Download · An Ode to Europe · An island nation · Anatomy of a currency crisis

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An Ode to Europe
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An island nation
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Anatomy of a currency crisis
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Surely volatility will increase
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Being bullish may take some time
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Protect your assets
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Boom and bust, again
Summary – A heavily indebted nation withdraws from a massive trading block and
its central bank cuts interest rates to 0.25 percent and resorts to buying corporate
bonds in an effort to underpin confidence in the economy. What do you think its
currency would do, go up or down? Welcome to post-referendum Britain. The pound
is falling, gilts are falling and the government is saying it is on the path to restoring
control. Yogi Berra’s History of the UK in Europe!
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An Ode to Europe – In nineteen hundred and ninety two, John Major led the
party blue. He tried and tried to defend the pound as the economy collapsed all
around. We gave up the peg, sterling was free, but the crisis of European policy was
plain to see. Along came Blair and we liked being in the EU, but then there was the
credit crunch and a debt crisis too. Labour was gone, the UKIP had shouters, and in
2016 Cambo gave in to the Tory doubters. Now there is Brexit and a sterling rout, we
can’t live with Europe but it will be tough when we are out. Where now for cable, gilts
and the footsie, for May, Boris and those north of the border? Inflation must rise,
business will suffer, as talks on trade are bound to get tougher. We can’t have both
market access and no freedom of movement, the country is divided but Brexit means
“out-out”. In the eyes of foreigners it must look like a mess, so parity with the dollar
and the euro, no less. I hope there’ll be no visas for visiting Spain, being out of the
EU could really be a pain.
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An island nation – Ok, so I am no poet but what I mean here is that it’s
Europe, it’s always Europe. The issue of the UK’s relationship with Europe has been
at the core of British politics for decades. Today it seems to have taken a turn for the
worse. The referendum result has put the UK on a road to leaving the EU and
investors are voting with their cash as it becomes clear that the UK government is
approaching the exit negotiations with a tone that does not sit well with the
international community. I’m sure that the “hard Brexit” posturing is just that, but it
clearly does not go down positively in Paris and Berlin. So far, the case for leaving
the EU has been helped by the fact that the economy appears to have done well over
the summer, helped by the more competitive level of sterling and lower interest rates.
However, the more considered analysis of the impact of Brexit would conclude that,
potentially, we haven’t really seen anything yet. The risk is that the UK decides
controlling immigration is more important than retaining access to the single market
which could mean a deterioration in our terms of trade. Being out of the single market
is reason enough for non-UK companies to consider their presence and some of the
comments made by Conservative leaders at the party’s conference in Birmingham
this week won’t have helped sentiment either. We all know the risks – the UK has a
large current account deficit, its policy direction is unclear in this post-Brexit world
and capital outflows could lead to substantially higher bond yields and a much
weaker exchange rate. The stock market has liked the decline in the pound so far but
increased volatility on the exchange rate and in the interest rate markets could have
a damaging impact on the economy, even before we see the real hit to trade and
investment.
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Anatomy of a currency crisis – The decline in the pound in 1992 was
because the currency lost its nominal anchor after it left the exchange rate
mechanism (ERM). A similar decline in 2009 was the result of Britain’s highly
leveraged position vis-à-vis the great financial crisis and fears about credit related
losses with counterparties in the UK financial sector. In the first case sterling
stabilized when the economy started to recover, in the second case it happened
because radical policies had to be put in place to stop the collapse of the financial
system and they eventually worked. Today’s crisis is because the UK economy has
potentially become the major victim of a single issue plebiscite which threatens to
disrupt all kinds of trade, legal, cultural and social relations over years to come. It’s
not that there is necessarily a bad outcome from Brexit but it is highly uncertain. Why
would a foreign investor take the risk on the UK when its future economic and
political position in the world is not known? Yes, the UK has traditionally been “open
for business” with a corporate friendly environment and a very mobile labour market,
helped by the open-door policy towards foreign workers. Some of the political
messaging recently has been that this may change with a more hostile attitude
towards big business and changes to the way the labour market works in favour of
British workers at the expense of foreigners. Calm heads should eventually prevail
but the political climate is toxic at the moment and the current UK government
appears to be much more of a Brexit government than perhaps appeared to be the
case when Theresa May took over from David Cameron this summer. What is more,
there is no effective opposition to represent the views of the 16mn or so people that
voted to remain in the EU. Single issue referendums are very different to the results
of parliamentary elections.
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Surely volatility will increase – All things being equal, a weaker sterling and
fiscal expansionism in the UK is not great for Europe and it makes it very difficult to
believe that the European Central Bank (ECB) is about to begin tapering its
quantitative easing (QE). Our view remains that it is hard to see much fiscal stimulus
in the euro area any time soon so the burden of supporting growth will remain on the
shoulders of the ECB. This means continued corporate and sovereign bond buying
and very low yields. The euro market might look quite different to other major bond
markets before too long. The UK could have higher yields because of currency
weakness and inflationary concerns while the US could have higher yields because
of Federal Reserve (Fed) tightening and a more aggressive fiscal policy should
Donald Trump become president. While the dollar did rally sharply against most
currencies in 2014, there is scope for it to go much further should we get very
different policy mixes between the US and Europe. A classic strong dollar regime
would be one supported by tighter monetary policy and an increased budget deficit
that pushes up interest rates across the curve and is associated with stronger
economic growth. My personal two-year view would be to see a stronger dollar
across the board (versus the yen might be the best way to play it) and to look to enter
US Treasury positions after the election. At some point sterling will bottom out but we
need to see more clarity on fiscal policy in the UK.
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Being bullish may take some time – Economic data might provide some
relief to the view on the UK economy but it is hard to get overly bullish on the UK or
on UK assets unless bonds cheapen up a lot more, there is a clear spending plan
from the Treasury and the attitude towards Brexit takes on a more positive tone. So
in my opinion there is currently not much reason to get bullish just yet. Politics and
policy have driven markets more than ever in 2016 and this is not going to change
and when I think about all the political risks it is a reason to be pretty bearish all
around. If global growth was running at 4 -5 percent then it might be different, but it
isn’t so the uneasy relationship between financial market valuations and economic
fundamentals is a very fragile one.
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Protect your assets – So where does this leave bond investors? I think
there is little reason to be anything other than cautious. That means limiting duration
risk because of the threats to higher yields from policy change expectations or higher
inflation risks. It also means limiting credit risks because of the sensitivity of narrow
credit spreads to any volatility in the rates markets. It is interesting that despite the
Bank of England buying over £500 million worth of UK corporate bonds last week,
spreads are wider and the corporate bond index has underperformed gilts since the
middle of September. What we do like is exposure to break-even inflation and the
diversification offered by emerging market debt. On the whole, though, the bond rally
is done for now and the last thing investors need is market beta exposure in fixed
income.
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Boom and bust, again – The déjà vu experience of listing to Little Englander
politicians and seeing the pound slump takes me back to my time in New York in the
early 1990s. I arrived in Manhattan as a junior economist and foreign exchange
strategist just a month before the ERM debacle and three months before Bill Clinton
was elected president. That seems like nothing compared to a full exit from the EU
and the potential election of Donald Trump. With hindsight, sterling’s 1992 slump
kick-started the economy while Clinton ushered in something of a golden age for the
US. It all ended in an asset boom and bust of course but it was fun while it lasted.
This time, I’m not so sure, except for the very likely asset boom and bust.