today, points to a further pickup in global growth in 2018 to 3.9% which is the fastest since 2011. The regional composition also increasingly looks more balanced, with slower growth in China and clear signs of recovery in the euro zone. But weak productivity growth and wage inflation in the industrialised world mean that workers may not immediately feel the benefit. Moreover, as the IMF pointed out, even though the global economy is looking stronger, a combination of weak productivity and adverse demographics means that the long-term potential growth rate in the industrialised world will be far slower than in the years prior to 2008 (the same also holds for China which is increasingly an ageing society thanks to the one child policy introduced in 1979 though subsequently abolished in 2013).

This obviously poses a problem for central banks, which wish to take back some of the monetary easing in place for the last nine years, and although the Federal Reserve has begun the tightening process, weaker potential growth will mean there are limits as to how far it can raise rates. But the Fed’s actions – and perhaps more importantly, its rhetoric – have contributed to taking some of the edge off the market rally with equity indices still some way below their end-January highs. My recommendation at the start of the year to reduce the degree of risk exposure in investor portfolios has thus been borne out by recent events. Recall, too, that I expressed concerns regarding the reliance of the US equity rally in 2017 on tech stocks, and the sharp collapse in this sector over the past month affirms my belief that now is not the time for rational investors to be taking risks.

However, I am less sure of my prediction that equities have 5-10% upside compared to end-2017 levels. Aside from the fact that all the good news is already in the price, the trade dispute between the US and China has changed the landscape somewhat and raised uncertainty levels. The actions of central banks are also increasingly a complicating factor.

Whilst the Bank of England looks set to raise interest rates next month, taking them above 0.5% for the first time since 2009, the weakness of inflation and the prospect of a loss of momentum in the real economy suggests that the case for further tightening is weaker than a few weeks ago. Meanwhile, the ECB continues to keep its foot to the floor and its asset purchase programme is likely to continue for another six months. The prospect of a monetary tightening in the euro zone any time soon is remote. But as I have noted previously, there is an argument for more aggressive tightening on this side of the Atlantic. Forget about inflation – the strength of economic activity alone suggests that we no longer need monetary policy on a setting designed to cope with the problems of 2009.

But as one investor asked me today, will this not lead to an undesirable slowdown in activity? It might, but there is a good case for using fiscal instruments to offset some of the pain. After all, monetary policy has done much of the heavy lifting over the past decade, and as the IMF pointed out “all countries have room for structural reforms and fiscal policies that raise productivity.” If we do not see some form of monetary normalisation, central banks will not have much conventional ammunition left to cope with the next downturn. As the IMF’s chief economist Maurice Obstfeld wrote, “global growth is on an upswing, but favourable conditions will not last forever, and now is the moment to get ready for leaner times. Readiness requires not only cautious and forward-looking management of monetary and fiscal policies, but also careful attention to financial stability.”

Markets may not like this prescription, but they have had a good run since 2009 and now it is time to put monetary policy on a sounder footing. European central banks take note.

A risky business

The recent equity sell-off has focused investors’ attention on measures of market volatility, which have been abnormally low for much of the last four years. I did point out last summer that implied equity and bond market had fallen to all-time lows, and that there was a risk of a nasty surprise if investors believed that central banks would no longer continue to provide the unlimited support that they had hitherto (here). In the event, equity market volatility measures fell even further, bottoming out in November, whilst both the Fed and Bank of England since have raised interest rates.

Naturally, this raises the question, why now? And the truth is we don’t know. Many ex-post rationalisations have been offered but I suspect that markets had simply been living off fresh air for too long. It is thus possible that someone, somewhere simply placed a sell order that was picked up by algorithmic trading systems and triggered a widespread bout of selling. But nobody was really surprised that markets did correct sharply downwards, even if the magnitude of the correction caught many people out. Indeed, I pointed out last summer that “if the Fed starts to run down its balance sheet and put some upward pressure on global bond yields, the equity world may look different.”

