As the month of October drew to a close, it became seemingly apparent that there is a growing discrepancy between international capital markets and British businesses in their assessment of project Brexit and the future prospects of the UK economy. While the 20% depreciation of £-Sterling since the beginning of the year indicates that overseas’ capital now demands a 20% upfront discount before investing in UK assets, the resilient UK GDP growth hints that the domestic story is more ‘keep-calm-and-carry-on’.
For UK private investors, the currency depreciation dimension of the Brexit shock turned what was a nightmare scenario for capital markets into a welcome surprise of a ‘Goldilocks’ summer. With £‑Sterling taking the brunt of the forward expectations adjustment, overseas assets increased as much in value as the UK’s currency depreciated, while UK large cap stocks benefitted from the same value relationship, due to their large overseas earnings streams. Fixed interest bonds, in the meantime, rose in tandem, due to the expectation that the increased political uncertainty would force the UK’s central bank – the Bank of England (BoE) – to keep rates lower for longer.
October’s party conference season put somewhat of an end to this benign environment and the political posturing forced the currency to ever lower levels. This not only opened up the perspective of a return of inflation, but also reminds those with a historical awareness that uncontrolled currency depreciation can have some very undesirable side effects. Back in 1976, this expression of global concerns about the direction of political travel went so far that the UK lost access to international finance and had to call the IMF to the rescue.
I am not suggesting we are anywhere near such a scenario, but there are a number of uncomfortable parallels (E.g. requiring external finance because we import and consume more than we export) which would explain why the UK bond markets reversed direction and fell over the month of October.
For the near term, however, the UK economy benefits from the ‘sugar rush’ the currency devaluation has bestowed on its export-oriented services industry in the South East. This should, for a while, more than compensate for the Brexit related loss of demand in the construction and industrial goods sectors.
The apparent discrepancy between the international currency markets and the real UK economy may therefore have more to do with time perspective than difference of judgement. For now, the admirable British attitude of ‘getting-on-with-it’, paired with short term currency devaluation benefits, has resulted in economists’ (well founded and rational) expectations being proven, in the short term, utterly wrong. This has bought the UK’s ‘newbie’ government time to devise a credible plan for a future beyond full EU membership. However, October’s further currency fall has hopefully been interpreted in No 10 as a warning shot that eventually long term expectations turn into present day realities.
1. Politics are back - £-Sterling plunges - again!
The new Tory leadership’s decision to set a start (and thereby end) date for their Brexit negotiations robbed markets of any hopes that the onset of the pain of the divorce proceedings may be delayed beyond the French and German election to late 2017. Overseas money may see this as a risk of the negotiations being exploited for electoral campaign purposes rather than European politicians being distracted, as Tory speakers liked to portray it. However, to my mind, the biggest source of disappointment was that, beyond assurances that the government would fight for the best deal for the UK, there was very little of substance to help business leaders in assessing the UK’s future trading framework with the rest of the world.
This may not yet lead to an outright business exodus from the UK, but it will certainly discourage or further postpone most forms of investment in productive capital goods, particularly those that are aimed at producing goods and services for distribution beyond the UK.
The world has now written off a combined 20% of the value of the UK economy by means of this currency devaluation. The reason UK company shares rose regardless has much to do with the fact that their business profiles are often international, meaning the future value of their non £-Sterling revenue streams increased by the same amount the currency declined.
UK investors observing double digit returns for 2016 from their investment portfolios should refrain from worrying that capital markets have lost the plot and are overheating. If they looked at the same investment portfolio from a US$ or €Euro perspective, they would find values have hardly changed this year. This means that professionally managed investment portfolios have succeeded in protecting investors from the value destruction of the fall of the Pound, but if their owners planned to use their funds to retire outside the UK, then I am afraid than its so far been a decent but no more than low single digit vintage.
2. Devaluation metrics: The good and the bad
£-Sterling is a free-floating currency - i.e., where the value of exchange is determined by capital markets by way of demand and supply. Therefore, depreciation is effectively a signal that a currency is overvalued relative to: other currencies, the economic prospects of that country and the prevailing conditions of trade (e.g., current account deficits will tend to put downward pressure on the exchange rate).
Currency devaluation is something that other European countries like Greece and Portugal might have benefitted from when they suffered economic setbacks, but have been unable to do because of the constraints of being tied to a shared, single currency (€). Therefore, the further weakening of £‑Sterling in October is not all bad news. Nevertheless, it does not represent a structural improvement in the UK economy, and neither is it necessarily all good news.
Just as a currency ‘devaluation’ can provide a short-term stimulus to an economy, it can also bring long-term side-effects. For example, a nation like the UK that imports more than it exports will see the resultant current account deficit widen, unless it can suddenly increase its export volumes substantially.
The foreign savers who have hitherto financed the account deficit may only be willing to continue doing so if they receive higher yields or otherwise the currency falls ever further due to lack of demand. Both lead to rising inflation pressures.
So, after the initial ‘sugar-rush’, if the reasons for the currency sell-off don’t dissipate in some form, then access to foreign finance may dry up and force the country to a significant cut back in consumption through and to increase interest rates significantly. While we are still far away from such a scenario, it is worrying that for more clarity to appear around a post Brexit trade framework, we most likely have to wait until after the German general elections in the autumn of 2017.
3. The growth of political risk
It has long been the conventional wisdom that political uncertainty, and the financial risks arising from it, is the preserve of emerging markets. The potential for default here and a coup d’état there is just why investors demand a higher risk premium for investments associated with emerging markets.
