Brexit: “Since EU Been Gone”
Song titles are popular amongst financial commentators to describe events in markets, and last week was no different. In our attempts to describe the triggering of Article 50 by the UK, we came up with the above title.
Older members of the financial community (like myself) will remember this as a classic 1979 song from Rainbow (with Graham Bonnet on vocals), but the title is actually a nod to Kelly Clarkson, who released “Since U Been Gone” in 2004. It describes a girl who is relieved that her relationship is over. The couple began as friends, and their romance became intense. Now she is free and feels like she can live again for the first time in a long time. Sound familiar?
We could have used Gloria Gaynor’s “I Will Survive” (“At first I was afraid, I was petrified, Kept thinking I could never live without you by my side…”) or Paul Simon’s “50 Ways to leave Your Lover” (“Just slip out the back, Jack, Make a New Plan, Stan…”). The Sun newspaper in the UK took advantage of last week’s news to project similar headlines on the white cliffs of the south of England, proclaiming their joy at the prospect of leaving the EU.
Thankfully, UK prime minister Theresa May’s official letter to Donald Tusk, president of the European Council, notifying him of the UK’s intention to start exit proceedings was less antagonistic. The tone was conciliatory and engaging as opposed to confrontational. However, the divisions between Europe and the UK are apparent from the start. Europe wants to settle the matter of the divorce bill first, before moving on to discuss trade agreements; the UK thinks both should be considered in tandem. May’s letter gave an unexpectedly strong commitment to completing the negotiations within the two-year time frame, something that most commentators believe to very ambitious and highly unlikely to be achieved.
Two of the guiding principles of EU negotiations are that “nothing is agreed until everything is agreed” and that “nothing is agreed until the last minute”. In addition, with national elections in Germany in September 2017, we believe significant progress is unlikely until a new German government is formed. And remember – agreement really needs to be reached by late 2018, as the deal has to be ratified by the individual parliaments of the EU member states, so the two-year window is really a lot shorter. We suspect Nigel Farage will be whistling Taylor Swift’s “We Are Never Ever Getting Back Together” quite a lot over the next two years.
Sterling – The battle between technicals and fundamentals
In all the excitement of Article 50 last week, much attention has been focussed on the UK currency and its outlook over the coming months. Since its precipitous fall in the aftermath of the Brexit vote in June 2016, the currency has been well behaved and actually has managed to rally somewhat. The overall tone in markets is mostly bearish on sterling, with only a few brave souls arguing for an appreciation of the pound. It’s worthwhile looking at the potential drivers of the currency over coming months:
- Uncertainty: as mentioned above, we believe that the next couple of months will be characterised by arguments around the sequencing of negotiations, and little signs of any progress. Remember – this is the first time that a country has left the EU. We simply have no road map for this journey. This uncertainty should be negative for sterling.
- Interest rates: forecasts suggest that the UK inflation rate could accelerate to 3% in coming months, which should be negative for the pound. The Bank of England is likely to keep rates unchanged, but some members of the Monetary Policy Committee could be tempted to vote for a rate hike, which might support the pound. However, with the US Federal Reserve likely to continue increasing US rates, and the ECB moving towards a tighter policy stance (tapering of QE bond-buying programme and/or increasing the deposit rate), interest rate differentials may move against the sterling. Overall, the period is likely to be slightly bearish for sterling.
- Real bond yields: unambiguously negative for the UK currency. UK real yields are the most negative of any major currency, and with UK inflation likely to accelerate higher, this is only going to get worse.
- Current account balance: another significant negative factor for sterling. The UK runs a current account deficit of over 5% of GDP, one of the highest of any major economy. Although its somewhat offset by large-scale repatriation of overseas earnings, the UK is still dependent on overseas investors to fund its deficit. And most investors don’t like uncertainty.
- Positioning: a clear positive for the UK pound. Most investors are quite bearish on the prospects for the UK currency and have positioned themselves accordingly. Data shows record high net short positions, meaning investors are already positioned for a fall in sterling. Any potential appreciation in the pound could lead to reducing or closing of these positions by investors buying back sterling, and pushing it even higher – the classic “short squeeze”.
Taking all the above factors into account, we believe an underweight position in the UK currency is warranted in coming months.
Euro-area March inflation – One number does not make a trend
The release of the euro-area March inflation numbers last week caused quite a stir in markets, not least because the number considerably undershot expectations. Printing at an annualised rate of 1.5%, the headline rate fell from 2.0% last month and was lower than market consensus of 1.7%.
Most of the downside surprise is related to an unwinding of the increase seen earlier in the year in seasonal food prices. From what we can see, this category fell to 5% annualised in March from 9.4% in February. This could be an on-going factor in coming months, so we might see a downward revision or bias to both forecasts and numbers in Q2 2017. The core inflation number also printed much lower than expected at 0.7%, down from 0.9% last month.
The timing of Easter had a significant impact on this number, since Easter fell in March in 2016 but reverts to April in 2017. German package holiday inflation, which is heavily influenced by the timing of Easter, fell nearly 9% between February and March. However, before we get too excited and start thinking these numbers give the European Central Bank (ECB) a “Get Out of Jail” card in relation to tapering their bond-buying programme, we expect to see a recovery in inflation next month. For a start, the Easter effect will be reversed. Secondly, the strong euro-area Purchasing Manager Indices are indicating signs of a pick-up in output price inflation. But “ECB sources” were quoted last week (“off the record”, of course) as believing that markets had “over-interpreted” comments made by ECB president Mario Draghi at the last ECB meeting press conference. So lower inflation, together with “over-interpreted” comments, would suggest that the bar is high for a deposit rate hike in 2017.
Cosimo Marasciulo is head of European Fixed Income at Pioneer Investments