Market Insights

Just a thought on GBP

The past year of how GBP/USD has traded could be characterised thus:

* Sell it on Brexit vote
* Sell it on Theresa May “Hard Brexit” conference speech
* Buy it on govt having to consult parliament on Article 50 trigger after losing court case
* Buy it on rebellious House of Lords

This could be called Stage 1 of the grief that a “Remainer-mindset” market felt after the UK apparently took leave of its senses by voting to Leave.

Then Trump turned up, Article 50 was triggered, and The People had to be heard. As they had said they wanted to Leave, well then, the market had to accept it. GBP/USD then turned into this:

* Don’t sell GBP as the economic data looks good, but wait to sell rallies instead, as the data will eventually turn
* Buy GBP for long-term hedges around 1.20-1.25 as it’s good value

Which led to a fairly narrow GBP/USD range. Until…. Theresa May calls an election! Given the massive lead for the Tories in the polls in the months prior to that decision, and the self-immolation of the Labour party, this could only mean one thing…. She would win, win big, and reduce the risk of a disorderly exit as her hand would be strengthened in negotiations. All that faffing with the court case wouldn’t happen again. The country would be set on its Brexit path. We entered a new phase:

* Buy GBP as Brexit is now going to happen in a “strong and stable” fashion
* Sell GBP if Conservative poll lead wobbles

This is somewhat ironic. Those opposing Theresa May have argued either for a 2nd referendum (the Lib Dems) or less hardline Brexit stance (Labour). Back in Stage 1, the thought of Brexit itself took GBP lower; anyone preventing it took GBP higher. That has now reversed.  This is because the market has reconciled itself to Brexit actually happening. The first stage of grief, Denial, has passed.

This means that the default impulse to be short GBP has passed. Indeed, some degree of certainty from Theresa May’s increased mandate, along with the improving economic data, suggests the natural inclination might be for a slightly long position. Or at least a neutral one. Certainly volatility in GBP/USD has been falling:

gbpusd historical vol

This opens the way for the Second Stage of Grief: Anger. Once we proceed to June 19th, when the negotiations truly begin, we will see a lot of heat and light from politicians on both sides. Theresa May could go into negotiations with a stronger hand; but David Davis seems to want to use that hand for an early knockout punch, threatening to walk out if the EU27 don’t play ball. The EU27 have been remarkably unified thus far, likely united by the dawning realisation that the UK’s money is coming out of the pot. No-one wants money to walk away without a fight. Hence their obsession with a large headline figure for the divorce bill. Who cares about who gets the cat when you realise you’re not getting the same income?

If the market thought the UK have been irrational, let’s see how they feel about the EU27’s position. If the market still has the mindset of the UK being the guilty party, then EU27 intransigence may be considered more rational than the UK’s.

The point of all of these musings is that the moves in GBP are strongly sentiment driven. It can be no other way, as we are about to enter a period of non-linear political risk. If investors felt that the risks for GBP died with the announcement of the election, they are about to receive a significant shock.

Narrowing again…

Four days pass, and the Conservative poll lead halves again. With 13 days to go until election day, an extension of this trend would see Theresa May out of power, and make prudence out of Gordon Brown’s decision to avoid a snap election! Fortunately, as all investors know, a couple of data points do not a trend make. It’s tough to extrapolate from this that the Conservatives will lose the election. Note that demographics are firmly in favour of the Tories:

  • In marginal Labour seats, there are an average 4,500 more over 65 voters than 18-24 year olds, while in Conservative marginals there are an average 7,500 more (from @election_data)
  • And Labour poll at 59% for 18-24 year olds, but Conservatives poll at 67% for over 65s (from @GoodwinMJ)
  • In 2015, 44% of 18-24 year olds voted, but 78% of over 65s did

In other words, there are more old people in Conservative seats, older people vote Conservative, and older people actually turn out to vote.

Hence the fact that the Conservative manifesto has focused on social care for the elderly appears to be such an own goal. Or at least that the emphasis of the manifesto has fallen on that policy so squarely. Further detail from the YouGov survey shows why the poll lead is narrowing:

Labour have promised some nice free stuff, accompanied by soaking the rich to pay for it. Meanwhile, the Tories appear only to have promised a reform that can be characterised as a “dementia tax”.

This is despite the reality that the Labour and Conservative manifestos are pretty similar in terms of how they affect people’s money across the income brackets:

Perception, of course, is reality. The average voter doesn’t have an Institute for Fiscal Studies ready reckoner of what the policies will do to their income. They just see “more NHS spending” vs “dementia tax” and react accordingly when the pollsters ring.

The Conservatives will still win this election, although after the giddy hubristic heights of expecting a 3 figure landslide majority, even an increased majority from the current 17 will look a potentially poor result. As discussed earlier this week, the election is a phoney battle ahead of the real war. And there is now a question mark hanging over how strong and stable Theresa May’s negotiating hand in that war is going to be.

