It is that time for us to kid ourselves that we have some insight of where FTSE is heading over the next six months. “Hurrah,” I hear you cry, “we’ve been waiting for a laugh.”
But first let’s have some humiliation by looking at what we foresaw back in March 2019. Back on 18 March, we confidently thought that Brexit would be resolved on 29 March. Oh how naïve we were. We thought that either a deal would be done, or no deal would be all sorted by September. Either way, we thought that resolution of Brexit would be supportive for FTSE, and so, with FTSE at 7228, we forecast 8150. The article was entitled “UK Equities About to Soar.” Wow, how confident we were. Sadly, our central assumption over Brexit was wrong, and so the out-turn of 7345 on 16 September was much lower. As we noted before, forecasting is particularly difficult when it involves the future (Ed; and as I remarked at the time, what other kind of forecasting is there? Now get on with it).
Looking forward to Monday 16 March 2020, what do we see? As noted last month, we see some risk of a global slow-down. And we have said this before, but surely by March, Brexit will be settled? The potential outcomes are;-
a) Deal on 31 October
b) No deal on 31 October
c) Extension to January, then Deal or No Deal
d) Revoke Article 50
Thus we feel that Brexit may well be off the scene. To some extent it will be hedged anyway, as a bad Brexit might lead to a lower GBP, which tends to support FTSE through the foreign earnings route.
Though we could have a Marxist/SNP/whatever coalition government too!
However Brexit is solved, we see it too soon to have a kick-start effect on the UK economy by March, and globally, we still see the risks on the downside. Therefore, we think the on-going global slowdown is bad for equities, but some kind of resolution of Brexit should help the UK market (dear God, any kind of closure, please, we implore you).
Thus for 16 March 2020, we forecast FTSE 100 at 7200. Yes, I know that is the same level we have forecast for December 2019, January 2020, and February 2020. At least we are consistent!
It is accepted wisdom in the chattering classes that trade tariffs are necessarily a bad thing. But why is this so?
The Principle of Comparative Advantage was published in 1817 by an economist (yayyy), David Ricardo. This postulates that in international trade, relative advantages in labour costs, productivity and other production factors will enable cheaper consumption – and hence higher living standards – for both the producing and importing nations, than the alternative of home production in each country.
An easy example of this effect, even within the UK, was the impact of the railways. Suddenly, there was no value in each small town having a maker of pots and pans. Such items could be made better and cheaper by a huge factory in Birmingham, and so pan-buyers (Pans-People as they might be termed by grey-haired fans of Top of the Pops) had a better standard of living, having devoted less of their income to obtaining better cooking utensils. The pan-workers presumably had marginally higher wages than elsewhere too.
However, it perhaps wasn’t so good for the country-town pan-makers, who were competed out of a job. And some of the inhabitants of such villages may have mourned the disappearance of their friendly local manufacturer – and all the workers in the previous supply chain. Special orders would be more difficult, with just a few standard designs. So the nett gains, including non-monetary items, weren’t always as large as perhaps thought at first glance.
It is the principle of comparative advantage that postulates that we are all richer as a result of international trade. And tariffs dent international transfers of goods, hence at the margin impoverishing both exporting and importing nations.
A clear, and currently pertinent example is the UK beef industry. It is not cost effective for the custodian of 200 acres of Devon countryside, with hedges, copses and ancient barns to maintain, to compete with a mid-west American farmer with a 640 acre (square mile) of flat, fertile, but featureless maize land. The US beef farmer keeps all his animals in a feed-lot year round and transports in fodder from the prairie or the local grain silos. Cheaper feeding with no overheads – oh, and growth hormones. Does the UK consumer want cheaper beef, or enough profit in UK farming to retain our beautiful countryside? In surveys, they would select the countryside, but I suspect in Morrisons they would choose the cheaper steak! So the UK farming industry will need tariffs to raise food prices or, alternatively, subsidies to maintain the countryside.
What do tariffs mean in terms of Brexit? In the case of a No-Deal Brexit, then the EU could choose to treat the UK as a third party country and apply tariffs. (It could drop tariffs on the basis that a withdrawal deal or trade agreement is imminent. It’ll be interesting to see if there is sufficient goodwill for that to happen). Given the 15% fall in sterling, the average 3% cost of tariffs across all goods won’t actually make much difference. However, in cases such as beef and lamb exports to EU, 40% tariffs will hurt. Here, sector support will be essential during any interim period, as the reaction of prices to these tariffs will be only partly a rise in prices in EU, with the rest of the slack taken up by a fall in export incomes received by British farmers.
