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By Stewart Richardson on 11/06/17 | Category - UK
To view a PDF copy of this report, click here. 
Although I am sure that you have had your fill of the UK election, we do feel the need to start off with a quick comment on our outlook for Sterling especially as the biggest position in our FX portfolio (going into the election, thankfully) is short Sterling versus the US Dollar. We were hoping that we could get away with just sticking to this story, and keep the commentary a bit shorter this week. That is until late Friday when the Nasdaq market in the US suddenly began to sell off. With our negative view on US equities, this sort of behaviour is clearly of interest, so we have to comment on this too.

So there is no way to sugar coat the election result for Theresa May; the outcome of the UK election was an absolute disaster for her. Instead of winning a majority of 70 or more seats, and being able to govern through what are going to be very tricky times from a strong and stable position, she has no majority at all. The UK has a hung parliament, which from a narrow political perspective, is the worst of all worlds. It appears as if she will rely on the Ulster Unionists for support, which is already causing some consternation as this may well compromise the brokering role that Westminster should be playing in Northern Irish politics. However, again from a narrow political perspective, this is hardly a strong and stable Government.

There has been much debate about what the outcome of the election means for Brexit. Hard or soft? Will access to the single market be back on the table? We simply can't tell at this stage. Furthermore, we have to understand that Europe has its own agenda, is much better prepared than the UK, and will surely apply "pressure" when they see fit in order to press their advantage, or worse, make an example of the UK so as to discourage other countries from leaving.

Aside from Brexit, the UK economy suffers from stiff headwinds, is clearly politically divided and has many social issues to deal with (e.g. affordable housing for the younger generation, care for the elderly and financial inequality and negative real wage growth again). However, although the election may have been a complete disaster for Mrs May, it does not have to be for the UK people and the economy. From an economic point of view, we wrote a paper last year before Brexit (see here) detailing some of the economic challenges, and we think this paper is still very relevant. Many of these issues will be solved, but it would be much easier for a strong government to do so rather than a weak one which is what the election has provided. Furthermore, with no progress made on the UK's enormous current account deficit, we think a weaker Sterling is part of the recovery process. We can also expect the Bank of England to keep interest rates at zero for a long time, which may encourage a little bit of weakness in Sterling.

Below is a chart of Sterling versus the US Dollar. As we have shown, Sterling had rallied to both downtrend resistance and to the upper boundary of a bullish channel. From a simple market analysis point of view, the 1.30 area was clearly important. We have also marked the day the election was called, which was a big up day for Sterling, touching a high of 1.2905. Cable then spent the next 7 weeks chopping around with a slightly higher bias, and was at 1.2950 immediately before the exit polls were announced. If you'd like more information on the RMG FX Strategy UCITS fund please see here or get in touch.

From our perspective, the market was pricing in a decent Conservative majority at 1.2950 and in any case would have had to overcome material resistance in the 1.30 area if the majority was bigger. However, the downside on a very small majority or even a hung parliament was more than the upside, and so we felt that holding some Sterling puts was a good reward/risk opportunity. Furthermore, with volatility half the level it was pre Brexit, we could buy these put options relatively cheaply.

Chart 1 - The Pound Sterling versus US Dollar
Where does Sterling go from here? With a much more fragile political situation and an economy that remains susceptible to shocks, we still think the risk is on the downside. We did book some profits at 1.2740 and 1.2660 on Friday, but we remain bearish in the short term.

Moving on to US technology stocks. Out of nowhere, The Nasdaq had its worst day relative to the rest of the market since 2008. Or put another way, the high flying stocks that had been the major driver of returns for the broad market suddenly buckled for no good reason and the selling was quite intense as Nasdaq volume was the highest since the August 2015 shakeout (as measured by the QQQ tracker). This may be just a flash in the pan, and the market will quickly steady itself and resume its upward trend. Alternatively, it could be a warning signal.

