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It's not just Sterling in the crosshairs .... or at least it shouldn't be

October 4, 2019

 

ref :- TAIL RISK by Katie Martin, The Financial Times, Companies and Markets

 

The monumental dog's breakfast that is Brexit is finally approaching its dénouement .... or at least it might be. If there's no deal agreed, which on the face of it is a scenario that seems more likely than not, the UK parliament will block an exit under those circumstances even as the Prime Minister maintains his commitment to be gone from Europe by the end of the month "come what may". How that might ultimately pan out is anybody's guess. Oh God, will this never end ?

 

Things being what they are, it's hardly surprising that Sterling is so volatile .... under the cosh when a "No Deal Brexit" appears more likely, rallying when the chances of it being avoided improve. That's fair enough, as are the prognoses for a pretty dire time for the UK currency should the worst come to pass. But Katie Martin's point is that it's not just the UK and the Pound that would suffer, a hard Brexit on top of existing problems could be just as damaging for the Euro. UK economic data, perhaps aided by pre-Brexit inventory building had proved remarkably resilient but is looking decidedly ropey now and even US data is slowing at a fast enough rate to encourage a growing number to predict a recession. But it's Europe that's in the van when it comes to slowing growth, its reliance on Germany's performance exposed by that nation's own exposure to manufacturing and exports .... the worst-performing sector.

 

And yet while Sterling fluctuates wildly (but on balance in a downward direction !), the Euro -v- US Dollar is remarkably calm. Which is not to say that it's not weak historically-speaking .... the state of global manufacturing, US-inspired trade conflict and the European Central Bank's super-easy monetary policy have seen to that, but there's a suggestion that the market may be a little complacent in assessing the risk attached to the Eurozone currency ..... whether it's to the downside or indeed if it rallies. The best measure of that assessment is found in the options market, where prices give us an implied 3-month volatility  --  a measure of how much the market thinks a currency pairing will move in either direction  --  of 5.6% for € / US$ , at the lower end of the range for the year so far. By contrast, the implied 3-month volatility for UK£ / US$ is at 12%. As Ms Martin tells us, that's on a par with that well-known bastion of stability the Brazilian Real, and much higher than the Mexican Peso (which, as a sign of extraordinary times, doesn't seem unreasonable).

 

The FT quotes Marius Schomer, chief economist of PineBridge Investments, who thinks that European markets are "sleepwalking" towards real trouble. Yes, UK assets will crash if there's no deal .... but so will those in Europe. Ironically enough, Mr Schomer believes that events might prove so costly financially and otherwise that they might prove the catalyst for a solution. "Money talks for the EU" , and previous crises (Greek debt, Italian bonds) reveal that the EU is prepared to sacrifice a little principle for pragmatism when it comes to keeping the ship afloat. UBS meanwhile call for an immediate drop in € / US$ to $1.05 should there be a hard Brexit, with further falls to follow.

 

Well, it's one view ..... but the point is that we are fast approaching a seminal moment for markets not just in the UK but in Europe too. If it makes sense to hedge your risk in one area (and it does), then it makes sense to do the same in the other and the evidence is that investors in assets on the European mainland may have left themselves a little under-protected.

 

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