Lately, it seems, that conventional wisdom is proving less reliable. The next 12 months will be punctuated at each end by fundamental shakeups in the political leadership of the world’s two largest economies. In the interim, between the ever-looming US Presidential election and the 19th Chinese Communist Party Conference next year, we will see leadership elections in France, Germany and The Netherlands, as well as a referendum in Italy which could well claim the scalp of Prime Minister Matteo Renzi.
Such uncertainty slows investment and consumer confidence, inevitably dampening prospects for growth – sometimes quite substantially. Given this, understanding the political dynamics and the potential consequences they entail is crucial. In fact, at Tatton we are currently monitoring political risk as much as economic cyclicality risk – quite unusual.
Even if the supposed ‘continuity’ candidates – the Clintons, Xis, Merkels, and Renzis of the world – all (or mostly) survive the gauntlet of the next year, we shouldn’t assume that policy is to remain the same. As seen with the ‘hard-Brexit’ line being flaunted by the UK government, the very fact that nationalism and populism is gaining traction is itself moving the traditionally ‘establishment’ politicians into positions they might not have taken otherwise. Even if all the markets’ favourite candidates win the upcoming votes, the policy environment for businesses and investors could very well still be shrouded in a veil of uncertainty. The Trumps and Le Pens could (and in our view most likely will) lose; but the walls might still go up.
4. Theresa May formally brings the post-Thatcher era to a close (?)
Observing the Tory conference, I wondered whether Theresa May decided to try and appease her rebellious electorate and pitch for traditional Labour and UKIP voters’ support, rather than provide a more certain environment for UK and international businesses by addressing Brexit concerns first.
However, what I found truly remarkable was how willing her party folk appeared to accept her formal closing of the post-Thatcher area, with its mantra of ‘if it is good for business then the benefit will eventually trickle down to everybody in society’. The Tories’ staunch following of a fairly pure capital market economy interpretation seemed to give way to a softer interpretation which reminded me in parts of Scandinavia’s and Germany’s ‘Social Market Economy’. There, the free market forces are tamed and, to a certain degree, suppressed, with the aim of achieving a more balanced outcome for all. This economic model is somewhat less dynamic and requires more cross-society consensus to drive through lasting change. It may also require additional virtues embedded and accepted across society in order to compensate for the lesser force of the ‘animal spirits’ of free market agents.
It waits to be seen whether the Tory party will ‘walk’ May’s ‘talk’ of such economic policy volte‑face. But, one of the other core elements of this model is a greater role of the state in the provision of infrastructure, education and social care. In the current environment of deficient private sector confidence – which holds back the utilisation of the country’s historic economic potential – additional fiscal stimulus in the economy should be beneficial. The persistent low growth environment of this decade is crying out for confidence building investment initiatives because, otherwise, the monetary stimulus with its side effects may well have been in vain. The announcements to proceed with various large infrastructure projects (HS2, Hinkley Point, Heathrow etc.) tell me that I can’t be very far off the mark here.
5. Central banks turning from heroes to villains – according to some
Perhaps it shouldn’t be a surprise that, in the aftermath of what UK Prime Minister Theresa May described as a “quiet revolution” in the UK’s vote to leave the European Union (EU), the political blame reflex has gone a bit too far. Within the space of a single party conference speech, May simultaneously laid responsibility for the popular discontent behind Brexit at the feet of international elites, unscrupulous bosses, low-skilled immigration, “divisive nationalists” (!) and overly loose monetary policy.
While the enterprise of delegating fault is hardly a novel development, the final choice of target sparked not just my interest greatly. Further on, the new Prime Minister unabashedly went on record with this statement: “while monetary policy – with super-low interest rates and quantitative easing – provided the necessary emergency medicine after the financial crash, we have to acknowledge there have been some bad side effects. […] A change has got to come. And we are going to deliver it.”
My incredulity here shouldn’t be interpreted as a lack of sympathy for the view that loose monetary policy is not a panacea for an ailing economy. I do, however, find it hypocritical to call it the cause of illness. For better or for worse, central banks are tasked with maintaining a stable level of inflation by setting interest rates which balance the supply and demand of money. Where this inflation target is being undershot, looser monetary policy is simply the only tool available to central bankers. It’s certainly true that low rates and QE do have some unintended side effects (the inflation of certain asset bubbles being a particularly interesting one), and that the persistence of what was originally deemed ‘emergency measures’ erodes confidence in central banks’ ability to control the situation. But, to our minds, this is merely indicative that monetary policy is not the be all and end all to maintaining a healthy economy.
In our view, there is an interesting debate to be had about effectiveness of monetary policy and what its aims even should be if the political side fails to deliver on its side of the bargain, namely rebuilding trust and confidence to spend and invest rather than stash away ever larger cash piles. However, to attempt to paint Carney and co as the pantomime villains of the piece is to have missed the point entirely. One cannot argue that rates should increase without a solid plan for how growth is going to return simultaneously, so that, for example, households can cope with the shooting up of their mortgage payment burdens without having to cut back on their growth driving discretionary spending. The collapse in private demand could easily drive the economy back into recession. This government has had 6 years to utilise the calm the loose monetary policy provided them with to rebuild trust and confidence in the financial and economic system their political class had been such poor guardians of. The fact they have not done so is hardly a failure on the BoE’s part.