Chart 2 - The Nasdaq 100 Tracker
To put this bad day for Nasdaq in some sort of perspective, we have been talking for weeks now that we expect the market to build a large top before the real bear market can begin. That topping process will by nature be a series of corrections and rallies within a developing price range. So far, we haven't even seen the first correction, which we would expect to be in the 5% to 7% range which will attract those looking to buy the dip. So, the question we are pondering this weekend is whether the Nasdaq selloff on Friday is yet another signal (amongst those we have recently highlighted) that the first stages of a topping process are beginning. Only time will tell, but for our part, we are viewing Friday's price action as immediately bearish.

We'll leave it there this week but suffice to say that price trends appear to be shaping up nicely for active investors. The continued low levels of volatility everywhere is also of note. Investors have been assuming greater risks for months and now those that would naturally look to hedge when they want to protect portfolios seem to have given up on that tactic. This sort of price action and investor behaviour is seen near market highs not market lows. 

By Stewart Richardson on 16/10/16 | Category - UK
After another horrible week for Sterling on the foreign exchange markets, it has become all too easy to be overly bearish. There can be little doubt that the UK faces unprecedented political challenges in exiting the European Union. With the likelihood that Brexit will ultimately mean no access to the single market, the economic challenges will be large as well. Nobody knows exactly what the future holds, but everyday business and investing life is full of uncertainties. Given all of this, here are some thoughts on the prospects for the Pound.

Even before the Brexit vote, the case for weakness in the Pound Sterling was easy to make. Indeed, we wrote a special report in April this year outlining why Sterling had to weaken, although the Brexit vote made the timing of weakness extremely difficult to predict. So, with a weaker Pound being part of the required rebalancing for the UK, should we be embracing the 20% fall  in recent months or panicking? Chart 1 below shows the Sterling trade weighted exchange rate back to the 1980s. The current weakness is the third period of accelerated weakness in the last thirty years, and is very  in line with the magnitude of previous declines.

Chart 1 - Sterling Trade Weighted Exchange Rate
The best case scenario for the UK is that the weakness in Sterling helps reduce our burgeoning current account deficit, and that our access to the single market remains open for as long as a trade deal (or compromise that focuses on certain key sectors first) takes to negotiate. The probability of this seems low at the moment as European leaders seem intent on punishing the UK as a way to discourage other countries from following this path. That said, the UK does have over two years of access to the single market whilst negotiations are ongoing, and a positive scenario is possible. It is our view that Sterling is undervalued in a positive scenario.

The worst case scenario is some sort of Armageddon. As the UK loses access to the single market, our exports suffer despite a weak currency. Furthermore, the city is cut off and the financial services sector collapses. The shock to the economy would be enormous, inflation would pick up as imports become more expensive. The current account deficit would remain stubbornly wide, and the Pound would continue to fall as international investors shy away from UK assets necessitating a rise interest rates to attract capital to fund the deficit. This cocktail would further impact the economy and also financial and real estate assets.

As with the best case scenario, the probability of some sort of Armageddon scenario seems low as well, at least to us. The 20% decline in Sterling has already given the UK a competitive advantage in global trade. The UK also has the benefit of a well educated workforce and a legal system that is very stable and used widely in international transactions. The decisions taken by our political masters will either protect these advantages or undermine them; we suspect that pragmatism will prevail.

So, the likely outcome is somewhere between the best and worst case scenarios, and from a currency point of view, we are trying to work out whether a 20% decline is enough to help in the rebalancing of the economy, or is there worse to come? Well, the trite answer is we simply don't know because the uncertainty is so high at the moment. That said, what we do know is that investor sentiment can be a great contrarian indicator, or as Warren Buffett says, "Be fearful when others are greedy and greedy when others are fearful".

This last week, the sentiment around Sterling has reached proportions that can best be described as near panic like. We have seen predictions that Sterling will fall to parity with the US Dollar (another 20% fall), comparisons of Sterling as an Emerging Market currency and comparisons with the Titanic ship breaking up just before it sank. The BBC also jumped on the bandwagon when the top story on the evening news last Wednesday was the decline in Sterling. In our experience, when a financial trend finally becomes the main topic on national news, that trend is close to exhaustion, at least for a short period of time.