The second impact of leaving the EU’s customs union will be an increase in paperwork. This is just sand in the machine, benefiting nobody (except perhaps paper-makers and form-fillers).
Work will be required on both sides of the channel to ensure delays don’t become excessive. We have seen figures suggesting that if the processing time per lorry increases from 30 seconds to a minute and a half, then the whole of southern England will somehow face gridlock. This view doesn’t seem credible to those without a pre-decided political position. Both sides of the channel have had plenty of notice about the forthcoming change, and already have capacity to cope with fluctuations in volumes. If each lorry needs three times as long to be processed, then is it not a case for having three times as many booths? Or maybe twice as many with a few changes to reduce the bottle-necks or critical time-paths of each customs inspection?
Finally, there is the Irish economy to consider. The vast majority of their goods travel across England to get to continental Europe. If tariffs are bad for the UK, they will be hugely worse for the Irish. Will they pay a tariff to get their goods into UK and another one to move them into France? One has to hope that Brussels won’t dump the Irish economy as a side-effect of punishing the UK!
In the very long-term, one has to assume trade deals will be made with both EU and US. There is some prospect that we will have to choose whether to be in the trading orbit of the US or EU, as having one foot in both may be untenable.
Tariffs (and paperwork) are bad, but not catastrophic.
The already lower pound sterling, and future tax and export-subsidy payments will mitigate the worst impacts.
Brexit is a political choice. Tariffs are a part of that decision, but should only be a small input, not the deciding factor.
Your friendly banker is pushing you to buy put options, seductively telling you that the option will protect you if the overseas currency weakens, by giving you the right to sell it at an agreed price. But the best bit is that if the overseas currency strengthens, you are not obliged to sell it at that agreed price, you can sell at the actual spot price on the day.
Sounds tempting eh??? Heads you win, tails they lose. The only trouble is…….. you have to pay a premium to get into such an advantageous position. And the premium will be such that on average you lose……. not by much, hopefully. Why is this?
From a bank’s point of view, an option is more complicated to lay off or to manage – and so that extra input needs to be paid for.
The more cynical may look at it and see that an option has three inputs into its price;
Each one of these has a spread involved – and as the customer you pay the spread. What is more, this complexity makes it much more difficult to obtain comparison prices….. and the bank knows that. Guess what tends to happen when the customer cannot compare prices being offered by bankers???? Yep, they tend not to be so hot (the prices, not the bankers).
So we recommend forward sales. The prices are transparent, and the bid/offer spread is as narrow as can be. So on average you will be flat in terms of P&L, but with the benefit of predictability in your cashflows and margins.
Then there is the issue of how much of the exposure to hedge. Only you can decide that, and it will be determined by your objectives and the certainty of your exposure. If you are selling grain that you haven’t grown yet, you might not want to sell the full amount you expect, in case of a poor crop that year. This is a reason to sell less than your expected income, to avoid being over-hedged.
Also, you might want to consider your attitude to risk and regret. If you sell all your income forward, but then the currencies move in your favour, might you be beating yourself up for hedging away the benefit? This is another reason not to hedge the full amount.
In this scenario, we advise hedging with a 50% FORWARD HEDGE. That way, you have some protection if the market moves against you, but you enjoy some of the upside if it moves in your favour! Doesn’t that sound like an option, but without the premium and long-term expected loss?
PS. Can’t have a currency article without a chart – my inner-quant won’t let me. So here is cable (GBPUSD) over 5 years. Hasn’t it been range-bound for the last 12 months? Despite all the Brexit news. Damnit, I’ve mentioned the B-word. Sorry sorry sorry.
Last month, back in those happy days when we believed Brexit would be sorted by the end of March – Yep, we were writing on 26 March – we made our GBP forecasts on the basis that No Deal would provoke a bit of a dip, whilst No Brexit would have a slight spike, but in either scenario, sterling would end up stronger against USD and EUR.
Things have changed over the last 3 weeks – but still they are the same. We continue to not know what is happening with Brexit. We could be heading for a No Deal at the end of October, we could be getting Mrs May’s Deal approved (though it seems unlikely), or we could be having a new Tory PM and a bit of re-negotiation.
Whatever happens, we feel that the UK economy will continue to motor along okay, with investment decisions increasingly being taken anyway. Life goes on eh? The UK data seems to indicate that this is occurring, with strong employment and wages data, and quiet inflation.