At this stage, I do not have enough evidence to change my year ahead prediction that equities will finish 2018 up by 5-10% on year-end 2017 levels. But that view looks a little more shaky than it did five weeks ago. Whilst much attention focused on the fact that the correction in the S&P500 on Monday was the largest single daily points decline on record, it is only the 39^th biggest percentage decline on daily data back to 1980 (although that puts it well inside the top 0.5%). Slightly more worrying is the fact that exactly 10 years previously, on 5th February 2008, the S&P500 fell by 3.2% on the day – at the time, the 30^th biggest daily fall since 1980. And we all know what happened later that year …

Recent trends in volatility raise a number of key questions. First, is volatility mean reverting? If so, neither the extremely low levels of 2017 nor the elevated levels of today will be sustained. Second, if market volatility measures do move back towards more “normal” levels, how quickly is this likely to occur? And third, is it possible that the trend volatility level has changed (i.e. that investors risk appetite has changed)?

With regard to the first question, the post-1990 evidence does suggest that equity volatility is mean-reverting although it can diverge from the mean for a considerable period of time. On average since 1990, each period of over- or undervaluation relative to the mean lasted for 17 months, which suggests that the period of adjustment is relatively slow. With regard to the second issue, in 88% of cases since 1990 the VIX was within one standard deviation of the mean (although on only 38% of occasions was it within half a standard deviation). One standard deviation represents a 7-point move in the VIX which is relatively tolerable. It is only when we see the kinds of spikes associated with the bursting of the tech bubble between 1999 and 2002, or the post-crisis period of 2008-09, would high equity volatility threaten to derail the markets.

However, there is a risk that an extended period of low volatility sows the seeds for a period of higher vol. Lower volatility during periods of economic upswing tends to result in higher risk taking and excessive leverage, with the result that even small price declines can force investors to dump asset holdings, depressing prices further and generating higher volatility. This triggers a second round of price declines and volatility spikes which could turn into a self-reinforcing spiral. But as it currently stands, despite the sharp spike in equity volatility in early February, the forward vol curve is pricing in a decline back to levels close to the long-run average over a five month horizon (chart). This downward sloping volatility curve is not indicative of a market which is expecting a significant change in risk conditions.

As for the third question of whether there has been a shift in the trend level of the VIX, and therefore a shift in investor risk tolerance, the jury is still out. We will probably only know after a prolonged period of tighter monetary policy. The most four dangerous words in finance are “this time it’s different.” Any data series which shows strong mean-reverting trends should be treated as such until we have overwhelming evidence to the contrary.

All in all, I am inclined to treat the current trends in markets as some of the air coming out of the bubble rather than as the beginning of a more prolonged sell-off. As many people have pointed out, the fundamental factors which drove markets higher in the first place – strengthening growth and the impact of US tax cuts on corporate earnings – remain in play. But the spike in volatility acts as a reminder that markets are like wild animals: they can act unpredictably and you can never tame them, so you have to act cautiously to avoid getting your face ripped off.

Some thoughts on the 2018 outlook

One of the anniversaries you may have missed was the bicentenary of the first publication of the novel Frankenstein, which first saw the light of day on January 1 1818 when the author, Mary Shelley, was just 20 years old. As you are no doubt aware, the eponymous title referred to the scientist who created the monster which in popular culture now bears his name. A couple more economically relevant anniversaries will also fall in 2018. Assuming that the US economy does not go into reverse, May 2018 will mark the second longest US economic expansion on record, exceeding the 106 month upswing between February 1961 and December 1969. Perhaps of greater symbolic significance, September will mark the tenth anniversary of the Lehman’s bankruptcy – an event which proved to be a Frankenstein moment for the global economy.

From an economic perspective, global GDP growth this year is predicted to post its strongest rate since 2011 with the IMF forecasting a rate of 3.7%. Indeed, there are increasing signs that the global economy is beginning to match the optimism which has long been a feature of financial markets, with Europe likely to be one of the brighter spots after years of underperformance. But markets appear to be in the late stages of a cycle which will soon enter its tenth year, with concerns about the overvaluation of equities whilst in the credit world spreads remain narrow and covenant-lite issuance is on the rise.