Given the current, and in our opinion, excessive bearishness towards Sterling, we are in fact looking for Sterling to try and form a base around current levels. At the moment, our weapon of choice is to sell Euros versus Sterling in the FX Strategy UCITS fund. We have always been in the camp that the Euro is a flawed currency project, and we have also been in the camp that ultimately what is bad for Sterling from the Brexit process is also bad for Europe and the Euro.  This is very much dipping a toe in the market as experience also tells us that markets can easily overshoot. We are not risking a huge amount of money on this trade, and will also look to trade some of our position actively to try and maintain as much flexibility as possible.

As for other trades on our radar, we have been bearishly positioned in selected Asian currencies as we see the global risk-on mood from recent months shifting towards risk aversion. If Sterling is able to gain a more stable footing in the weeks ahead, we may well buy a little against selected Asian currencies as well.

To try and wrap things up here, we simply do not adhere to the Armageddon outlook for the UK resulting from Brexit. The case for Sterling weakening as a natural way of rebalancing the UK's huge current account deficit was easily made before the Brexit vote and what we do know is that when everyone is fearful of an asset, we should be looking to buy. As always, we need to be measured in the amount of risk we can take on any individual trades, and so the current position size in our bearish Euro/Sterling trade is necessarily small. If we are wrong on this view, then so be it, however, with so many now utterly bearish of Sterling, it will not take that much to see a shift back in favour of Sterling.

By Stewart Richardson on 02/04/16 | Category - UK
The UK finds itself in a very uncomfortable position at the moment. Although most of the scary headlines recently have surrounded the question of whether we vote to leave the EU or not, we see the news this week that the UK's current account deficit has hit a record high as much more disturbing in the longer term. At some point, the deficit will have to be reduced, and unless the World economy is about to enjoy a massive growth spurt, the process will require some tough decisions.
The further we delved into the problems facing the UK, and how the twin deficits (current account and budget) could be rebalanced, the more disturbed we became. This is a far larger subject than can be covered by a short weekend research piece, and so we will publish a more in depth piece next week. So let's crack on with the shortened version.
Although the UK has been running a persistent current account deficit for a number of years now, the sheer size of the deficit was a shock. In the fourth quarter, the UK's current account deficit amounted to 7% of GDP, the highest peacetime level since records began 244 years ago. This is a vivid sign that the UK is living well beyond its means as seen in chart 1 below.
Chart 1 - The UK current account as a % of GDP
All deficits have to be funded, and in the case of a current account deficit, this has to be funded by foreign capital, either in the form of long term foreign direct investment (FDI) or short term capital flows. Either way, foreign capital has to be attracted to the UK.
In terms of net foreign direct investment, the UK has many advantages, some of which are due to our historical and geographical position on the world stage. We have no real view on how a Brexit will impact on this, although we suspect that it will discourage capital from seeking a home here in the short term. Perhaps the point to make here is that the current account deficit will remain whether the UK leaves the EU or doesn't. So let's consider short term capital flows.
To be attractive to foreign capital, the UK has to offer attractive investment returns, either from equity, fixed income or a cheap currency. As the deficit will be funded, the deciding factor is at what price. At what level of interest rates and currency valuation will foreign capital be happy to fund our excess consumption? Our guess is that it is unlikely to continue at current levels over the long term. Either our interest rates have to go up, which is not an attractive proposition for the domestic economy, or the value of Sterling has to decline. It's likely to be a combination of these factors, but key in the long term is likely to be a decline in Sterling.
The trouble with being bearish of Sterling in the short term is twofold. First, Sterling has fallen by about 10% on a trade weighted basis in the last four months. This is a big move in a short period of time, short Sterling has become a very popular trade, and nothing moves in a straight line forever (well, usually!). Second, we have to deal with Brexit. As we all know, UK voters go to the polls on 23rd June to vote on whether we stay in the EU or vote to leave. It's a binary outcome, and if the outcome is a vote to leave, we along with everyone else expects Sterling to fall heavily. If we vote to stay in the EU, there should be some sort of bounce.
Chart 2 - Sterling Broad Trade Weighted Exchange Rate
So, with the long term prospects for Sterling looking quite grim, we believe that any reasonable rally in Sterling should be sold. As noted above, we will publish an in-depth note next week on the structural problems facing the UK (please contact us if you wish to receive this). Our choice would be to sell Sterling against the US Dollar in the RMG FX Strategy UCITS fund, using options as a way of controlling risk. We will consider other asset currencies as well as we expect Sterling's weakness to be broad based. 

