RMG Investment Bulletins
After a superb run of weekly commentaries, my colleague Stewart Richardson has called time on the treadmill of finding fresh insights every seven days. Let me start by saying that effort is not one I, or my fellow fund manager, Ciaran Mulhall, will try to measure up to. Instead as times change, so do we and recognise that depth of research, in a world of so many opinions, is fighting for too few eyeballs. No, my aim is far more to inspire thought, provoke reaction, and to be brief. I will trouble you but once a month (Ciaran will do likewise on macro themes), but I hope I will also disturb you to.
So, where goes the Pound?
It has become a focus of attention, with the exchange rate being taken by many as a barometer for the future prospects of the UK post Brexit (if indeed Brexit occurs).
"Pound down is bad, Pound up is good" so goes the logic. And on each and every coiffured utterance from Barnier, we get in a frenzy.
Let's face it, Brexit is probably the single most important political issue to face the UK since 1945. You can have a sound economy, you can have revered legal and financial institutions, a dominant international language and favourable time zone, but politics can override it all. Especially if the perception (or reality) is one of institutional paralysis or failure.
The UK has had a current account deficit more or less throughout my adult lifetime. Call it 40 years. Now basic economics tells us, on that basis the exchange rate should adjust downwards, until at least we get somewhere close to an equilibrium level.
The historical effective exchange rate index has traded roughly between 140-90 in that time, and we sit close to the bottom now.
Sterling is weak, and actually it should be. It's been trending that way for decades, with the occasional period of exuberance.
That long term trend is unlikely to change, unless we see a post Brexit supply side revolution.
But there are legitimate reasons to be concerned about a Brexit characterised by UK institutional failings. By that I mean inept government and the inability, or unwillingness, of institutions of government, to do as instructed by the British people.
Wherever you sit on the Brexit debate, no sensible person should want to see the apparatus of government so undermined. Yet that is the real and present danger to Sterling. If that trust is lost, then it will be incredibly hard to re-establish it.
In such circumstances, Sterling will fall hard, and that drop would be sustained.
An organised and visionary Brexit may well also see a fall in Sterling, but I suspect it would be short lived. An open and flexible UK economy, perhaps with significantly lower corporate tax rates, and an immigration policy open to all with the required talents, could be the kind of supply side reform that markets embrace.
But a fudge just won't do. It will lead to increased uncertainty, and prolonged government bickering, further undermining our institutions of government.
One of the eternal conundrums of foreign exchange is after identifying the liability currency, you then have to find the asset currency. In other words, you may think the pound falls, but against what?
In a messy exit lacking vision, Sterling will fall against most things. But let's not kid ourselves that the Euro is some kind of safe haven. The election of Macron was viewed by some as the dawning of a European Renaissance. However, I would suggest that it is more like the apogee, than the start of "more Europe".
Markets adapt to economics in a relatively orderly manner, but when the big picture politics go awry, all bets are off.
And the politics of Europe are changing. This is no localised short-term protest movement, but rather widespread and deep held convictions that somehow Europe or the Euro isn't working for great swathes of people. Both right and left of the political spectrum are seeing a surge in support, and I suspect too many people in Berlin and Brussels are viewing this as just another minor irritant, rather than a groundswell of opposition.
And unlike Greece, Italy is going to be no pushover for either the EU or the ECB this time around. Debt levels are unsustainable, the buyer of last resort that has kept European bond markets so buoyant, will be no longer be present, the demand for infrastructural spending, post the bridge collapse in Genoa and the introductions of minimum incomes and lower taxes, will simply blow the EU budget rules out of the water. And the ECB and Germany are on the hook, big time.
Italians are fed up with internal devaluations forced upon them by Berlin and Brussels.
And the Euro is viewed as the major millstone around their necks.
This has the makings for one heck of a showdown.
So I'd suggest that selling Sterling against the Euro is at best a very short term proposition. An existential threat to the Euro is raising its head, and the beast could easily display hydra like qualities.
The dollar is still the best asset currency to hold against Sterling, although from an historical point of view, anywhere approaching 1.10 dollars to the pound is "cheap".
