The Pound’s last hurrah
- Despite all the political dysfunction, the GBP is not a sell, just yet.
- Brexit negotiations that begin this week should see yet another stalemate.
- Carney is right to raise rates as Q2 growth is rebounding.
- There are four reasons to be wary of shorting the pound here.
(This is an excerpt from our July 17 flagship report)
Question time at the UK Parliament can be very entertaining and for all my concerns and trepidations about Labour leader Jeremy Corbyn, he can be quite amusing when attempting to lambast the very lambast-able government of Prime Minister Theresa May. Last week’s resignations of Foreign Minister Boris Johnson and Brexit Minister, David Davis over Mrs. May’s extremely watered-down version of what she would accept regarding the UK’s future relationship with Europe was a political debacle. From claiming party unity to hanging on to leadership by a thread, the Conservative Party’s handling of the negotiations has put a hard Brexit well and truly back on the agenda. This almost inevitable train wreck is playing about before our eyes.
The market’s response to Brexit is very similar to investor attitudes toward the protectionist policies of President Trump. We have been told for several years now that Mr. Trump was going to impose tariffs on China, Mexico, and others in response to what he believes is an unfair global trading system. On this, he could not have been anymore clear. Yet the markets chose to ignore the signals. There were those of us who put on hedges far too early, shorting Apple, Caterpillar and of course, Boeing, as proxies for global trade retaliation, only to see them squeeze higher as rhetoric was slow to be realized and profitability remained strong. Investors waited for concrete actions from the administration before becoming fearful that tweets were now becoming official policy. Conventional wisdom tells us that markets are forward looking. In the case of the deterioration in the outlook for global trade, the signals were ignored until the point where talk became certainty.
While Brexit is much more opaque, the similarities are worth considering. While many saw the chance for negotiations to go nowhere given the short time frame and the belief that I, and many of you had that the EU held the upper hand regarding the composition of any deal, there was a tremendous amount of uncertainty over how bad it could get. The pound’s near 20% rally off the January 2017 lows was sensible given the strength of the UK economy (ironically driven in part by strong European demand), but also because of the discussion of a “transitional deal” that would have delayed the day of reckoning for the UK economy, which was described by Alan Posen of the Peterson Institute as “a supply side shock a dire consequences”. If I have learnt anything about financial markets in the last several years is that worrying about future scenarios that are yet to eventuate is pointless and loss making.
Through all the noise and hyperbole, there has been Mrs. May. I stated last year that she currently has the worst job on earth (with all due respect to US Deputy Attorney General, Rob Rosenstein) and while this continues to be without question, she has somehow maneuvered through the conflicting factions within her own party over what is increasingly becoming extremely unpopular with the electorate. Her narrow victory in the 2017 surprise election has certainly bought her time to see through the Brexit process, even with the transitional deal. However, the latest rejection by hard line Brexiteers such as Mr. Johnson and Mr. Davis show just how splintered her party actually is. The one saving grace is that while her own position and especially the negotiating stance has been weakened in the past ten days, there appears to be no other suitable replacement, capable of seeing the UK through increasingly muddied times.
With eight months to go before the UK leaves the EU in its current form, we are now reaching the stage where decisions need to be made. While the EU cannot be happy with the political instability because it significantly increases the chance of a Hard Brexit that leaves trade rules in the hands of the WTO, EU representative Michel Barnier appears unlikely to alter his stance insisting that the UK cannot “cherry-pick its favorite parts of the EU rulebook”. With issues such as the prospects of a “Hard” Irish border and the 98-page White Paper dealing with the trade of goods but not services, it is difficult to see how discussions that are set to begin again on July 16th do not end with yet another stalemate. While few want a hard Brexit, Mrs. May’s White Paper will have few friends in Brussels and fewer friends amongst those in her party who believe that the 2016 Brexit referendum was a mandate to leave, period. While Mr. Johnson’s resignation letter discusses the UK becoming an EU “colony” is typical of his hyperbole, it is clear that his supporters will fight tooth and nail to prevent Mrs. May’s version of Brexit from moving forward. The end result will be enormous pressure on Mrs. May and limited positive scenarios for a sensible outcome where all sides are content.
