In our final Market Outlook of 2018, we take a look at three major geopolitical events over the fourth quarter 2018 and into 2019: the final stretch of the Brexit negotiations, the Italian budget proposal and the US midterm elections
As we enter the final quarter of this year, we expect three geopolitical events to overshadow the more conventional market drivers like corporate earnings or macroeconomic developments. Thus, in this market outlook we will examine how these three events – the final stages of the Brexit negotiations, the Italian government budget for 2019 and the US midterm elections – may impact financial markets.
Before we do this, however, we warn investors from putting too much emphasis on geopolitical events. History teaches us that investment returns in the long run are driven by a small set of fundamental variables: real risk-free interest rates, inflation expectations, the ability of businesses to pay for debt and make a profit, future earnings growth, a risk premium etc. The vast majority of geopolitical events do not significantly impact any of these variables. Instead these events may lead to a change in investor sentiment and risk perception rather than an actual change in investment risk. As a result, most geopolitical events only lead to short-term corrections that can provide buying opportunities for investors with sufficient liquidity.
However, there is a small set of geopolitical events that do change fundamental variables. The US corporate tax reform at the beginning of this year is one such example because it changed the profitability of corporations and boosted earnings growth – at least for the year-to-date 2018. On the other end of the spectrum is all the talk about trade wars that so far has largely been just that: talk. The impact of the newly introduced tariffs on corporate profits or consumer demand has been very small so far and does not meaningfully alter the risk profile of US or Chinese corporations as a whole. Nevertheless, Chinese stock markets have declined dramatically as these trade fears have increased providing, in our view, an opportunity for long-term investors.
Out of the three events we discuss in this report, only Brexit is likely to have a fundamental impact on financial assets, while the Italian budget negotiations and the US midterm elections will likely remain short-term events that may rattle markets for a brief time without fundamentally altering the outlook for US or Italian markets. With this caveat in mind, let us focus in some detail on the final stages of the Brexit negotiations first.
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