There is much already priced in to the exchange rate, and some hold the view that markets are already too pessimistic and Sterling offers value. That may be true, but only on a short to medium term economic basis.
The outlook is not dependent on Brexit, but on the
health of our political institutions and the vision or leadership when Brexit
occurs. If the perception grows of institutional ineptness or indeed deliberate
thwarting of long held democratic principles here in the UK, then the pound
will fall hard and deservedly so.
To view a PDF of this report, click here.
We've all seen charts similar to the chart below, showing US bond yields, and the extraordinarily orderly decline in yields over the last 30 years or so. On the chart, we have marked the trend channel that has contained all price action for at least 25 years, and the red horizontal line illustrates some chart resistance at current levels. At the risk of stating the obvious, within the confines of a multi-decade trend that has shaped the performance of all financial markets globally, we are near a tipping point that should be resolved within the next 9 months.
Chart 1 - Weekly chart of US 10 year bond yield
We have made the case recently that higher interest rates could easily impact global financial markets, and although equity markets are seemingly ignoring this as they melt up, there is a potential coming together of macro factors that really could change the world as we know it.
Since the end of WWII and the signing of the Bretton Woods agreement, there has been one major change to the global financial system. Between 1944 and 1971, most currencies were fixed against the US Dollar, and with the Dollar convertible to gold at a fixed price of $35, there was a backstop against US profligacy. So long as the world had faith in the Dollar, and decided against converting Dollars to gold, everything would be fine.
However, the fiscal strains for the US began to show in the 1960s, and in August 1971 the US ended the convertibility of Dollars into gold, and the world order shifted from an effective Gold Standard to a US Dollar Standard.
For decades, the Dollar standard has worked incredibly well. Credit creation, untethered from gold and controlled by commercial and central banks, has led to strong global growth and rising asset prices. The dark side of the Dollar Standard is that it has also led to an unparalleled growth in debt in virtually every country and every sector. The economic outcome is that rather than the economic cycle being mostly about inventory cycles, it is now much more sensitive to boom and bust cycles in the financial markets.
But so long as everyone played to the rules of the Dollar Standard, things would generally be ok. What we don't know is what would be the impact on the global economy and global financial markets if the global system shifts away from the Dollar Standard.
In just the last few weeks, we have the following dynamics to consider;
1.Trump slapping tariffs on selected items with more to come
2.China hinting that they would hold fewer reserves in US Dollars
3.Other central banks admitting that they are already holding more reserves in Yuan, and that they expect the amount to be higher in the future
4.US Treasury secretary publicly saying a weak Dollar is good because it will help the US trade position
5.The passing of US tax legislation that is likely to lead to a much larger budget deficit
6.The beginning of quantitative tightening that will see the Fed's balance sheet reduced by $450 billion in 2018 and likely more in 2019
These dynamics, together with Trump's more isolationist agenda, are threatening the Dollar standard. So the big picture questions are 1) will the Dollar standard remain in the years ahead and 2) if it changes, how and what will the new system look like and 3) what will happen to the global economy and markets during any transition?
These are such big issues that we won't be able to answer them in one commentary. What we can see is that if global investors begin to lose confidence in the Dollar at a time when US inflation is rising, bond yields are rising, the Dollar is weakening, the budget deficit is set to increase dramatically and the US central bank is draining Dollars from the system, there is a case to be made that the future may not be quite as bright as many pundits are currently claiming.
But these dynamics change relatively slowly, and financial markets are currently in no mood to think negative thoughts.
We would like to add just a couple more thoughts in the big picture. First, the US consumer may be running on fumes. The household savings rate has collapsed, and as a result growth remains reasonable. At the same time, consumer debt is increasingly dramatically just at the point when interest rates are rising. There is a strong case to make that unless households can find a new source of income, rising interest rates and inflation will impact both consumer spending and therefore the economy.
The second thought is on oil. At $65 on US WTI, this represents an increased burden for the US consumer compared to a year or two ago, and a potential boom for US shale. If the US consumer begins to retrench at a time when US policy is becoming more isolationist and the US continues its shift towards energy self sufficiency, this will reduce the US current account deficit, adding a further strain to the Dollar standard that has been in place since 1971.