As I noted in my previous post, it was possible to rationalise market movements in 2017 on the basis of accelerating global growth, low inflation and a lax monetary stance on the part of global central banks. But one of the features of the current market cycle is that many investors describe themselves as “reluctant bulls.” This suggests that they may decide to jump off the bandwagon in the event of an event which triggers a change in sentiment. This is not to say that I believe markets will necessarily crash, but it might pay to reduce the degree of risk exposure – perhaps by switching the top 10% of risky assets in the portfolio for something less risky. One curiosity of market moves of late is that the surge in US equities is increasingly reliant on a narrow base of stocks. Indeed, the so-called ‘FANG’ stocks (Facebook, Amazon, Netflix and Alphabet) accounted for roughly 17% of the rise in the S&P500 in 2017: If we add Apple, this figure rises to 25%. A market which is so dependent on tech stocks is clearly vulnerable to a shift in sentiment.

Monetary policy is likely to play a more important role in market thinking in 2018. Whilst the market shrugged off US rate hikes during 2017, it will probably have to contend with another 50-75 bps of monetary tightening this year. In addition, the Fed will continue to run down its balance sheet. Admittedly, an expected reduction of $300 million relative to an overall balance sheet of $4.5 trillion does not represent a huge amount of liquidity withdrawal, but to the extent that more air is being taken out of the monetary balloon than at any time in the past decade, it might point to a market which rallies at a slower pace than we witnessed in 2017. I expect that global stock markets will end the year higher than they began and I’ll stick my neck out by predicting a rise of 5-10% in the major US and European indices.

One of the interesting developments to watch in 2018 will be the course of bitcoin prices. There are numerous unknowns regarding the nature of the first digital currency to capture public imagination, notably who holds it. Despite the establishment of a bitcoin futures contract last month, this is unlikely to increase the depth and liquidity of the market so long as institutional investors remain on the sidelines. I still believe bitcoin is a bubble waiting to burst – it is after all currently trading 23% below its mid-December high (chart) – but predicting the future course of events is a mug’s game, as anyone who tried predicting its course last year discovered. I will, however, be that willing mug and predict that the price will end the year lower than where it started.

Politics in the Anglo Saxon world will continue to feel the aftershocks of the great 2016 populist revolt. US mid-term elections will be held in November where attention will focus on whether the Democrats can win back control of the House. Last month’s Alabama Senate election, in which Democrat Doug Jones pulled off a stunning win over his Republican opponent, Roy Moore, is an indication that there are limits to the electorate‘s tolerance of the nastier elements of Republican politics. Moreover, the parties of first-term presidents have in recent years tended to lose seats in the mid-terms, suggesting that there is a chance that the Democrats can mount a political comeback. Whilst I would not put money on it, it does raise a risk that 2018 might be the year in which political gridlock returns to Washington.

On this side of the Atlantic, the Brexit soap opera will continue to play out. In twelve months’ time the UK will be staring Brexit in the face, so it is imperative that progress is made with regard to setting out the terms of the subsequent relationship between the UK and EU. Nothing that we saw in 2017 gives me much hope that the UK government is up to the task. Such progress as we have seen has been dependent on the goodwill of the EU, such as accepting the Irish border fudge as a sign of genuine progress (it isn’t). There is also evidence to suggest that questions are being raised amongst voters regarding the Brexit process and whilst this will not mean that the UK government changes its position, it may be forced to soften it. Undoubtedly, this is a theme to which I will return.

Other things I have been asked about of late include whether I believe the Italian elections due in March are a big deal (no); whether there will be a war on the Korean peninsula (doubtful) and whether Donald Trump will be impeached (no). Unfortunately my clairvoyant abilities do not extend to giving definitive answers to these questions, so let us just say that I would assign a probability of less than 50% to any of them. Of course, the big question of 2018 is who will win the World Cup? I can respond with much more certainty than to any of the issues above: Not Italy.

2017 in review

After an unpredictable 2016, 2017 was unable to live up to that level of excitement – and I for one am extremely thankful for that. From a macroeconomic perspective there were certainly no fireworks: GDP growth in most parts of the world was steady, and in Europe it outperformed expectations – even in the UK, where recent data revisions suggest a growth rate closer to 1.8% in 2017 rather than the long-predicted 1.5%. Central banks did not have a lot to do, other than the Fed which raised rates in three steps of 25 bps, although the Bank of England surprisingly stepped into the ring with a 25 bps rise in November. The lack of both wage and price inflation is becoming an increasing cause for concern in many parts of the industrialised world, although policymakers hope that ongoing recovery in 2018 will eventually prompt a pickup.