BTFD

A week ago, there were wobbles. Trump impeachment! Brazil impeachment! Here it comes! Risky assets correcting! Finally! There has been a bizarre desperation for a downturn in order to feel more invested in the upturn. The truth is, we feel uncomfortable. We know the underlying drivers are changing: central banks are trying to turn off the liquidity taps; wages aren’t going up enough to suggest lower unemployment will translate into growth; and the new actors on the stage, the politicians, are unpredictable. So why does “Buy The Dip” win every time?

It’s not just a funny feeling in our stomachs. Here’s a chart from BAML on how quickly drawdowns bounce back:

The fact is, cheap money is still sloshing around, and that money has to be put to work. But that doesn’t get to the heart of why recent history appears so markedly on this chart. BAML have looked at “5 sigma” drawdowns. That’s 5 standard deviations; in physics, it’s being 99.9999% confident of an outcome, or of it happening only once every 3.5million years. In other words, it’s a drawdown of a magnitude that doesn’t happen very much. Something akin to a crash. (Note the first bar on the chart is October 1929). But the drop in the S&P last week didn’t feel like a full on crash, did it? That’s because the standard deviation is measured on recent history: if things haven’t moved around much, then it only takes a small move to feel quite significant.

So the real reason that recent history appears on this 5 sigma chart is because volatility is so low. And when it moves, it doesn’t move for long. So the volatility OF volatility is also very low. Volatility eats itself. We first flagged this in the summer of 2014, which marked the absolute lows in cross asset volatility. But since then the impulse has proliferated. In September 2015, we noted ‘All of these bets to protect oneself against volatility are in fact causing volatility’. The flash crashes started, from the biggest drop in the NZD for 30 years to US Treasury yields. They were tremors. It took new foundations for our economies to shake them out further, with the introduction of political risk. GBP/USD hit 1.5000 the night of the Brexit vote; 24 hours later it was 1.3500, and then 4 months later, 1.1800. But then political risk was assimilated by the vol-eating machine. It learned. The impact of Trump’s election on risky assets was just a few hours; by the Italy referendum it was minutes; by the French election, it was ahead of the event itself.

Buy the dip is becoming a monster. It started as a mandated policy from central banks to drive animal spirits out of their “sell everything” funk. It took over as economies genuinely recovered. But then the proliferation of ultra-liquid ETF trading, plus the assimilation of volatility itself as an asset to be traded, created a self-reinforcing cycle. Active fund management lost out: more money flowed into passive. Buy risky assets, but buy VIX ETFs: a portfolio protected against tail risk, and cheap at the price! The more VIX buying, the more vol-selling strategies succeeded. And so on, and so on.

When will it stop?

Well, things are still only at the edge of insanity. Here’s BAML with another chart, this time of how “high yield” credit now yields less than plain old equities:

Of course, this has been twisted by the QE implemented by the ECB and the BOJ. Unlike the Fed QE these guys are deliberately buying up corporate debt, just as it’s become even harder to source, due to the regulatory reduction in banks holding this to warehouse risk. Yes, we can throw regulatory change into the new market structure too. It’s all allowing the persistent passive money to become a dominating force in driving the market.

You think it’s insane now? Well Robert Shiller, he of irrational exuberance fame, just came out with the line of staying in the market because it ‘could go up 50% from here’. He does go on, “But I think if one wants to diversify, US is high in its CAPE ratio. You can go practically anywhere else in the world and it’s lower”, suggesting that maybe the S&P500 might not be the best place to Buy The Dip (or at least, Buy Less Than Elsewhere On The Dip).

This will all only crack when economic growth genuinely stalls, or when political risk becomes taken more seriously. To break the quant driven market, where we talk in terms of 5 sigmas, we need to become aware of the unquantifiable. Be ready for volatility to suffer some serious indigestion. But in the meantime, yes, BTFD…

European Eurovision – Change of Tune

 

This morning saw Germany’s Business Confidence index rise to all-time highs.

IFO

The Euro has hit one-year highs against the Dollar. Even as European interest rates are still negative, and the European Central Bank persists with QE. This is, of course, the point about the Eurozone. The ECB set interest rates for all countries within the Euro, not just Germany. Yes, Germany persistently runs surpluses, but hey, it’s propping up Greece now isn’t it, basically? That’s the deal of a monetary union. Oh but it’s not just an intra-Eurozone matter these days, now that DJT is in the White House. He hasn’t used the threat of calling anyone a Currency Manipulator yet – mostly because some of the key targets, such as China, are now allies required to fight a bigger enemy. But that won’t always be the case.