All of these thoughts need to be fleshed out, and we will attempt to do so in the weeks ahead. However, as we sit here watching equity markets melt up, retail investors piling in at record levels and reliable valuation measures at levels comparable to 2000 and 1929, we begin to worry that a collapse or large shift to the Dollar standard would come as a huge shock to the global system. We are watching the rise in US bond yields, the decline in the US Dollar and the policy shifts occurring on the global stage, and wonder whether these are indeed major warning signs that investors are ignoring simply because the equity market party feels like a great place to be and there is a huge inertia and fear of missing out.
We are also acutely aware that either our concerns may be mis-placed, and that it could take a long time for them to matter even if we are correct to be concerned. So, for the moment, our concerns remain focused on bonds and the US Dollar, and even in the short term, we wonder whether the Dollar in particular is oversold and due some sort of relief rally. However, with market valuations so stretched, we do think that equity investors need to have their exit plans at the ready. So far in 2018, we have seen volatility inch up across the major assets, and with everything else noted above, we wonder aloud whether an increase in market volatility could be the harbinger of greater change in the months ahead.
To view a PDF copy of this report, click here.
My colleagues have been urging me to write a weekly commentary on Bitcoin/Cryptocurrencies. However, although my interest in the sector is growing, I am not sure that I am nowhere near close enough to the action to comment. I will continue to read as much as I can about this new phenomena, but in the meantime, we will stick with traditional fiat currencies. So here goes.
The US Dollar, having enjoyed a reasonable bounce from the mid-September lows, is struggling to maintain its balance as we head towards the end of the year. The weakness is apparent even though interest rate differentials appear to be supportive. The most obvious explanation for the Dollar weakness seems to be that investors and traders continue to expect the Fed to be more dovish than their forecasts suggest.
Frankly, we can build both bullish and bearish Dollar scenarios at the current time, and with price suggesting the Dollar is struggling a bit, we will err on the cautious side in the short term until proven otherwise. But we are not sure that any upcoming Dollar weakness, if seen, will be as broad and persistent as it was between April and September. Let's jump in and have a look at a few charts to develop our thinking here.
First up, the Euro seems to be leading the charge against the Dollar. Why so? Well, economic data shows that the Eurozone is performing pretty well and perhaps signs that Germany may not have to have another election help. But it could also simply be that if traders want to sell the Dollar, they will first buy the most liquid alternative, and that's the Euro. It could also be more structural, as the Dollar's reserve status seems to being chipped away constantly. In chart 1 below, we can see that the Euro rose strongly between April and September, and that the recent downward price action broadly found support at the previous highs of the last few years. From the most simple of technical perspectives, we think that the recent move lower from about 1.21 to near 1.15 looks more corrective in nature, and that the Euro has to at least trade back to the September high of around 1.2100.
Chart 1 - EUR/USD weekly price graph with 21 week moving average
Drilling down to a shorter time frame, in chart 2 we have shown the daily price graph. We have shown two resistance lines on the chart. One being a downward sloping trend line (in white) drawn off the high in September, and also a horizontal line (in red) drawn from the high in mid-October. On Tuesday of last week, having already broken the downward sloping trend line, EUR/USD appears to have tested the same downward sloping trend line from above and reversed higher. On Friday, EUR/USD moved higher and traded above the highs seen in mid-October.
Chart 2 - EUR/USD daily price graph with 21 day moving average
From a purely trading perspective, as noted, we should really now expect EUR/USD to carry on higher and at least trade to the 1.21 area. If this level is exceeded, price may even extend towards the 1.25 area (although we are less sure about this at this stage). First support is in the 1.17 area, and for the bullish Euro thesis to remain valid, price has to remain above 1.15 area.
Moving onto Sterling, the situation does not look quite as robust as the Euro. Chart 3 shows the daily movements of Sterling versus the Dollar, and we think the most important technical feature at the moment is the gently rising channel shown. If this interpretation is correct, then we should look at this sideways type movement since late September as a correction of the decline from 1.3650 to nearly 1.30, which should at some point lead to a test of 1.30 and below.