This may sound a little generic at this stage, however, as can be seen in chart 2 above, not only has Sterling fallen a long way in a short period of time, it is also trying to bounce off a support level that seems important to us. Furthermore, the UK's problems appear to be structural, and will take a long time to unwind. So, we do not feel compelled to hold significant positions at the current time. That said, Short Sterling trades really need to be considered on any reasonable rallies.

By Stewart Richardson on 15/11/14 | Category - UK
The Bank of England was pretty dovish this week as Mark Carney presented their quarterly inflation forecast. They reduced their GDP forecasts for 2015 and 2016 and now believe that inflation is likely to fall below 1% within 6 months. The outlook is "weaker due to Europe" which may well be facing the "spectre of economic stagnation" according to Mr Carney. The Bank's forecasts were assuming the first rate rise in October 2015, however, some economists are now even talking about this being delayed to 2016. Let's just say that UK rates will remain low for a very considerable period of time.
Politically, ever since the Scottish referendum vote a few weeks ago, investors have begun to fret about the UK. For 3 decades, the UK was seen as politically stable with power shifting between two centrist parties. With neither party commanding an obviously winning lead in the polls, the likelihood of a hung parliament is increasingly obvious. Whereas the Conservative/LibDem coalition was initially seen as a good outcome after the lack of a clear winner in 2010, there is certainly the potential for a very messy outcome from next May's election.
So here we have a situation where growth (which had been good enough to put the UK at the top of the G7 league table) is losing momentum as is the key housing market. The UK has a huge exposure to a structurally moribund economic zone and now we have a markedly more dovish central bank. In a world of zero rates and extraordinary monetary policies, central bankers are increasingly looking towards currency levels as a way of helping at the margin. We suspect that Mr Carney would be privately quite happy to see Sterling weaken given his more dovish position.
Given the still relatively strong performance by the US economy in an increasingly troubled global economic environment, the obvious longer term trade here is to sell Sterling against the US Dollar. We have no problem with this idea, however, the bullish US Dollar camp has become quite overcrowded of late and we worry that something will lead to a short term shakeout for the US Dollar. Our favoured short term trade idea is to sell Sterling against the Canadian Dollar which offers a marginal yield advantage over Sterling, is located within the outperforming North American bloc and has been hurt by the 30% decline in the oil price, which may just try and stabilise around current levels.
The chart above shows the Sterling vs Canadian Dollar FX rate on a weekly basis (with 13 and 34 week simple moving averages). The strong Sterling performance from early 2013 to early 2014 is in the process of being corrected or unwound. This period of a strong Sterling coincided with the marked improvement in the UK economy especially relative to other developed economies. As noted above, the relative out-performance of the UK economy is now over and the downward correction in Sterling appears to be gaining some momentum. From a technical perspective, if the 1.75 area is broken there is little in the way of support until the 1.65 area or lower.
The other implication of the more dovish Bank of England is for the rates market. After the more hawkish Mansion House speech from Carney in June, the Libor market was pricing in rate rise starting before the end of 2014! Not only has the environment changed markedly since June, but the Libor curve continues to adjust to the rates lower for longer view. We believe that this has further to go and we remain bullish on the December 2016 Libor contract. Indeed, we also think that the longer end of the Gilt market will benefit from the lower for longer rates environment and the current low levels of inflation in the UK.
Was the Bank of England inflation report this week a game changer? Not really. It was probably more the outcome of a robust "mark to market" exercise in the Bank's economic forecasts. That said, the markets were caught slightly wrong footed and the adjustment to low rates for longer has further to go. In this adjustment process, the rates and bond market should rally and Sterling should be relatively weak especially given the political situation.

