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August 2019 Market commentary

“We should not be afraid of being wrong but we should be afraid of persisting in error”. Sir Karl Popper

by
Simon Martin

19.08.2019

In the space of a few months the UK has moved from a scenario where we expected a close post-Brexit relationship with the EU to one of antagonism.

I have no idea who the following quote can be attributed to but it is certainly one that a lot of Brexiteers appear to be pinning their hopes on; “The EU blinks and there’s a deal or the EU doesn’t blink and we crash out without a deal”.  It has undoubtedly been fuelled by Michael Gove’s comment when he said “no-deal was now the government’s working assumption”.

Remainers, on the other hand still believe that “Parliament will somehow stop no deal” although it’s not obvious how.

Three weeks into Boris’ regime one FTSE 100 chairman is reported to have commented “There’s no point in shouting that no-deal is bad — that ship has sailed. We need to get our heads down, hope for the best and plan for the worst.” Another said: “It reminds me of the Y2K bug. I can’t believe the world’s going to end on November 1 if there’s no-deal. There will be chaos, but there will be chaos with a deal too.”

We still have no idea what is going to happen with Brexit and continue to believe that it’s almost impossible to second guess the outcome.  But we feel that it is important that we have a view on the matter and at the moment we have to look beyond Brexit with the knowledge that the UK economy will continue to function, that UK PLC will adapt to whatever situation emerges from the Brexit debacle.  The only thing we can predict about the run up to Halloween is that we know that there will be a phenomenal furore in the media that will distract a lot of interest away from the most important issues facing the UK economy.

As the title implies we accept that we may be wrong but we have to have a view and we have therefore decided to retain with our international exposure which will benefit from sterling weakness

 

WHAT IS GOING TO HAPPEN TO THE DOLLAR POUND AND OTHER CURRENCIES

The bigger picture is the impact current news is having on global currencies, with the main concern being the reaction of the US dollar!  US interest rates are still the highest in the developed world and although the Federal Reserve has recently cut rates, the US dollar is still in a strong position. 

We know that President Trump is anxious to weaken the dollar, relative to other currencies, to try and make the economy more competitive as he resents the facts that their main trading competitors all have weakening currencies.  However, the Chinese currency has fallen below a psychological level and the Euro rate relative to the dollar is at a low ebb and therefore compounding the trade gap between countries such as Germany and America. 

HISTORY LESSON

As we all know, since the referendum Sterling has depreciated significantly because of the fact that economists have cut their forecasts for UK economic growth as a result of Brexit.  It reached a low in October 2016 when Theresa May, the prime minister, promised a “hard” Brexit.  Yet it appreciated fairly steadily in 2017 and 2018.  This was largely because the economy was surprisingly resilient.  GDP managed to grow and unemployment fell to multi-decade lows and because currency traders started to believe that the most likely outcome was a “soft” Brexit and thus less economic harm.  The “doom and gloom” predicted during the referendum also failed to materialise.

However, the pound’s recent fall started in April, shortly after the EU agreed to delay Brexit to October 31st.  Since then global factors have started to play a greater role.  Around May traders began to panic about the effect of a trade war between America and China on global economic growth.  That prompted “de-risking” i.e. moving assets out of countries highly reliant on inflows of foreign capital.  Britain, which runs a large current-account deficit, saw its currency depreciate.  Although worries about the trade war eased for a while they have been ratcheted up over the past week or so as President Trump started to tweet again. 

We know that technically the pound should be stronger when compared with the euro.  The UK has positive interest rates, low unemployment, some economic growth and at this moment no need for Quantitative Easing (QE) or to cut interest rates.  In Europe many countries are struggling with negative interest rates, low or non-existence economic growth, high unemployment and with the prospect of more QE again to try and kick start some economic performance.  In normal conditions the currency weakness should be the other way round, with the pound considerably stronger than the euro.

Instead, we are having to deal with markets and investors making assumptions that the pound could be headed below parity with the Euro.  Tourists are already having to deal with these rates when they convert cash for their holidays. Industry and commerce have to factor these rates into their business models.  

Some people, of course, welcome a weak pound and believe that Sterling’s fall is now mature enough to suggest that we could now be on the upslope.  Devaluation should produce a trade rebalance because imports are more expensive, followed by an improvement because our exports are more competitive.  Lord Wolfson, chief executive of Next, recently said he would “challenge some of the gloomiest prognoses of what no-deal means” and said there were “no fundamental reasons” why the pound would stay depressed in the long term.

 

IS TALK OF A GLOBAL RECESSION JUSTIFIED?