The price action on Friday just may be of interest as well. Sterling did rise against the Dollar, but the advance was a lot less robust that the Euro's advance, indicating perhaps some underlying relative weakness in Sterling. Furthermore, price traded right up to the top of the channel during Friday, but began to fade away into the close. The way we are looking at this is that Sterling may be close to a short term peak against the Dollar, and we will hold a bearish trading bias so long as price remains below 1.3380 area on a closing basis.
Chart 3 - GBP/USD daily chart
Let's quickly take a look at two more currencies; the Aussie Dollar and Japanese Yen. The Aussie Dollar has been amongst the weakest of the majors during the Dollar rally that began mid-September. We in fact highlighted the Aussie Dollar a couple of times in recent months as potentially a weaker currency play, and our view remains bearish. Chart 4 shows that price remains in a steady downtrend, and we are looking for the rally in the last week to fail around about current levels, or if the Dollar is weaker than expected, we could see a rally up to the 0.7700/30 area. We have highlighted before how the Reserve Bank of Australia remains quite dovish, and this is still the case. We also harbour big worries over the level of household mortgage debt and the Australian property market, but we'll leave that story for another time.
Chart 4 - AUD/USD daily price graph with 21 (gold) & 50 (purple) day moving averages
The Japanese Yen may be the most unpredictable major currency at the moment. Aside from stories that the Bank of Japan continue to play around in the market, price itself is smack bang in the middle of a 108 to 115 trading range, as can be seen in chart 5. When we analyse market positioning, the Yen is the only currency where speculators are holding a large short position. The net speculative short position is large enough to make us worried about selling the Yen.
There is also a growing feeling that the Bank of Japan is laying the groundwork for a subtle shift in policy next year. Subtle perhaps being the word, as when policy is as extreme as it is in Japan today, and with the knowledge that any major reversal could have seriously negative consequences for Japanese financial markets, the Bank of Japan are in a dark corner that they don't know how to get out of. But there is talk that they may shift their yield curve control policy, and instead of targeting the 10 year yield at zero per cent, they will shift that to the 5 year yield. This would allow the 10 year yield to trade more freely, and presumably with an upside bias which, all other things being equal, would be positive for the Yen.
Chart 5 - USD/JPY weekly price chart
So, at the moment, we are somewhat agnostic on the Yen, but with a bias to look for opportunities to buy as speculators may have to cover their short at some point, especially if the market perceives that the Fed will be more on the dovish side of the ledger, and/or risk assets ever have a period of corrective price action.
Looking at some of the major currencies, we get the overall picture is a mixture of themes, without one dominant one. When we see this sort of backdrop, we think we need to be careful not to become married to any one theme, and that we should maintain a flexible and more tactical approach as the market may switch focus very quickly.
As we see it, the Euro is currently the strongest of the major currencies, followed by the Yen. The Antipodean currencies are at the bottom of the pack, and the US Dollar is somewhere in the middle. We think the factors that the market is focusing on for the Dollar can change quite quickly, although tax reform seems to be taking a little longer than the White House would want. The UK did not have a great week in our opinion, with growth estimates reduced and borrowing expectations increased in the Autumn Statement. Despite being a relatively cheap currency, the UK has a monstrous task ahead, and we think that Sterling can sit near the bottom of the pack.
With Central Banks trying hard not to rock the boat, or make any obvious policy errors, we doubt that we see any major moves in the FX markets between now and year end. Yet, after such a long period of calm in global financial markets, we have to suspect that volatility will increase at some point soon. By maintaining a flexible and tactical approach in the short term, we think that we will have the opportunity to identify future changes in the early stages of their development.
- Where Goes the Pound?
- The End of an Era
- A Short Update on Our Equity Market View
- Some Extremes Held by Speculators Could Force Change
- Emerging Markets Challenging Our View of a Quiet Summer
- Has US Business Confidence Peaked?
- Central Banks
- Fixed Income
- FT Special Report
- General Update
- Show all