‘When everyone thinks alike, everyone is likely to be wrong’
Humphrey B. Neil
The Art of Contrary Thinking, 1954
Here at Validus, we are much more comfortable being in the minority. When our market views are reflected in the newspapers’ front pages we tend to get nervous, and begin to question whether it is time to re-assess our position. Is there new information that we have not yet factored into our analysis? Have the factors which are driving our market view already been priced into the market?
The market contrarian’s philosophy is perhaps best summed up by the following passage from Humphrey B. Neil’s classic ‘The Art of Contrary Thinking’:
“What it comes down to in the final analysis is that a ‘crowd’ thinks with its heart (that is, is influenced by emotions) while an individual thinks with his brain. This is no reflection on any individual because, when any of us are grouped in a crowd, we are likely to lose our balance, you might say; we become one of a group rather than remain as an individual.”
What Neil is referring to in the above passage is the common tendency for financial markets to overreact; once a particular theme gains traction amongst market participants (e.g. the euro is doomed), then emotion begins to outweigh rationality – the strength of the view is boosted by the sheer volume of participants (and cheerleading in the financial and mainstream media) to the point where any contrary position (or even slightly differing perspective) is quickly shouted down or ignored. As such, the importance of rational analysis is diminished, and raw emotion drives the market forward. This, ultimately, is what creates market opportunities and mispricing.
Which brings us to the recent performance of sterling. We have been consistently bearish in our views on the British pound since the middle of last year, citing factors such as:
- The Bank of England’s aggressive (even compared to the US) quantitative easing programme;
- The UK’s deteriorating current account balance (despite a weaker currency); and
- The UK’s poor fiscal position (and the lack of fiscal improvement, despite the continuous talk of austerity from both sides of the political divide).
In fact, as highlighted two weeks ago in our 2013 outlook report, GBP’s resilience during 2012 was perhaps the market trend which most surprised us last year. However, 2013 has begun in a very different fashion. Sterling is poised for its worst month in more than four years when compared to the EUR, and the only major currency which has fared worse than GBP so far this year is the JPY, (which is being actively and explicitly weakened by the efforts of the new Japanese Prime Minister Shinzo Abe).
Pessimism about the UK is also evident in gilt market. Yields on UK government 10 year bonds fell as low as 1.41% last year, as the UK benefited from a capital flight from the euro zone periphery. Last week, the 10-year gilt yield had risen back to 2.06% as international investors continued to reverse these flows as confidence returns to the European capital markets.
So, with the markets punishing both the UK’s currency and bond markets, and with the consensus view now clearly turned against the GBP, has the time come to re-assess our bearish view?
Not yet. GBP has not yet reached our targets in either GBPUSD or GBPEUR (which we revised even lower earlier this month). Furthermore, we are seeing some additional warning signs for GBP which we feel the market might have not yet fully priced in.
Notably, GBP risks falling between two stools, trading neither as a ‘safe’ currency, nor a ‘risky’ currency. This represents a distinct reversal from last year, when GBP benefited by being considered both a safe haven (particularly from the euro zone crisis), yet also rallied alongside the EUR whenever risk sentiment improved. This year, GBP’s ability to benefit from improved risk sentiment has been dramatically weakened, as demonstrated in the following chart:
Chart: GBPUSD (Blue, LHS) vs. S&P 500 (Pink, RHS):
Also, we feel the ‘Carney Effect’, will be more damaging to GBP than many (including us) originally thought. When Mark Carney was appointed as Bank of England governor-elect back in November, the appointment was viewed primarily as GBP-positive; largely due to Mr. Carney’s strong reputation in the international financial community.
However, as we highlighted last year (link), Carney is on the record as being open to unconventional monetary policy options, even if he did not implement any during his tenure at the Bank of Canada. Mr. Carney reinforced this view with his statement in Davos last week, stating that the objective of monetary policy should be to ensure that the economies ‘achieve escape velocity.’ If Mr. Carney is to be taken at his word, this means that the Bank of England’s over-riding objective will be to boost nominal GDP growth; this growth will almost certainly come at the expense of the currency.
On interesting fact about escape velocity (defined as the speed at which the sum of the gravitational potential energy and the kinetic energy of a moving object is zero) is that it is largely dependent on the mass of the object from which another object is trying to escape; as the UK’s finance-centric economy was disproportionately impacted by the global financial crisis, then the impact on GBP of achieving such ‘escape velocity’ will also be disproportionately large.