7th October 2016 by Chris Iggo
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!
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.
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.
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.
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.
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.
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.
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.