Sobering October

28 October 2016

As the month of October draws to a close it becomes seemingly apparent that there is a growing discrepancy between the assessment of international capital markets and British business of project Brexit and the future prospects of the UK's economy. While the near 20% depreciation of £-Sterling since the beginning of the year indicates that overseas' capital now demands a significant upfront discount before investing in UK assets, the resilient UK GDP growth tells a domestic story of '˜keep-calm-and-carry-on'.

For UK private investors the currency depreciation dimension of the Brexit shock initially turned the feared capital markets nightmare scenario into a welcome surprise of a '˜Goldilocks' summer. October's party conference season put somewhat of an end to this benign environment and the political posturing forced the currency to ever lower levels. This not only opened up the perspective of a return of inflation, but also reminds those with a historical awareness that uncontrolled currency depreciation can have some very undesirable side effects. Back in 1976 this expression of global concerns about the direction of political travel went so far that the UK lost access to international finance and had to call the IMF to the rescue.

While by no means an imminent scenario, there are a number of uncomfortable parallels. E.g. the UK once again requiring significant external finance because we import and consume more than we export, also known as a Current Account deficit. This would explain why the UK bond markets reversed direction and fell over the month of October, although it is also true that they were hopelessly overbought at the end of the summer, which would be just as good an explanation.

For the near term, however, the UK economy benefits from the '˜sugar rush' the currency devaluation has bestowed on its export oriented services industry in the South East. This should for a while more than compensate for the Brexit related loss of demand in the construction and industrial goods sectors.28

The apparent discrepancy between the international currency markets and the real UK economy may therefore have more to do with time perspective than differences in judgement. For now, the admirable British attitude of '˜getting-on-with-it' pared with short term currency devaluation benefits have resulted in economists' well founded and rational expectations for the short term to be proven utterly wrong. This has bought the UK's '˜newbie' government time to devise a credible plan for a future beyond full EU membership. However, October's further currency fall has hopefully been heard in No 10 as a warning shot that eventually long term expectations turn into present day realities.

In terms of investment returns for our UK investors, October should prove to be another positive month, although as forecast, fixed interest bond allocations struggled to add any value. Growth came predominantly from large cap UK equities, which were once again buoyed by the falling value of £-Sterling, which increased the value of their overseas revenue streams from a Pound perspective.

UK investors observing double digit returns for 2016 from their investment portfolios should refrain from worrying that capital markets have lost the plot and are overheating. If they looked at the same investment portfolio from a US$ or €Euro perspective, they would find values have gone up only little or in the case of fixed interest bonds even lost value. This means that professionally managed investment portfolios have succeeded in protecting investors from the value destruction of the fall of the Pound, but if their owners planned to use their funds to retire outside the UK, then I am afraid than its so far been a decent but no more than low single digit vintage.