“It’s all just a little bit of history repeating” The Propellerheads
“We learn from history that we do not learn from history.” Hegel
“The history book on the shelf is always repeating itself” ABBA
Instinctively, I tend to assume the human race has made progress over the last 100 years and our understanding of most things has increased dramatically. Technology has advanced enormously and clearly one thing that has changed in financial markets is the ability to access liquidity in all manner of financial instruments. But has the understanding of what drives financial markets and what is the appropriate valuation for markets improved? I would like to say yes, but my experience tells me that the answer is no. Technology has vastly increased the amount of information available to market participants, but the understanding of the importance of various different pieces of information seems no better than it was in 1929, 1974, 2000, 2008 or times in between. In fact, the huge increase in the amount of information available may only serve to obfuscate the information of real importance, as markets react to red headlines and systematic asset managers are programmed to react in the same way as in the past or to follow the crowd. An increase in the volume of information only reduces the impact of the information that is of real importance if the market assigns some importance to every piece of information. Or in other words, the more information there is the more possible reasons there are to justify any given market valuation. Thus, the 2000 dotcom bubble found a reason for a wildly out of line valuation, and there were enough greedy investors and trend followers to send equity markets to stratospherically silly levels.
So much for philosophy. What’s the relevance to today’s markets? I wrote recently about the low valuation of European equities (see “A huge opportunity”), and I stick by that view. Some have come back to me worrying about low European growth, Italian banks, Cocos, European immigration, populist movements, but this seems to me to miss the point. There are always risks and concerns, but they have to be evaluated relative to the things that matter for value – in the case of equities this means growth prospects, the initial level of earnings and dividends, alternative investments (interest rates), and risk premia, which is a bit of a catch all and can be used to justify almost anything, but a sensible view tells me that risks now are less serious than they were at the height of the Greek crisis.
For currencies the metrics are different, and although most of the time the markets are dominated by risk on/risk off trades, it makes little sense to think of currencies moving in this way over the long run. Real currency levels are ultimately anchored to fairly static long run valuation measures, unlike equities which rise over time with nominal growth. Relative growth rates can certainly matter for currencies, not least because they affect relative interest rates, but in the developed world there is actually relatively little long term divergence in growth rates, especially when adjusted for population growth. This isn’t really that surprising, as in the developed world technology and capital is very mobile, and it is hard for one country to show a sustained superior growth performance. Most of the time, better growth is temporary, and comes with a price, usually a bigger current account deficit, as is currently clear in the UK. Changes in the terms of trade – as can be seen with the big move in the oil price – will of course have a long term impact, but I distrust debt fuelled growth (and any growth that is generating an unsustainable current account deficit is debt fuelled from a whole country perspective) as long run reason for currency strength. Sooner or later (admittedly usually later) the positive currency impact of stronger growth and higher rates is reversed either by the need to rein back on growth to control the current account or inflation or the budget, or by others catching up.
What does this have to do with history repeating for GBP? Well it’s a roundabout way of saying that the strong pound, the growing UK current account deficit (and indeed twin UK deficits) are a repeat of a long history of similar episodes in post war UK economic history. The strength of the pound won’t last and we are headed for either a slow or a fast decline in the pound, depending on whether the UK stays in the EU (staying will hold GBP up) and whether the world economy picks up (if it does the decline in GBP will be slower). But the period of UK and GBP outperformance is hitting traditional current account buffers. Sure, UK won’t have to go cap in hand to the IMF this time as in 1976, and a fading of Brexit fears may trigger a GBP rally of sorts. But whatever the politicians agree, the risk of a vote to leave will remain, and more importantly, the underlying economics doesn’t justify a stronger pound, or even as strong a pound as we have now in the longer run. With even McCafferty accepting that UK rates aren’t going up, EUR/GBP is a buy on the dip, even if the ECB cut again as is widely expected and add to QE. Look for 0.85 this year in EUR/GBP, possibly 0.95 if things go badly on Brexit.