By Stewart Richardson on 14/06/14 | Category - UK
June has been an interesting month so far for global central banks. The next FOMC meeting concludes next Wednesday so there could be more surprises in store. What is increasingly clear is that, after seven years of all major central banks pursuing the same stimulatory monetary policies, the next two years will see divergent paths. This should help create trading opportunities in relative value strategies and an increase in volatility albeit from near record low levels.
Last week's surprise was undoubtedly delivered by the Bank of England Governor Mark Carney. In his Mansion House speech, he said that the first increase in interest rates "could happen sooner than markets currently expect". This is dramatically different language than we have heard from Governor Carney in recent months and therefore deserves serious attention.
There are two core drivers of the change to a hawkish bias for Carney. The strength of the economy and the high level of asset prices. On the economy, he said "Growth has been much stronger and unemployment has fallen much further than either we or anyone else expected". On markets, he said "There is evidence of growing vulnerabilities in financial markets", which is central banker code for asset price bubbles. He is particularly worried about an overheating property market.
Carney is not saying that rate hikes are imminent. The ultimate decision to raise rates will be data-driven. In fact, the MPC still sees some spare capacity in the economy and they expect the rate at which this spare capacity is removed will slowdown in the second half of the year as more supply becomes available. In any event, he stressed that "eventual increases in Bank Rate will be gradual and limited".
If we were to try and sum up Carney's current position, he has put the country and the markets on notice that rates need to go up in the long-term and the first rate rise could be "sooner than markets currently expect". He will probably implement macro prudential policies to cool the housing market before any rate rise and will only raise rates in the next few quarters if the data continues to be strong. We suspect that the first rate rise will be just after the election next May.
For the sake of injecting some balance into the debate here, we would note that if the UK economy were to slow down of its own accord, the Bank may not raise rates for some time. First, Carney's speech alone caused a tightening in financial conditions with short end yields and Sterling higher and equities lower. If these trends continue, then they could help slow the economy.
Two other factors are worth noting. First, as noted by the World Bank this week, global growth is just not picking up yet and second, oil prices are rising again as Iraq descends into civil war. These issues could also dampen UK growth. Monetary policy in the UK will clearly be a delicate balancing act in the next few quarters.
The main conclusions of this week's events in the UK are that Sterling should be a strong currency in the months ahead and the UK equity market is beginning to look a little vulnerable. The chart below shows the FTSE 250 which fell heavily this week and has the look of a classic topping pattern. Resistance here should be the 16,250 area and a clean break of 15,250 would be ominous indeed.  

By Stewart Richardson on 10/08/13 | Category - UK

With great expectation (within the media at least) Mark Carney the new Governor at the Bank of England revealed his new strategy this week. Mark Carney is viewed by many as the pre-eminent central banker of the day and his boss at the UK Treasury will certainly be hoping that he can help lift the UK economy into escape velocity. So, what do we make of his new strategy?

The first point to make is that central bankers really only have four tools in their policy set; interest rates, liquidity (granted against high quality collateral), quantitative easing and verbal intervention. With interest rates at the zero lower boundary, the Bank's balance sheet already bloated by £375 billion of QE and liquidity being sparingly provided via the Funding for lending scheme, the only tool left for Mr Carney was verbal intervention (what central bankers now call "forward guidance"), or put another way, promise to keep rates at close to zero for as long as it takes.

