Weighing the Risks for the UK

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Although I am sure that you have had your fill of the UK election, we do feel the need to start off with a quick comment on our outlook for Sterling especially as the biggest position in our FX portfolio (going into the election, thankfully) is short Sterling versus the US Dollar. We were hoping that we could get away with just sticking to this story, and keep the commentary a bit shorter this week. That is until late Friday when the Nasdaq market in the US suddenly began to sell off. With our negative view on US equities, this sort of behaviour is clearly of interest, so we have to comment on this too.

So there is no way to sugar coat the election result for Theresa May; the outcome of the UK election was an absolute disaster for her. Instead of winning a majority of 70 or more seats, and being able to govern through what are going to be very tricky times from a strong and stable position, she has no majority at all. The UK has a hung parliament, which from a narrow political perspective, is the worst of all worlds. It appears as if she will rely on the Ulster Unionists for support, which is already causing some consternation as this may well compromise the brokering role that Westminster should be playing in Northern Irish politics. However, again from a narrow political perspective, this is hardly a strong and stable Government.

There has been much debate about what the outcome of the election means for Brexit. Hard or soft? Will access to the single market be back on the table? We simply can’t tell at this stage. Furthermore, we have to understand that Europe has its own agenda, is much better prepared than the UK, and will surely apply “pressure” when they see fit in order to press their advantage, or worse, make an example of the UK so as to discourage other countries from leaving.

Aside from Brexit, the UK economy suffers from stiff headwinds, is clearly politically divided and has many social issues to deal with (e.g. affordable housing for the younger generation, care for the elderly and financial inequality and negative real wage growth again). However, although the election may have been a complete disaster for Mrs May, it does not have to be for the UK people and the economy. From an economic point of view, we wrote a paper last year before Brexit (see here) detailing some of the economic challenges, and we think this paper is still very relevant. Many of these issues will be solved, but it would be much easier for a strong government to do so rather than a weak one which is what the election has provided. Furthermore, with no progress made on the UK’s enormous current account deficit, we think a weaker Sterling is part of the recovery process. We can also expect the Bank of England to keep interest rates at zero for a long time, which may encourage a little bit of weakness in Sterling.

Below is a chart of Sterling versus the US Dollar. As we have shown, Sterling had rallied to both downtrend resistance and to the upper boundary of a bullish channel. From a simple market analysis point of view, the 1.30 area was clearly important. We have also marked the day the election was called, which was a big up day for Sterling, touching a high of 1.2905. Cable then spent the next 7 weeks chopping around with a slightly higher bias, and was at 1.2950 immediately before the exit polls were announced.

From our perspective, the market was pricing in a decent Conservative majority at 1.2950 and in any case would have had to overcome material resistance in the 1.30 area if the majority was bigger. However, the downside on a very small majority or even a hung parliament was more than the upside, and so we felt that holding some Sterling puts was a good reward/risk opportunity. Furthermore, with volatility half the level it was pre Brexit, we could buy these put options relatively cheaply.

Chart 1 – The Pound Sterling versus US Dollar

Where does Sterling go from here? With a much more fragile political situation and an economy that remains susceptible to shocks, we still think the risk is on the downside. We did book some profits at 1.2740 and 1.2660 on Friday, but we remain bearish in the short term.

You can view details of our FX Strategy UCITS Fund here.

Moving on to US technology stocks. Out of nowhere, The Nasdaq had its worst day relative to the rest of the market since 2008. Or put another way, the high flying stocks that had been the major driver of returns for the broad market suddenly buckled for no good reason and the selling was quite intense as Nasdaq volume was the highest since the August 2015 shakeout (as measured by the QQQ tracker). This may be just a flash in the pan, and the market will quickly steady itself and resume its upward trend. Alternatively, it could be a warning signal.

Chart 2 – The Nasdaq 100 Tracker

To put this bad day for Nasdaq in some sort of perspective, we have been talking for weeks now that we expect the market to build a large top before the real bear market can begin. That topping process will by nature be a series of corrections and rallies within a developing price range. So far, we haven’t even seen the first correction, which we would expect to be in the 5% to 7% range which will attract those looking to buy the dip. So, the question we are pondering this weekend is whether the Nasdaq selloff on Friday is yet another signal (amongst those we have recently highlighted) that the first stages of a topping process are beginning. Only time will tell, but for our part, we are viewing Friday’s price action as immediately bearish.

We’ll leave it there this week but suffice to say that price trends appear to be shaping up nicely for active investors. The continued low levels of volatility everywhere is also of note. Investors have been assuming greater risks for months and now those that would naturally look to hedge when they want to protect portfolios seem to have given up on that tactic. This sort of price action and investor behaviour is seen near market highs not market lows.

Stewart Richardson
RMG Wealth Management

 

 

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