US Non-Farm Payrolls were 196,000 in March, which matches our “decent level target” of 200,000. China seems to be stabilising its recent weakness. So it is only Europe skating on the thinnest of economic ice.
So whilst we see GBP strength still, it will not be as robust as we thought – until Brexit is fully resolved. Thus, in 6 months time, we see GBPUSD rising from today’s 1.30 to 1.38 (forecast down from 1.42). However, there is a serious risk of weakness in the EU area, so we still see EUR weaker against GBP. As last month, we expect EURGBP to fall from 0.8680 today down to 0.8200 in 6 months time regardless of the B-mess.
What a bizarre sight. A Remainer is arguing for a harder Brexit, negotiating with a Leaver, who wants to effectively stay in the EU. It’s not easy being a politician is it? Poor old Theresa May doesn’t even believe in Brexit, but is trying to hold together a party which on the whole feels it should deliver it, whilst having a full spectrum from the ERG to Dominic Grieve. Meanwhile, even poorer and even older Jeremy Corbyn does want Brexit, but is trying to lead a party that is happy to oppose it.
Clearly, the talks are just about the blame game, with both leaders wanting to avoid any backlash. In reality, the two positions are so close that a skinny fag-paper (which is an official engineering measure by the way) could not get between them. Which puts Jeremy Corbyn in a tough position. Having started the year by committing to oppose any Tory deal, now he needs to be seen to get meaningful changes in the talks. But Mrs May can’t give significant ground at this stage as it will split her party – which is of course the real reason he is there at all.
And across the channel, where Merkel and Macron are to lose another day of their lives listening to British begging, perhaps it is dawning that imposing an impossible deal on the weak Mrs May could lead to an unpleasant outcome for EU.
Yet again we are begging for an extension, but the only credible justification Mrs May can offer is her own resignation – which will lead to a tougher scenario for the EU, as whoever follows is likely to be more antagonistic.
The City has decided that Brexit is not going to happen. In our view, the risk of the EU refusing a long deal is not negligible. They might give us only a month, just so that all sides can finalise their no-deal preparations. And leaving on Friday, although unlikely, is not impossible.
Given the City’s complacency, there is little upside on being long UK assets and GBP this next few days. A long delay is built into prices. If a quick deal or no-deal happens, expect a sharp move downwards.
Apologies to all those Grandmas out there sucking eggs. Although, rather disappointingly, neither of my grandmothers bothered to teach me how to undertake such a venture. (See, a deprived childhood!)
However, we do know a bit about Currency Hedging for Corporates. And the starting point is to understand how your company’s bottom line could be affected by movements in currency markets. And that is the key to understanding a currency exposure. It might not be evidenced by an actual transaction in a foreign currency. Or it could be that a currency exchange should not be hedged.
It all comes back to clarification of the objective of your currency hedging. Are you attempting to;-
a) Ensure that this year’s budget is not disrupted by currency movements increasing costs, or reducing sales income?
b) Make sure that a competitor cannot price you out of a market due to exchange rate changes?
c) To avoid changes in the reported value of overseas assets?
d) To ensure overseas profits are translated at planned rates?
e) To keep your Treasury Team on their toes (yes, I have heard this justification)?
f) To make a bit of extra cash for the business
Clearly, where any of the above situations are critical to your business, then a hedge should be installed. Except e) which is unlikely to be critical… or f), which is just plain scary. But if any of those scenarios represent a tiny impact on your P&L, is it worth the hassle, expense and risk of currency hedges?
And what if you have 10% of your domestic market and your overseas competitor has 90%? Well firstly, you’re probably in more trouble than currency hedging can help. But think about the dynamics of market pricing. If your currency suddenly strengthens against theirs, your competitor can underprice you and decimate your sales. So you have a big exposure to their currency, even if you never even use it. Food for thought eh?
Or the converse held for a client of mine, who was exporting luxury goods from US to Mexico. They had very diligently (and expensively) been hedging forward their exposure to the Mexican Peso. But guess what happened when the Peso devalued by 25%? All of the luxury goods in Mexico – supplied by the client and their competitors – just went up in price by 25%. The USD value of sales remained unchanged. Meanwhile, the hedge proved to be a great windfall – but in truth, there was no exposure there, despite all the currency transactions.
Finally, I want to remind readers of the Mitchells and Butler fiasco of 2008, where they lost £274mil on a hedge that suddenly became very expensive when the deal creating the exposure never happened. It is hard to comprehend how that Treasurer (who lost his job) and the Bank Executive (who didn’t lose his job, funny that) agreed to put such a risky strategy in place, given that the exposure was uncertain.