In this benign environment markets continued to make hay, with equity indices on both sides of the Atlantic setting new highs. This confounded one of my predictions for 2017 which was that the ongoing equity rally would peter out in the spring. Many measures of equity valuation certainly appear elevated: Robert Shiller’s long-term trailing P/E measure for the S&P500 is currently at the level seen at the time of the 1929 Wall Street crash and is only exceeded by the levels of the late-1990s tech boom (chart). A measure of the S&P market cap relative to US GDP is also running at levels which in the past have preceded a bust. Add in the fact that measures of market risk, as proxied by option volatility, have touched record lows in the course of 2017, suggest that this is a market which looks too frothy.

That said, solid growth and low inflation add up to a goldilocks scenario for most investors, particularly with central banks continuing to offer cheap money. But if we think about equity P/E ratios, the denominator (earnings) is currently not being driven by rapid price inflation: Corporate profits generally reflect the solid growth picture. Investors are thus prepared to pay a sizeable premium for equities, which is normal in a low inflation environment. Thus, a focus on elevated P/E ratios may paint an overly pessimistic market view. This does not mean we can afford to be complacent and I will look at the 2018 outlook in my next post, but given the macro and monetary policy backdrop, we can at least rationalise market movements in 2017.

Indeed, markets have shrugged off the biggest risk identified 12 months ago: politics. In that sense, one of my 2017 predictions was borne out when I wrote in early January that “I would be surprised if Donald Trump can do much damage to the US economy in 2017.” To my surprise, the administration did manage to force through its planned tax reform before year-end, with the proposed cuts in corporate taxes giving equity markets a boost. Refinements to the package suggest that the longer-term economic impacts may not be quite as bad as initially expected, with analysis by the Tax Policy Center pointing to a short-term GDP boost and a smaller rise in the deficit over the longer-term compared to the analysis it produced in June.

On this side of the Atlantic, fears that the populist surge unfolding elsewhere would find renewed expression in the Dutch and French elections proved unfounded. Indeed, the emergence of Emmanuel Macron was one of the biggest political surprises, and a positive one at that, with Europe at last finding a charismatic centrist politician committed to the liberal democratic ideas which have underpinned the peace and prosperity of the last 70 years. But the German election did provide an upset as voters deserted the two main parties in favour of smaller groups, with the AfD emerging as a relative winner. The fact that Germany has not yet managed to form a coalition government more than three months after the election is an indication that Europe’s largest economy is not without its own political problems, and the general consensus is that Angela Merkel has entered the twilight of her political career. The fact that the twin motors of the EU project continue to run out of synch suggests that the EU reform process may not make much headway in the near term.

Which brings us to Brexit, a subject that has taken up so much of my time in recent years. I assigned a 45% probability to the likelihood that the UK government would trigger Article 50 in March without making any contingency plans in the event that discussions with the EU proved more difficult than expected. But in effect, that is precisely what happened. The UK remains a divided and polarised country characterised by an absence of effective government. On Friday, Andrew Adonis, a Labour politician who chaired the national infrastructure commission, resigned citing the dysfunction at the heart of government and accused the prime minister of being “the voice of UKIP”. 

To quote Adonis, “I do not think there has ever been a period when the civil service has been more disaffected with the government it serves. I do not know a single senior civil servant who thinks that Brexit is the right policy, and those that are responsible for negotiating it are in a desperate and constant argument with the government over the need to minimise the damage done by the prime minister’s hard-Brexit stance. It is an open secret that no one will go and work in David Davis’s department, and Liam Fox is regarded as a semi-lunatic.”

Whatever one’s views on Brexit, Adonis’ comments highlight what many of us have suspected for a long time: The government does not have a plan, without which Brexit will be an utter car crash. And to think, the Conservatives remain the largest party in parliament (despite losing their majority following a spectacularly incompetent election campaign). What does that say about the opposition? Or indeed us? We deserve better in 2018.