Current racing conditions: remaining soft. Q4 asset allocation preferences (unhedged US dollar-based, updated at start of quarter): neutral equities vs. fixed income relative to benchmark. Prefer emerging stock markets to developed. Longer term outlook is to be pro-risk assets.
This week: Sterling falls to $1.25, monetary policy fears, Deutsche Bank is not alone
Last week’s fat-fingered ‘flash crash’ of the pound has highlighted financial market’s dislike of Brexit. Not because global investors necessarily have a strong view on Britain’s relationship with the E.U, but because they hate the uncertainty to economic activity that a ‘hard Brexit’ will bring.
Similarly, investors hate the new uncertainty that they feel is entering European and Japanese monetary policy, with the ECB and the Bank of England under political pressure to raise interest rates while the Bank of Japan appears to be dragging its feet over a further expansion of its QE program. This coming week may be volatile on capital markets, we can be thankful for last Friday’s relatively weak September U.S non-farm payrolls, which came in at 156,000 (compared to 167,000 in August), and which should weaken the case for a December Fed rate hike.
Investors should remain diversified by currency, geography, asset class and sector. This includes holding a small amount of cash and gold.
Sterling falls to $1.25
· Sterling’s sharp fall during the Conservative Party conference last week, and sudden spike down to below $1.20 on Thursday night, was a reaction by currency traders to the more-risky ‘hard’ Brexit strategy outlined by the U.K government. This coincides with the country running the largest current account deficit in the developed world, meaning we are dependent on the ‘kindness of strangers’ (as BoE governor Mark Carney described it) to help us pay our way in the world. In addition you have the possibility of higher USD interest rates and possibly lower GBP ones. Goldman Sachs now predict further 5% fall in sterling’s value on a trade weighted basis, over the next three months.
1) ‘Hard’ Brexit. Speeches at the Conservative Party conference suggested that the U.K government will be willing to sacrifice membership of the single market, and possibly the E.U’s free trade area, in order to ‘take back control’ of immigration and end ‘meddling from Brussels’ on a range of issues. This is despite, over the summer, it appearing that Theresa May was favouring a ‘soft’ Brexit. She has taken this position probably to appease Conservative Party members, who are more euro-sceptic than Conservative M.Ps and May herself, but whose support she relies on if she is going to keep her job.
A hard Brexit caries a much greater risk of economic dislocation. Investment plans will continue to be put on hold by UK businesses, and by foreign ones considering investment in the U.K, as they wait to see what tariffs and conditions will apply to U.K/E.U trade once the Brexit negotiations are completed. Consumer confidence may weaken, with purchases of big-ticket items put off if consumers fear a slowing economy and a rise in unemployment. A weaker economy usually is bad news for a currency.
2) Current account. In addition, the country hasn’t been paying its way for years, with deficits in both the trade & services account with the rest of the world, and in investment flows. Our current account deficit (which is the total of these) is -5.4% of GDP ($162bn). It is-2.6% for the U.S, and +3.2% for the euro zone. This means we rely on foreigners to buy our debt, equity, buildings, factories etc to the tune of $162bn each year in order for the books to balance. There is a real risk that with slower growth and Brexit uncertainty increased, these inflows shrink. Then sterling must fall in order to bring the current account deficit and matching inflows into balance.
3) Interest rates. Don’t forget that interest rate trends currently favour the USD over other currencies, as the Fed is clearly itching to raise rates. Slower growth in the UK as a result of a hard Brexit may lead to the BoE cutting interest rates again, down to zero. A widening interest rate differential against the USD will lead to a weaker pound, everything else being equal.
· What should sterling-exposed investors do? Sit still. There are too many uncertainties to take an active bet on sterling either recovering, or weakening further. Brexit negotiations might go surprisingly smoothly and the U.K is allowed to exit the single market for labour (ie, to curb immigration from the EU) while remaining in the single market for goods, services and capital. Alternatively, Brussels may wish to delay negotiating until after a swath of European elections are out of the way, ending with next November’s German election. Delays will generate fear and uncertainty, bad for sterling. It may be that a weak pound boosts exports and economic growth is stronger than forecast, which would be good for sterling at first glance; but it might also encourage the gvt to take more risks in its Brexit negotiations resulting in it overplaying its hand.
· Surely a weak pound is good for the economy? There are different ways we can each feel good: we can eat well and take regular exercise, or we can take alcohol, nicotine and other substances.
· For economies, improving competitiveness through better manufacturing techniques and improving the skills base is the equivalent of eating well and taking exercise. It’s not the easy option, but it has a long term beneficial impact. Devaluation, on the other hand, is the equivalent of taking alcohol and nicotine. Certainly it boosts competitiveness for exports temporarily (though hurting consumers and businesses who import goods). But it reduces the need to cut domestic costs, to improve a product by spending on R&D.
· British post-war history shows a habit of squandering devaluations, relying on them to support exports of increasingly out-dated products rather than investing in new plant and R&D. It is noticeable that Japan and Germany saw they currencies constantly appreciate in the post-war decades, and yet through focusing on improved competitiveness they rapidly emerged as two of the three largest economies of the period.
Monetary policy fears
· The Brexit shock to sterling is taking place while investors are already wresting with fears that major central banks are walking away from existing loose monetary policies, but with no plan B to implement.
· The Fed is itching to ‘normalise’ interest rates, and yet CPI inflation of just 1.1% in August, and ambiguous economic data throughout this year suggest the economy is not yet ready for such a move. A Bloomberg report last Tuesday suggested that the ECB may wind down its QE program ahead of its scheduled ending in March, which led to a fall in European bond prices and a rise in their yields. This while euro zone CPI inflation is at 0.4%, unemployment at 10% and a banking crisis is unfolding.
· Also last week, the U.K Prime Minister Theresa May expressed exasperation with current Bank of England monetary policy, hinting that higher savings rates would be nice, and so implying the Bank’s independence may be under review.
Deutsche Bank is not alone
· Deutsche Bank is almost certainly going to be part-nationalised, given the reluctance of private investors to stump up more capital. But this is not a one-off bank crisis, problems on euro zone banks’ balance sheets and income statements are making them fragile.
· Germany -like much of Continental Europe- has too many banks, and the banks are often well entrenched into local and national politics. This makes the near-impossible to allow to fail, or to merge, despite growing concerns that profitability will remain poor until something is done. Now, and hot on the heals of the Italian banking crisis that reared its head again in the spring, we have a German banking crisis with Deutsche Bank being the focus of attention.
· The bank has been regarded as sick for years, with the $14 bn fine from the U.S Department of Justice for mortgage miss-selling being simply the trigger for what was an inevitable crisis given doubts over the quality of its loan book and failure to become a dominant global player in any of its activities. For instance, they had an ambition to become ‘the Goldman Sachs of investment banking in Europe’, but instead it has been Goldman Sachs itself that has this spot.
· Investors fear that Deutsche Bank is facing two choice. That it will be forced to either 1) raise more share capital, which may be near-impossible on account of the uncertainty over the health of the bank’ balance sheet. 2) Or require state aid, in which existing shareholders may be heavily diluted. Angela Merkel is reluctant to bail out the bank, at a time when anti-bank sentiment is high in Germany and, indeed, across Europe and the U.S.
· In addition to non-performing loans on its balance sheet, Deutsche and other euro zone banks are facing problems on the income front. The negative interest rate policy of the ECB. This means they 1) have to pay to leave deposits at the ECB, but if they lend the money on to clients 2) the interest they can charge is very low because the ECB has brought down the yield curve through neg. interest rates and its bond buying program.