Hence Angela Merkel pops up yesterday with a nice little chat to school children – and ends up driving the Euro to the highs of the day. She responded to a question about trade with ‘The euro is too weak — that’s because of ECB policy — and so German products are cheap in relative terms. So they’re sold more’. If the Euro wants to rally on that, then that’s just a sign of market psychology. The gap higher in the Euro following the 1st round of the French election has never been filled. Ever since Macron successfully won the 2nd round, we have seen massive inflows into European equities:

European equity inflows

Comparing the previous peak is instructive. That period of ECB QE was accompanied by a weaker Euro, as the inflows into those equities were hedged. That made sense – own the asset that’s rallying, but not the currency when it’s evidently being deliberately trashed. This time around, it really is different. Not only is there a massive underweight European equity position that’s turning around, but the currency has fewer detracting forces than ever before. You may still question the value of a currency whose structure is an imperfect union. But the lessons of the last few years have shown, as Merkel herself said, that the answer to Eurozone crises is “More Europe, Not Less”.

Now we have that German election to throw into the mix. The year began with a riot of headlines from across the German press, severely criticising the ECB’s policy. Bild screamed “Raise Rates Now” and SZ warned “Change Course Mr Draghi”. How will that translate in 4 months’ time when inflation, growth, confidence are all even higher? And 2 year German interest rates continue to be heavily mired in negative territory?

Germany 2yThe pressure on the ECB to move away from their stimulus will be intense. Already there are calls from Merkel’s MPs that the next ECB President must be German. To be fair, Italy, France and the Netherlands have had a go so far in the life of the Euro – and Germany would be a sensible choice during a period in which the EU and the Eurozone will be under even more pressure to reform, post-Brexit.

So, we have a political backdrop that wants the ECB to change course…
We have improving European economic data…
We have portfolio flows going into European assets…
We have a central bank that’s starting to use the sacred “taper” word….

The fly in the ointment for a stronger Euro will be how the market interprets the inevitable heat and light of Brexit negotiations. Does the UK storming out of talks hurt UK or European assets more? Or does 100bn EUR, and other EU27 demands, look so unreasonable that Europe is penalised? Or is it considered a sideshow unless the European economy itself wobbles?

Whatever happens, the days of “the Euro is there to be trashed” are over.

The Phoney Battle and the Real War

The Conservative poll lead is narrowing; halved in fact, according to one poll. That sounds perilous – but the reality is that they were so far ahead, a halving would still deliver a healthy majority. Maybe not the landslide 150 seats of early predictions; this latest poll would apparently translate into a majority of ‘just’ 46. It’s enough to stir Tory party jitters however. Financial markets appear disinterested, having decided that May calling the election means she will shore up her domestic power base, thus reducing the risk of a disorderly Brexit. With just two and half weeks to go until Election Day, this disinterest will soon ebb away. Then the real war begins: Let Brexit negotiations commence.

The outcome of the election will determine just how much of a power base Theresa May really has. The wobble in their poll lead has been put down to the unpopularity of Conservative manifesto changes to social care – a policy that was allegedly inserted unilaterally by her powerful Chief of Staff, Nick Timothy. Without powerful outriders beyond her (explained well in this article by the excellent Robert Colvile), May could end up in ever more of an ivory tower.
That’s fine if she can ensure party discipline. The ivory tower can centralise and magnify power as the negotiations progress.

What if, heaven forfend, politicians become restless?

Ah, but there’s no opposition is there! The Labour Party is imploding; UKIP are redundant; and the Lib Dems have comitragically failed to capitalise on Remainer sentiment. It turns out that Brexit does indeed mean Brexit, and people just want it got on with, whatever it will be (chart below from @GoodwinMJ):


So, no opposition. That means the Conservative Party can indulge in its favourite sport: self-immolation. Fighting itself to the death. That can be avoided in a period of relative calm, and ever increasing growth (cf. New Labour in the 2000s). No need to fight when there’s lots of money flying around, is there? (Although that didn’t ultimately stop Gordon Brown trying constantly to unseat Tony). But now, we have a subject that inflames passions. Our membership of the European Union blew apart the Tory Party in the 1990s, casting them into the electoral wilderness for over a decade. Could history be about to repeat itself?

Added to this, we have the negotiation itself. David Davis is chomping at the bit to get into the ring. The Brexit negotiator has been giving plenty of pugnacious interviews, and this weekend remarked “We don’t need to just look like we can walk away, we need to be able to walk away”. As the EU put the finishing touches on their alleged 100bn EUR divorce bill demand, he noted that even 1bn would be “a lot of money”.

What happens if he oversteps his hand? Will Theresa May fire him? What if her ivory tower becomes an isolated prison? What if public opinion becomes Brexit at any cost?

Theresa’s election victory has already been played out in the markets, with Sterling’s rally from 1.2500 towards 1.3000. Now it’s time to play out who will be the victor in the real battle of the UK vs the EU27.