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.
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