Take-Outs (For non-Americans, I mean learning points, not McDonalds)
Before currency hedging, work out what your objective is.
Ensure you understand where your exposure properly lies
Know how likely the exposure is to undershoot, overshoot, or disappear altogether.
What is happening to sterling? You’d think it would be thrashing around like an angry hornet stuck in a beehive hairdo.
But it remains calm , as has done since last autumn. Under normal circumstances, GBP acts like a divorce-child, torn between Europe and the US. Sometimes it goes with the Euro, on other occasions it sticks with the US Dollar. And very infrequently, enough happens in UK for it to make a simultaneous move against both its “parents”.
So what is happening now? Are currency traders;-
a) woefully short-sighted and not interested in Brexit, as it won’t happen today or tomorrow?
b) utterly complacent about Brexit and not factoring it in the price at all?
c) estimating that the percentage chance of No-deal has not changed, and so the effect on GBP has not altered?
But here is a little heads-up!
Currencies do move on matters other than Brexit. Hard to believe isn’t it, but there are a whole range of different inputs into a currency price? You know, GBP did move up and down before Brexit – and it will continue to trade after Brexit has either died or been settled.
Since our last currency forecast on 5 February, “Cable To Go Higher On Brexit”, the Brexit debate has moved on a little, in that it now appears to be more binary – No Deal or No Brexit. More on this tomorrow (sorry).
The world economy has slowed too. US Non-Farm Payrolls (our fave number) were weak in February. Europe looks weak too, with German industry catching a cold from China. Let’s hope that doesn’t become Asian ‘Flu. Meanwhile, the UK economy continues to trundle along with record employment and flaccid inflation. Suddenly, that isn’t looking too bad.
Interest rate rises seem to be off the board in all main economies, with the chance of more QT in the Euro Zone.
So to the forecasts.
a) No-Deal Brexit is probably 20% in the price of GBP already. If it happens, then watch out for some weakness against USD in the short term, but strength once the media-highlighted logistics problems are resolved, the strong UK fundamentals come into play.
We see GBPUSD at 1.2800 in a month and at 1.4200 in 6 months under this scenario.
Against the EU, we think No Deal is nearly as bad as for Europe, and so the EUR will maintain its level with GBP on a one-month basis at 0.8600. Over 6 months, we seen GBP stronger against EUR, with EURGBP at 0.8200 in September.
b) No-Brexit (aka Long Delay) then we see the same forecast levels in 6 months (driven by fundamentals), of GBPUSD at 1.4200 and EURGBP at 0.8200, but with a step up (provoked by guess what) rather than a dip in the meantime.
PS. Well done if you liked our pounds shillings and pence pun in the title. No prizes for spotting it though.
Whatever happens on B-Day, 29 March, we see GBP/USD (Pounds Sterling against the US Dollar, or “Cable” in FX Trader lingo) much stronger.
Our house view remains that a fig-leaf deal will be brought in just in time to cover the embarrassment of a no-deal, but even in a no-deal scenario, there will be a relief rally that the uncertainty has ended. Any currency wobbles in the case of a no-deal outcome will only last a couple of weeks until everyone wakes up one day to spot that the sky remains in the heavens.
Alternatively, should a clear path to a Brexit trade deal be established, then we see GBP being marked higher as a result of raised confidence in the UK economy and sudden capital inflows to the UK equity market and direct foreign investment.
The other end of Cable is the USD of course. The US economy is doing just fine – as shown by the Non-Farm Payrolls last week. However, we see interest rate rises in the US coming more slowly than the market expects, which would be negative for the dollar. We don’t see much in the way of rate increases in the UK either, but interest rates are more likely to surprise on the upside in UK than in the US, which again would be positive for sterling.
Thus there exists one of those attractive asymmetrical risk/reward situations for Cable. In a worst case scenario it could go down by 5 big figures (down 5c per pound), but we see it 12 big figures higher. Having more upside than downside makes a long GBP position very tempting.
Our forecast is GBPUSD at 1.42 by the end of August 2019.
Oh, and for Liberal Democrat fans attracted by our “Cable to go Higher on Brexit” headline, Sir Vince has announced his retirement after Brexit. It is a racing certainty he will be elevated to the House of Lords. It seems that old politicians always are ennobled, presumably out of sympathy so that they can continue to use the subsidised bars and restaurants in Westminster, rather than getting under their wives’ feet as ordinary retired men are wont to do.
We look forward to reading about Lord Cable of Middle-Road.