Pride And Prejudice

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By Amareos

For many, the undisputed winners of the Rio Olympic Games were Team GB. The US may have topped the medal tables in terms of overall count[1], but coming second with 67 medals (of which 27 were gold) ahead of the likes of China, Russia and Germany is an impressive performance. Indeed, when measured on a per capita basis, it approximates to just over one medal per million; a high ratio for a nation with a relatively large population size. (Grenada tops the ranks on this metric because it won a single silver medal and it only has a population of 105,000). Prowess in the sporting arena, combined with the appearance of a bright yellow object rarely visible in the British sky, provides a nice feel - good jolt to inhabitants of this small island. However, the sentiment data we track at Amareos suggest that a more substantive and durable improvement in sentiment is occurring.

As we detailed in earlier posts and tweets[2], in the aftermath of the Brexit vote a broad-based slump in crowd sentiment towards UK financial assets occurred. Equities, commercial and residential real estate, not to mention the currency, all witnessed very sharp declines. Similarly, UK economic growth perceptions plummeted to levels not seen since early 2009; indicating that the public considered Brexit to constitute a negative economic shock nearly equivalent in magnitude to the Great Recession.

This immediate and strongly negative crowd response was consistent with the dire warnings issued by the vast majority of economists and policymakers - both in the UK and abroad - in an attempt to sway the electorate against leaving the EU. However, we suspected at the time that this almost certainly constituted an overreaction. Indeed, in our first post[3] written after the referendum we stated:

while Brexit will create a strong near-term downdraft for the UK economy, the independent estimates from HM Treasury dire predictions put forward by the Remain camp (not a typo - just an attempt at humour) will prove to be too bearish."

Barely two months on and this more tempered and balanced assessment appears to be the more accurate. Not only has Britain so far avoided a deep economic slump marked by tumbleweed rolling across High Streets up and down the country, but, encouragingly, a broad sweep of UK sentiment indicators has recently shown signs of improvement.

As can be seen in the two exhibits below, crowd sentiment/optimism towards the UK (upper chart) has rebounded from the low observed on August 8. This improvement is reflective of less negativity towards UK growth (lower chart) where sentiment bottomed in late July. Even though in absolute terms UK sentiment remains weak, the change of trend is positive. Moreover, with subsequent official data releases coming out better than expected - retail sales, export orders and the jobless numbers all recently surprised on the upside - crowd sentiment towards UK growth is likely to be further bolstered as the hard data serves to corroborate a less pessimistic view.

Exhibit 1. Country Sentiment & Optimism - UK


Exhibit 2. Economic Growth & Future Inflation Sentiment - UK


Nevertheless, many economists/investors who predicted that the UK's decision to rescind its EU membership would be a cataclysmic economic event argue that it is too soon to conclude that the impact of leaving is not be as bad as previously feared[4]. After all, the British government has yet to trigger Article 50 meaning formal negotiations with the EU to determine the nature of future bilateral economic relations (most crucial of all - international trade in goods and services) have not begun.

Certainly, it is true that given such lingering unknowns additional negative economic shocks may occur in the future[5], meaning that the warned about detrimental impact from Brexit could still happen, just over a longer-term frame. However, the tone of comments from EU officials recently suggests that reasoned heads are prevailing and that in the end a soft Brexit will occur with the EU not seeking to "punish" Britain with retaliatory trade measures[6].

Also positively, UK policymakers have, by their actions, shown a readiness to support economic activity. Chancellor Hammond refused to introduce an emergency budget threatened by his predecessor - if anything, there is a modest tilt to fiscal relaxation - and the BoE injected considerable monetary stimulus at the last MPC meeting when it cut the bank rate and upped its asset purchases.

Despite the fact that UK inflation is set to accelerate over the coming months, as the 10 percentage point devaluation in GBP's trade-weighted exchange rate feeds through via higher import prices, there is no reason to conclude that UK monetary policy will become less growth supportive.

Ceteris paribus the post-Brexit move in GBP will only cause a transitory boost to UK inflation[7]. Sustained inflation, which is what would really be of concern to BoE officials, from this source requires sustained currency depreciation and there is growing evidence that the worst may be over for GBP. Concomitant with the rise in sentiment towards the UK economy, sentiment towards GBP has also turned up (see exhibit below) pre-empting the recent modest rebound in the exchange rate[8].

Exhibit 3. GBP Sentiment Vs. Trade-weighted Exchange Rate


There remains, however, the possibility of so-called second-round effects materializing, by which we refer to the situation where a one-off rise in inflation is sustained because private-sector inflation expectations are revised up, pushing up future input costs. Thankfully, there is scant evidence of this occurring. Public perceptions of future inflation in the UK have risen since the Brexit vote, but to levels still low by historic standards (refer to exhibit 2 above).

Taking all of this into account, we remain of the view that the UK economy will fare better than most economists feared would occur in the event of Brexit. A further unwind of pessimism stands to provide a useful support to UK risk assets. In this regard, real estate could prove interesting because as the final exhibit illustrates, this was the asset class where sentiment was most badly affected by Brexit.

Exhibit 4. Commercial and Residential Real Estate Sentiment - UK


*Sentiment Analytics are based on Thomson Reuters MarketPsych Indices

[1] We are ignoring the EU's attempt to claim the top spot by adding up the medal tallies of all 28 members; a clumsy PR move that has triggered a social media backlash, see here.

[2] Follow us to see our daily sentiment-focused amuse bouche on a trending news item or important market event.

[3] See here.

[4] For one recent example, see here.

[5] Irrespective of Brexit, such risks are ever present.

[6] See here.

[7] A point the BoE acknowledged in the latest MPC minutes.

[8] This was a scenario we outlined a few weeks back - see here.