Let's be honest here, compared to interest rates and money printing, forward guidance packs a very modest punch indeed. Perhaps the UK economy only needs a bit of cajoling to hit escape velocity; there has certainly been an improved tone to recent economic data. If this is the case, then as noted by many commentators this week, promising to keep rates low for an extended period may lead to too much borrowing (with attendant problems when interest rates finally rise) and possibly an inflation problem further out. Indeed, the Bank of England upgraded both their growth and their inflation forecasts this week and so perhaps the new forward guidance is simply not required.

Yet, despite the better tone to recent data and the up grade to forecasts, Mr Carney chose to strike a somewhat downbeat message during his press conference. Not only does the bank expect unemployment to fall from 7.8% to 7% in three years (seems like a long time to us), he spoke of continued headwinds. Perhaps he is hoping to under-promise and over-deliver. Perhaps he is being downbeat to justify his forward guidance when it may actually be unnecessary. Perhaps he just doesn't trust the recent data.

Whichever, he decided to press on with forward guidance, but with some caveats;

  1. So long as they do not expect inflation to be above 2.5% in the future.
  2. So long as their policies are not leading to financial bubble.
  3. So long as inflation expectations remain contained.

The cynics out there may say that he has given himself a lot of wiggle room to change the goalposts. Some will say that it is right and even prudent to give out the message that rates will remain low as long as necessary but only so long as inflation and financial excess do not get out of control .

What strikes us as odd about this forward guidance is that the Bank is tying itself to promise on future policy and is using lagging indicators (inflation and unemployment) to guide them. Each cycle has seen economic growth bottom well before inflation - in fact, inflation generally goes up in the early stages of economic deterioration. Also, the unemployment rate always peaks some way after the economic recovery begins.

The first chart below shows the relationship between UK GDP and the CPI inflation rate. We have lagged the inflation data to try and get abetter fit. Does this show inflation is a lagging indicator? We think so, and the economics text books tell us this is how it should be. It will be interesting to see whether the Bank of England's forward guidance policy actually generates sufficient growth in the economy to generate the jobs they are looking for and without creating inflation.

 The next chart shows the relationship between GDP and the unemployment rate. We have advanced the GDP data by 20 months, and the unemployment data is inverted so as to show troughs in growth with peaks in unemployment. What is interesting is not just the correlation between the two (with unemployment being a lagging indicator!) but also the fact that unemployment held up so well during the last recession. This could be because there were a lot less corporate bankruptcies in this last cycle and perhaps the labour market is just that much more flexible. Whatever the cause, we have to wonder whether, having not collapsed as we would have suspected, the unemployment rate fails to recover as in previous cycles. If the unemployment rate remains sticky above 7%, will the bank be able to keep rates low even if inflation remains above 2.5%?

Clearly, the Bank is now following policies to promote growth and willing to be more "flexible" in targeting inflation at the same time. So does higher inflation lead to lower unemployment? Anyone who lived through the 1970s high inflation period will remember how high unemployment was at the time. The chart below shows the relationship between inflation and unemployment. What is clear is that low and stable inflation is desirable in terms of keeping unemployment low.

Our view is that Mr Carney has a very difficult balancing act. If the economic headwinds knock the UK economy off track, he really has very little left in the tank. Forward guidance will simply not be enough to support a struggling economy and QE is a great policy for inflating asset prices but seems to be less effective at generating real economic growth. On the other hand, if the economy is now improving, how can a central bank anchoring policy against lagging indicators hope to get ahead of the inflation curve? Our best guess is that in this scenario, the Bank will remain accommodative for far too long.

As we know, Mr Carney is not alone as all major central banks are struggling as they operate at the extremes of policy. Perhaps the UK will be better off than our competitors with Mr Carney in charge. It's not easy to know at this stage whether there are any obvious investment strategies that we should be implementing at this stage. Frankly, US policy, the Chinese slowdown, the Japanese reflation policies and lack of real progress in Europe are more powerful macro drivers at the moment.

Mr Carney certainly brings a different style to the Bank of England but for the moment we will reserve judgement as to how effective he will be.


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