Politics are back - £-Sterling plunges - again!
7 October 2016
As we suspected and had forewarned, politicians have become the main drivers of capital markets over the past week. Theresa May, as the new Tory party and UK government leader, decided to try and appease her electorate and pitch for traditional Labour and UKIP voters’ support, rather than providing a more certain environment for UK and international businesses by addressing Brexit concerns first. This would suggest that, given the strong recovery in business activity since the July slump, she may have deliberately prioritised the consolidation of her thin majority in parliament over any further short term gains for the economy.
What I found more remarkable, however, is how willing her party folk appeared to accept her formal closing of the post-Thatcher area, with its mantra of ‘if it is good for business then the benefit will eventually trickle down to everybody in society’. The Tories’ staunch following of a fairly pure free capital market economy interpretation seemed to give way to a softer interpretation which reminded me in parts of Germany’s ‘Social Market Economy’.
Here the superiority of the free market economy also serves as the cornerstone, but there is also the belief that, in its pure form, unrestrained capitalism leads to too much undesirable hardship. Free market forces are therefore tamed and, to a certain degree, suppressed, with the aim of achieving a more balanced outcome for all. This economic model is somewhat less dynamic and requires more cross-society consensus to drive through lasting change. In my opinion, its success also requires additional virtues embedded and accepted across society in order to compensate for the lesser force of the ‘animal spirits’ of free market agents.
It waits to be seen whether all of the Tory party will follow May’s economic policy volte-face, but one of the other core elements of this model is a greater role of the state in the provision of infrastructure, education and social care. In the current environment of deficient private investment in productive goods and services – which holds back the full potential of the country’s economic recovery – such fiscal involvement in the economy does not have to be a bad thing.
We have, in previous editions, commented at length about how the persistent low growth environment is crying out for fiscal investment initiatives because, otherwise, the monetary stimulus and its side effects may well have been in vain. The announcements of intention to proceed with various large infrastructure projects like HS2 and the 3rd Heathrow runway tell me that I can’t be very far off the mark here.
Judging by the reaction of capital markets, their focus was on a different aspect of the speeches from the Tory conference. They were looking out for any insight as to whether the new UK government had succeeded in drawing up a strategy for an orderly EU exit since the post-referendum chaos of the summer. The around 6% fall in the external value of £-Sterling since May started her first speech informs us that such hopes were disappointed. Private investors may have rejoiced over the UK stock market’s rally back to previous highs but, from a broader perspective, the rest of the world has just written off another almost 6% of the value of the combined UK economy.
Since the beginning of the year, £-Sterling has fallen close to 20% against a basket of the other major Global currencies, which can be interpreted as the UK being worth 20% less to the rest of the world than it was in 2015. The reason UK company shares rose regardless, has much to do with the fact that their business profiles are often international, meaning the future value of their non £-Sterling revenue streams increased by the same amount the currency declined.
The new Tory leadership’s decision to set a start (and thereby end) date for their Brexit negotiations has robbed markets of any hopes that the onset of the pain of the divorce proceedings may be delayed beyond the French and German election to late 2017. They may see this as a risk of the negotiations being exploited for electoral campaign purposes rather than European politicians being distracted, as Tory speakers liked to portray it. However, to my mind, the biggest source of disappointment was that, beyond assurances that the government would fight for the best deal for the UK, there was very little of substance to help business leaders in assessing the UK’s future trading framework with the rest of the world.
This may not yet lead to an outright business exodus from the UK, but it will certainly discourage or further postpone most forms of investment in productive capital goods, particularly those that are aimed at producing goods and services for distribution beyond the UK.
I suppose the another way of looking at this 2nd bout of currency weakness since the Brexit vote is that, in exchange for an increase in uncertainty about the future outlook for any international operator in the UK (and indeed the prospects for the UK economy as whole), investors are asking for an ever larger price discount on UK assets. The only reprieve they grant is for those assets/companies whose profitability may benefit from the devaluation of the home currency.
Now, while the rapid devaluation of £-Sterling may be disturbing and hurtful to the nations pride, there are many other developed economies who might observe the developments more with envy than Schadenfreude. Envy, because a devaluation helps the affected economy in the short term through improved price competitiveness in Global markets. As the Global economy is currently expanding, UK businesses will be able to secure a larger share of this growth than otherwise. Furthermore, the recent threat of deflationary expectations should be quickly cured, as general price levels are expected to rise in the not so distant future – due to the knock-on effect of retailers’ imports becoming more expensive.
Unfortunately, there are, as always, also longer term downsides to the pound’s depreciation and, for an insight on those, I recommend the next article of the full edition.
The political and currency noise drowned out some very encouraging UK economic data releases which we also discuss in more detail in a separate article. Just to mention here, the recovery in business activity levels has continued from August and has now more than compensated for the July slump. The stimulating effect of the currency devaluation is clearly working and the relative calm of the summer also helped to rebuild business sentiment over the course of September. This most recent and somewhat unexpected upswing is even making the UK (at a par with Spain) the fastest growing economy amongst western industrialised nations – as projected by the IMF last week.
This all bodes well for investment returns from a UK perspective and the table at the very top shows just how good they have been for the year so far. At this point, however, allow me a word of caution. There is a distinct possibility that, in terms of investment time horizons, we may have once again experienced one of those periods where, just like the proverbial buses, we get all the returns at once (or upfront), meaning we might have to wait for a while before the next ‘wave’ comes through. On this basis, we are in the process of crystalising some of the investment portfolios’ UK gains and reinvesting them in overseas regions which we see as less affected by political ‘altercations’.
However, the resilience with which the wider Global economy is continuing to expand, and thereby gradually normalises, makes it unwise to assume an immediate reversal of the direction of investment returns. We are, at the same time, cognisant that the return levels reached pose a risk of sudden corrections, due to nervous sentiment swings as last seen in January. However, robbing investment portfolios of further growth potential through an equity underweight, is by our assessment at this juncture unwarranted and unhelpful for long term return prospects.