Despite the long-term uncertainty, Mark Carney is poised to raise rates in August
And all along, Bank of England Chief, Mark Carney, has done what all Central Bankers should do, and focus on the data. He raised rates in November as the strength of the global economy and full employment saw inflation pressures re-emerging. While the UK economy has had a history of GBP weakness leading to inflation spikes, the data was strong enough for the BOE to move rates higher from levels that still remain historically accommodative. Of course, Brexit bears like myself have argued that the supply side shock coming to the UK economy will lead to eventual recession, but with transitional deals being discussed, the timing of Britain’s divorce from the EU remains uncertain. Carney’s concerns over Brexit are well known, but he has been prudent in the conduct of monetary policy in the face of the conflict between the current outlook for pricing pressures and the potential for dire outcomes down the track. Central bankers are not in the business of pre-empting outcomes and hence, it is likely that the BOE will raise rates by another 25bps in August.
The economic outlook remains conflicted. Q2 GBP has rebounded off depressed levels in the first three months of the year with services, retail, and construction all showing signs of life. The housing market has stalled but funding costs are not onerous, even with a slight uptick in rates. Wages are stagnant and full employment remains, and housing bears miss the point that prices will not fall precipitously if home owners have a job and low mortgage costs. It just won’t happen and big picture, a slight increase in rates won’t choke off the economy. This rate increase is an insurance policy. While I am not a believer in the need to raise rates because you need to cut later, recent data probably justifies the action.
Bears like myself often fall into the trap of looking too far ahead. I have done it with trade and frankly, I did it earlier this year by holding onto structural GBP shorts far too long. Headlines from Airbus and BMW about the future of UK operations should concern business owners who service these companies and the workers at their plants, but investors need to be careful not to over-analyze the impact this will have on the GBP. Business investment is a mess but is it really the reason for the pound’s weakness against the USD?
Despite all the analysis we do on particular economies, the USD remains the dominant driver of global currencies and it has been recent USD strength has created a perception that the GBP looks weaker than it is. On a trade weighted basis, the pound is off its best levels of the year but is still at the upper end of its trading range over the course of the last 12 months. Despite much hype about the USD being firm over the course of the last six months, the USD is well off the 2016 highs, while the GBP is still roughly where it was post the shock of the referendum. Despite, the weakness in the GBP versus the USD since the start of Q2, I do not believe the GBP, on a trade weighted basis is reflecting the botched handling of the negotiations by the government of Mrs. May.
Four reasons not to short the GBP at this precise time
All that said, I am conflicted by my grave concerns for the UK economy as 2019 approaches and the short term economic and monetary policy narratives that will drive the pound here and now. Putting sentiment aside, there are four reasons why shorting the pound at current levels is difficult:
Firstly; The growth rebound in Q2, admittedly off a low base. As stated above, the Bank of England is in the business of analyzing data and not pre-empting the economic impacts of Brexit that still remain uncertain due to scale and more importantly timing. Inflation has softened from the peak of H2 2017 levels but is stabilizing at elevated levels.
Secondly; As such, solid growth and elevated inflation should see the BoE raise rates in August. While recent political turmoil has seen expectations for an August hike come down, unless inflation data due this week comes in well below expectations, the odds favor an increase in cash rates to 0.75%.
Thirdly; The USD looks capped more broadly and with little incentive for the USD to move significantly higher, GBP weakness will be muted and thus the incentive to sell the trade weight pound is less compelling.
Fourthly; Speculative short positions in the pound are growing again.
So, I am caught between my long-held view that the policy framework for the UK economy is a disaster and the shorter-term cyclical drivers of growth, interest rates, and GBP that are temporarily well supported. The pound is a sell into strength, predominantly against the Euro and while the timing of any GBP capitulation will be some toxic mix of further political deterioration and market constructs for the GBP, time is beginning to run out for Mrs. May.
If the resignations of Mr. Johnson and Mr. Davis have done anything, it has shown that the world needs to focus its attention on Brexit because, over the next eight months, it will begin to dominate the narrative. I am not saying that it will drive global beta. Investment returns will continue to be dominated by the growth and profits outlook. That said, any signs that Mrs. May could face a leadership challenge or scenarios where the USD breaks higher could see the GBP sold aggressively. There is going to be global investment consequences of Brexit, just not yet.
The thematic model portfolio has a long UK 10-year Gilt position which is my way of expressing my Brexit fears and the underlying weakness of the UK economy versus the rest of G10. Despite my list of reasons not to short he GBP at this time, the tenuous position of the Conservative Party and lack of momentum regarding negotiations means that the chance of the trade weighted GBP rallying sharply is slim. You just need to have a token position at this stage.