Brexit “no deal” would have major negative ramifications

It has been one week since the UK formally triggered Article 50. Here is my view…

The chances of negotiating a trade deal between the UK and the EU within two years are incredibly close to zero. An extension of the talks or some transitional (or “bridge”) deal to an eventual relationship are far more likely.

The “no deal is better than a bad deal” mantra is absolute lunacy and should be dismissed for the nonsense it so clearly is. If the UK reverted to World Trade Organisation (WTO) rules in a hard Brexit in March 2019 it would have major negative ramifications for the economy.

WTO rules deal pretty clearly with trade in goods, of which the UK is a net importer from the EU of about £100bn per annum; the normal rates are not too punitive but agricultural products have high tariffs. But the WTO hardly mentions services, which tend to be more responsive to unified regulations and standards than differentiated by tariffs, yet the UK exports about £20bn in services to the rest of the EU.

Regardless of the eventual outcome, the UK economy is going to face an extended period of uncertainty. So far the consumer has remained remarkably strong. Consumption has partly been driven by an increase in credit (growing at over 10% each year) and a decrease in the savings rate. As real incomes are squeezed over the next few months due to the lagged inflation impact of weaker sterling, I would expect consumption to slow. In the meantime, if negotiations falter, sterling could weaken further as international investors examine the UK’s twin deficits (fiscal and current account).

For the next few months the inflationary effects of weaker sterling should dominate and it is conceivable that other members of the MPC will join Kristin Forbes in voting for a rate rise – thus our strategy is to remain generally underweight UK duration risk.

However, later in the year when economic growth slows this positioning stance may have to be reversed as further monetary stimulus can be anticipated. The Bank of England is likely to wait this time for the hard data to show signs of a slowdown, having been publicly castigated by the hard-core Tory Brexiteers for acting (in their view) prematurely in response to the weak UK survey data. But if the economy does start to slow then there is very little impediment to further quantitative easing from the Bank of England.

A dovish rate rise

As anticipated by every single economic forecaster, the Federal Reserve raised rates last night.  Their range for interest rates was increased by 25 basis points to 0.75% to 1%.  The 2017 and 2018 median dots were unchanged with two more rate rises anticipated by the end of 2017.  The 2019 dots nudged up an eighth to finish at 3%, with the long term rate (AKA terminal rate or r*) at 3%. Yellen reminded Fed watchers that the 2% inflation target is symmetrical and economic indicators are panning out as the Fed predicted.

Overall, this was a more dovish rate rise than most anticipated which was clear by the 10bps rally in 10 year US Treasuries.  But we have seen this tune being played before last year when Yellen talked about running the economy “hot” in the autumn, then pulled back from that later.  The Fed is trying to manufacture a Goldilocks tightening cycle and will continue to manipulate the markets one way or another to suit their own agenda. That is after all their job.

On the not insignificant issue of the $4.5trn Fed balance sheet it is still deemed tomorrow’s problem and will only start to be reduced once rates have “normalised” (new normalised – sic) a bit further.

Going dotty tonight

At 6pm GMT it is widely anticipated that the Federal Reserve will raise interest rates by 25 basis points.  It would be a huge market surprise if they did not increase rates and an absolute shock if they moved by 50bps.  What matters more is the language around the move. How bullish on the economic outlook the Fed will be and how hawkish on the path for interest rates.  Fed officials’ best estimates of where they expect interest rates to be in the future are covered in their “dot plot.”

Clearly there are differing opinions from the various officials, but the median for the end of 2017 is 1.375%.  I anticipate a general upward movement in the dots, however the median is not expected to shift yet with 6 voting members currently on 1.375% it would currently need 4 of them to move to mathematically increase the median.  2018 and 2019 may well see increases though. The bigger movement upwards in the dots (i.e. rate expectations) are likely to come if Trump follows through on an ambitious expansionary fiscal policy.  Until then I hope you will enjoy joining the dots tonight!

The high yield stopped clock reporter mistakes indigestion for something more serious

A certain newspaper that has pink coloured pages seems to have an editorial stance that hates high yield.  The sub investment grade market, or even speculative grade bonds, are always referred to in a derogatory way as “junk”.  The proverbial stopped clock does tell the correct time twice a day or so whenever high yield has a dip there follows rapid editorial copy.  The focus today is on the ETF outflows last week; the $3.1bn outflow coupled with a heavy week for supply ($18bn) has led to an increase in yields in the US market of 0.50%.  Decomposing this, about 40% comes from the increase in the underlying government bond market and 60% from corporate bond spreads widening.

However, one should not overstate the long term impact of high yield ETF flows – they make a lot of noise and are a rapid asset allocators’ tool of choice, but they only impact the flow in the market in the short term and represent a very small proportion of the long term stock.  What usually happens is the most liquid bonds, which the ETFs are exposed to, sell off and the smaller less liquid bond issues’ prices remain static.  We view these distortions as short term in nature and use them to top up positions in our favoured credits or do relative value switches.  I think last week was merely a case of some much needed market indigestion and not a harbinger of anything more serious.

No fund manager should ever be bored at work

In a survey cited in the FTFM section of today’s FT it was stated that 68% of fund managers are bored at work. I would argue that it is practically impossible to be bored as a fund manager. In a rapidly changing world, keeping on top of all the developments occupies a large part of the day. Add to this the scouring of the markets for new investment opportunities, and the desire to search for any supporting or contradictory evidence surrounding macro and stock level positioning, and there are never enough hours in the day.

Whether you are digesting information out of intellectual interest or to gain a competitive edge, you have to be driven. The moment that you think you know everything, the markets will reach up and teach you a whole host of new lessons! The one question I always ask in interviews is “what outside of work are you passionate about?”. Within reason I don’t really care what the answer is, I just want to make sure the candidate has natural enthusiasm. In an industry rife with overcapacity I am genuinely surprised that so many people can be bored doing fund management. However, their lack of motivation must make it easier to outperform them over the longer term.