Who would have thought that the British pound would be the top performing major currency last quarter?
Well, I was certainly not as bearish as the consensus, following the mini-budget and subsequent Liability Driven Investment (LDI) crisis. At the time I felt there had been an overshot on the downside – but I did not think the US dollar rate would be back above $1.25 by April 2023.
So what is going on? There are two major factors. First, the UK economy is not in the dire state that the Bank of England (BoE) was projecting just six months ago. I was, and still remain, cautious on the outlook for UK growth but the actual data has been surprisingly robust. The latest figures showed no growth in February but there was a small upgrade for January and it looks like Q1 GDP will show modest growth.
Second, the US dollar has been weak. This reflects the change in interest rate expectations in the last two months. Problems with US regional banks and signs of economic cooling has led expectations of a material cut to the Federal Funds rate in H2; this has made the US dollar less attractive. But if you listen to US business programmes a big theme is ‘de-dollarisation’ i.e., the process of substituting US dollar as the currency used for trading commodities and reducing the exposure to US dollar within central banks’ forex reserves. And here we get tied up with trends in geopolitics. There are several overlapping developments which are pushing countries to make a choice: which side are you on – China or the US? Perhaps the question is slightly different: will you align your country with US policy? It seems that, for a variety of reasons, a growing number are deciding to either be neutral or hostile to the US. Part of this reflects shifting demographic and economic realities, as growing Asian, African, and Latin American countries become more important to the global economy. This fosters more independence of thinking and less reliance on the US. In may also reflect some push back to the cultural values espoused in western democracies.
But it also is due to the Chinese policies. Over several decades China has pursued initiatives to embed itself into the economic eco-systems of less developed countries – as in the Belt & Road programme. This has seen China investing in infrastructure across countries representing approximately 60% of the world’s population and a third of global trade. These initiatives have been financed with a combination of debt and equity – and as reported in the Financial Times there have been some dud investments. But it has resulted in greater Chinese influence over a range of issues and policies. More recently, the Russian annexation of Crimea and the invasion of Ukraine has moved Russia more into China’s orbit; increasingly, their interests are aligned. Add in China brokerage of an Iran – Saudi rapprochement, reflecting China’s growing impact in the Middle East, and a narrative of de-dollarisation sounds feasible. A word of caution here: it has not paid to underestimate the US over the last 70 years.
What are the implications for markets? The demographic trends are clear. Over the next few decades there will be an economic shift away from western economies; equity and debt markets will reflect the reality of these moves. Countries like India, Indonesia, and Brazil (these three represent almost a quarter of the world’s population) have massive potential and western investors will need to widen their horizons. Discounted oil, bought from Russia, is giving many a competitive advantage in a vital area. Investors will address this changing landscape but there will be challenges along the way. Many of these growing economies have different attitudes to environmental, social and governance concerns and enforcement of property rights may be more difficult. It will not be a comfortable transition but, ironically, as globalisation takes a step back the case for more targeted investment into emerging markets increases.
US 10-year yields rose over the week, taking the level back above 3.5% and 20bps higher than the April low. In Germany, the rise was a bit more with the European Central Bank seen to be hawkish. The BoE continues to give out mixed messages but better data helped push 10-year yields towards 3.7%, 40bps above the March low. Breakeven inflation rates moved higher, offsetting some of the weakness seen in recent weeks. In the UK implied inflation at the 20-year horizon is around 3.5%; this still looks rich against a BoE target of 2% but there is a lot of uncertainty out there.
I am torn a bit on credit at the moment. In big picture terms, investors are being paid to take credit risk, relative to government bonds. However, I have been surprised at the resilience of investment grade and especially high yield bonds over the last six weeks. Looking at investment grade bonds, spreads are lower than at the start of the year yet we have had a mini US banking crisis, the collapse of Credit Suisse and the wipe out of their AT1s. I would have expected more short-term weakness in credit valuations against this background.
So, where next? I see scope for corporate earnings disappointment and a dip in risk assets. However, for medium and long-term investors the yield premia available in credit markets make them more appealing than government debt. There just may be a better short-term entry point. One last thought: western governments have been profligate, spending money they don’t have. This has been easy, as a savings glut emanating from the Middle East and Asia has kept long-term interest rates at exceptionally low levels. As more of these savings are diverted into domestic activities and fewer are stored in US dollars, the financing of the US fiscal deficit will get that much harder.
This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.