At this stage we are not expecting a Global recession within the next 18~24 months but a number of commentators have questioned whether the latest Chinese / American trade dispute could be the catalyst for the end of the current economic cycle or is it simply the means for President Trump to pressurise the Federal Reserve into cutting interest rates.  Inevitably the conspiracy theorists speculate that it could simply be a cunning plan by President Trump’s election team to give the US economy a further boost as he runs into the election campaign.  The weaker dollar will inevitably help make US exports more competitive and help to reduce the trade deficit. 

President Trump’s latest round of tweets continue to weigh on the US economic outlook and we feel that he expected those uncertainties to produce more than the half-point rate reduction we saw earlier this month.  A Quarter point rate reduction is probably not enough for a sitting President, who is preparing to start a re-election campaign over the next 12 months.  So we have to ask ourselves whether we should expect the Presidential to increase pressure on the Fed over the next few months.  In fact, many analysts now expect the next rate cut to hit early next year, just in time to help voters decide whether the tweeter-in-chief deserves four more years.

Despite President Trump’s agenda, US authorities must also concern themselves with the state of the world economy.  As we know Britain is preoccupied with Brexit.  In Germany, various economic indicators are at their lowest level in nearly a decade.  The Italian and Greek economies labour under the weight of Germanic austerity policies.  However more importantly, China’s highly indebted economy is staggering from Trump’s tariffs, with the effects rippling out to the many countries dependent on exports to China to keep their economies humming. Germany is one.

It is not unsurprising that President Trump believes the EU has adopted a deliberate policy to keep interest rates low in order to keep the value of the euro relative to the dollar.  As part of President Trump’s “America First” agenda the European Union has been told to lower barriers to US goods, or suffer the economic fate meted out to other nations who fail to believe that Trump will follow through on his threats.  This is why we still believe that as he gets closer to the US Elections he will back off the harsh rhetoric against China and Mexico and turn his full attention on Europe. 

This change in strategy should reduce the threat of a US recession being caused by the China /US trade war and help boost the US economy as he starts campaigning.  This is why we have been reducing our weighting to mainland Europe over the past few months.

CONCLUSION

By changing its dialogue with markets, the Federal Reserve has helped to remove the threat that caused the economy to stumble in November and December 2018.  When we add in the fact that President Trump is now running for a second term we feel that all things being equal the US economic cycle should continue for at least the next 18-24 months which in turn should be sufficient to prolong the US market out-performance until after the election campaign.  This in turn will help keep global markets high as we manoeuvre past the initial stages of Brexit and we can see how the land lies as we move into 2020.   This is the primary motive for maintaining our International exposure and building up direct exposure to the US market.  If we can focus on core ‘value’ driven US funds generating a reliable income that will compound over the next few years this will protect on downside risk and the income will be a key part of our total return expectations over the next few years

Moving back to the UK, Adam Cole, chief currency strategist at RBC Capital Markets, agrees that the only meaningful upside for the pound, he suggests, would be if Britain reversed its decision to leave the EU. Anything is possible, but that looks unlikely in the short term hence why we feel confident with our weighting in overseas investments and our high concentration in internationally focused UK companies.  If the pound falls prices will go up, dividends will also go up, which will help us to weather what could be a difficult final quarter. 

So can sterling regain its poise?  Probably not for this year’s summer holidays, but perhaps for next year? The pound has few friends at the moment, but, if we see a period where the pound falls below parity with the euro and close to it with the dollar we can at least plan a strategy for its recovery.  Because at that stage we feel that the markets will have over-reacted and therefore we can reasonably expect to see a sharp recovery.   

As we have mentioned on a number of occasions Britain is dependent on the “kindness of strangers” as is relies heavily on inward investment to balance the payments deficit or, at least, a low enough exchange rate to make UK assets cheap enough for foreigners to want to buy.  We have heard that funds are being created in the US to take advantage of this currency weakness.  It would appear that they may have identified UK assets that will be very attractive to US investors if we see the exchange weaken further.  This has the potential to boost UK assets in a post Brexit gloomy period!

There are numerous comments in the Economist magazine questioning whether Trump can afford to weaken the dollar by selling it especially when he is running up against the Chinese government who control their currency and the euro which is in a very weaken state.  It is therefore vital that we have a strong view on the currency rate and this will help us to navigate our way through the uncertainty that we are currently seeing with Brexit, and in the context of a general slowdown in global growth.

 

Simon Martin
Senior Investment Manger
Leeds

 

13th August 2019

 

 

Nothing in this article should be construed as personal advice based on your circumstances.  No news or research item is a personal recommendation to deal. 

 

The value of investments can fall as well as rise. Investors may get back less than invested

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