The Brexit continues to impact the pound negatively. After Britain voted to leave the European Union (EU) in June 2016, the currency was massively devalued against the euro and the US dollar and has not really recovered since – the main reason being the uncertainty about the outcome of the exit negotiations between the EU and the UK.
Before the Brexit vote, the pound was still trading at around 1.30 euros (around 1.47 dollars). In the days following the vote, the currency then plummeted, losing roughly eight per cent against the euro and 11 per cent against the dollar. Now in early 2018, a little over one and a half years later, the pound stands at around 1.13 euros or around 1.35 dollars, which means that it has hardly recovered from the shock following the Brexit, especially against the euro. Since early 2016, it has dropped more than nine percent against the dollar and over 16 per cent against the euro.
The exit negotiations between the EU and the UK are currently in full swing. An initial agreement has already been reached on the question of Ireland's border with Northern Ireland, the future rights of the approximately three million EU citizens in Britain and the UK's financial commitments to the EU. Phase two deals with the future bilateral relations between the EU and London after the Brexit. However, it remains to be seen whether the UK will leave via a “hard Brexit” – i. e. an exit without subsequent access to the EU's single market.
Weak pound drives inflation in UK
The British economy has suffered noticeably from this uncertainty. According to the International Monetary Fund (IMF), economic growth on the island has already slowed down this year – despite a favorable global economic environment. The weak pound has also led to rapidly rising inflation through higher import prices, putting pressure on real wages and private consumption. This is a concern for investors; consequently they are focusing their investments on other currencies for the time being.
The euro, for example, saw an upturn in 2017, climbing from around 1.05 dollars at the beginning of 2017 to 1.20 dollars at the start of 2018. The euro zone’s booming economy, helped this trend along, among other things. However, this has also increased expectations for the European economy, which significantly reduces the potential for surprises in 2018. Some experts therefore expect a slight decline in the euro this year. The YOU INVEST funds are currently hedging risks against foreign currencies.
Forecasts are no reliable indicator for future developments.
The result of the US presidential election was probably surprising on two levels. Firstly, Donald Trump’s victory itself came as a surprise. And secondly, the analysts had made predictions for the event of Trump’s victory that did not match reality: after a very short moment of shock, the stock exchanges turned clearly into the positive. The bond markets, on the other hand, recorded a significant decline. In view of the announced higher spending on infrastructure and the planned tax cuts, the US budget deficit will rise drastically in the medium term. This also means higher inflation and would tend to trigger higher US Treasury yields. The correction of the US Treasury bonds also hit the stock exchanges in the emerging markets, which are negatively affected by the possible barriers to trade, such as higher import duties for certain goods, and the now stronger US dollar.
In the YOU INVEST funds we had already prior to the elections sold off US Treasury bonds either completely or, in case of the YOU INVEST solid fund, reduced them to about 5%. The assets were regrouped into inflation-protected euro bonds or into more aggressive emerging markets bond funds. With the exception of YOU INVEST solid, the weighting of classic government bonds from the Eurozone and the USA is therefore currently zero percent. We left the equity allocation of the funds unchanged. Within the equity portion, we slightly increased the weighting of US equities at the expense of equities from Canada, Australia, and Korea. US equities therefore account for slightly more than 40% of total equities.
On 10 March, the Council of the European Central Bank (ECB) loosened its monetary policy further, as had been expected. Here are the most important measures:
In view of the decline of the leading economic indicators and the excessively low inflation in the Eurozone, the bundle of measures introduced by the ECB is necessary. The economy is currently not running smoothly. Inflation remains low and is far from the ECB target of slightly below 2%. We are still waiting for effective tax policies and structural reforms.
What do the ECB measures mean for the investor? The yields of safe government bonds remain very low in the foreseeable future. The central bank expects unchanged rates for a sustainable period of time – or even lower ones, should the data deteriorate. Yield increases, if any, would then only be of a temporary nature.
All this exacerbates the desperate search for yield by investors. The incentives to shift to asset classes that promise a higher rate of return, but that also come with higher risk such as corporate bonds and equities, have increased. The incentives for banks to expand their lending volume have increased as well. This might lead the moderate economic upswing of the Eurozone to continue.
Forecasts are no reliable indicator for future developments.
Commodity prices have fallen drastically since the beginning of July. The commodity price index provided by Bloomberg has fallen by nearly 12%. In fact, many commodity prices are locked in a bear market. The index is currently almost 50% below the level of the beginning of 2011.
Over the same period the currencies of emerging countries have depreciated by about 35% vis-à-vis the US dollar, and equities have fallen by about 26%.
In line with these developments, real economic growth in the emerging countries has weakened significantly. The growth estimate for Q2 has been cut to only 2.5% q/q. Net of the Chinese economic growth, the remaining emerging economies (accounting for about two thirds) have even shrunk on aggregate. Industrial production has stagnated in the first half of the year, and both exports and export prices have fallen.
The most recent leading indicators also suggest that there is no end in sight for the downward trend. For example, the purchasing managers index for the manufacturing sector, as compiled by Markit, continued to fall in July. While at 49.1 it is currently only slightly below the threshold of 50, which indicates neither decline nor increase, the trend is headed downwards.
In the YOU INVEST portfolios we take this development into account and have reduced emerging markets corporate bonds to zero.
The current bailout programme with Greece is about to expire at the end of June. The new government in Greece has not accepted the terms of the programme right from the start. It hopes that the creditors will agree to a new programme with more favourable terms for Greece. It would be a rational move to reach an agreement both for the institutions and for Greece, with massive welfare losses and chaos in Greece as well as spill-over effects and the increase of the disintegration risk in the Eurozone looming in the absence of an agreement. It should be possible to reach a compromise between austerity and haircut if both parties are negotiating in good faith.
Nevertheless, a possible default and an ensuing exit from the Eurozone would not come as a surprise to anyone anymore at this point. The instruments of the central bank – unlimited provision of liquidity for a country in case of emergency and the bond purchase programme – restrict possible spill-over effects to equities and government bonds. Still, in the event of a default, risky assets are likely to incur temporary losses. In Greece, capital control would be implemented, and savings would be frozen. The Greek government would probably use (worthless) vouchers for its expenses at the beginning. In this scenario, new elections are realistic. But even in case of an agreement in the eleventh hour a sustainable solution is unlikely. After the crisis is before the crisis. Here one of the weaknesses of the Eurozone becomes apparent: the lack of the necessary institutions that would facilitate a common economic and financial policy. The countries of the Eurozone are not irrevocably tied to each other.
The strategy of the YOU INVEST portfolios adjusted towards the more conservative end at the beginning of June. The equity portion overall and the share of Eurozone government bonds were reduced, among others.