The Frustrating Referendum

A strong advocate of remaining in the EU, I remained quietly hopeful that the status quo would prevail. For me, a vote to leave is one the biggest disasters in postwar politics, a gamble which backfired catastrophically on David Cameron. Whilst I respect the referendum and recognise the only way forward now is to make the best of a bad situation, I have written this blog in an attempt to highlight the key frustrations of the vote and to look at the bleak steps that lie ahead. 

It is a dark path to argue that the people should not have a say in a democratic society, however, I do believe an issue as complex as EU membership is not something an uninformed public should have voted on. I became increasingly frustrated by both camps' attempts to educate the public on the two key areas of ignorance - immigration and sovereignty. 

Before I turn to these two often misunderstood areas, I decided to give the blog some balance for all the Brexiters who have genuine economic and political angst. For me the best argument for leaving the EU has been a clear lack of ability to progress and reform, more so at a Eurozone than EU level. The clearest signs of this are in the Greek bailout package which shows the EU's method of kicking the can down the road rather than tackling issues head on. The inability to apply common sense led to a continued "extend and pretend" strategy. Whilst the European commission did not penalise Spain or Portugal for missing its deficit targets, the continued push for specific budget targets and the continual failure to meet them not only undermines the EC's credibility but also shows their lack of adaptability in allowing rules to evolve. 

That said, a lot of these arguments focus on the Eurozone and whilst I sympathise with some of them, I believe Europe has come a long way since the creation of the EU. The UK should be at the heart of the next 40 years of progress, not distinctly in the background. To think that the biggest issue that these once warring nations now fight over is the correct degree of monetary policy says a lot. I fear that Brexit is the first step in a major move backwards for the European nations that goes way beyond economics. 

Migration 

By far the most misunderstood issue in the referendum was migration. Whilst there are justifiable reasons to want controlled and manageable migration, the EU referendum should not have been a vote on migration. Unfortunately, for many, a vote to leave was in their mind a vote on limiting EU migration. For the even less informed, it was a vote on limiting migration from everywhere (Syria and beyond), a blanket anti-migration protest. Whilst I understand many have valid economic reasons for wanting less or managed EU migration (a point I hope I will valiantly argue against), the referendum is far more than a migration debate.

First of all, let's put EU migration into context. Last year, the UK saw net EU inward migration of 184,000 people. That is less than 0.5% of our population. The UK actually saw slightly more net migration from the rest of the world (188,000 people). We have roughly 3 million EU citizens living in the UK and 1 million Brits live in the EU abroad. Germany saw 1 million refugees enter their country last year alone as the they fled war zones. So the first point is that the UK does not have an overwhelming migration problem from the EU. 

My second point is the "lump fallacy". People believe their is a fixed number of jobs and if migrants take them then there is less for domestic citizens. That simply is not good economics. Migration can create industries and jobs along with new competitive advantages. It can complement the existing workforce rather than act as a substitute.  

With everything, there are always the bad apples and I often hear anecdote after anecdote of a migrant abusing the system. Whilst I understand they do exist and that some rules could be improved, it has been proven time and time again that migrants add more to the UK pot economically in taxes, national insurance, technology, ideas, health care (and many more) than they take out in benefits or cheating the system. In fact the OECD estimated that half of the UK's economic growth is due to immigration alone since 2005. There is very little evidence that points otherwise. Furthermore,  the UK and the US are ageing societies. A key reason Japan has failed to grow in the last two decades is a lack of immigration. As the country ages and the elderly become a bigger burden on society, immigration can help fill the gap. In Japan, the ageing population continue to work later and later into their lives. Perhaps why 73% of young people decided to vote remain. 

The myth that migrants reduce jobs, reduce wages and are a burden on society simply is not true in the UK. If anything we need more migration. EU migration often fills skill shortages, improves efficiency and productivity in areas where UK citizens are unwilling to work for the going competitive rate. 

What about security? The UK does police its own borders. Whilst they must accept free movement of labour they can still turn away threats to its security. In fact the UK has turned away 6000 EU nationals since 2010. Whilst I do not believe sharing of intelligence will stop after the UK leaves the EU, I do not see how leaving the EU will help prevent threats. That argument is highly illogical to me.  

Putting all of this aside, even if migrants were net negative, how much are we going to reduce it anyway? After all the UK saw more non EU net migration last year. The idea of cherry picking the "right" migrants is another absurdity for a different blog. I will say one thing on this though. You cannot know now what industry the UK will develop a comparative advantage in and often migration is the very thing that determines this advantage. It need not be above a certain skill level or a particular profession and I dislike the arrogance of knowing the future that this argument entails. Furthermore, lacking certain skill sets or industries whilst focusing on your strengths is the entire foundation of the gains from trade. Ultimately I have not heard a strong economic reason for less or managed EU migration given its current scale. Ultimately I wish for a world of acceptance and embracing other cultures, where your race, creed or colour should not prevent you from pursuing your dreams abroad. Whilst I realise these dreams are naive, it is worrying to see the world going backwards on globalisation instead. All too often people blame foreigners for their problems, and I fear this time it is no different for many that voted. 

Sovereignty 

Perhaps just as frustrating as the migration debate is the idea that we are regaining our
sovereignty, the idea being the UK is "no longer governed by the unelected European officials". In fact, the OECD concluded that the UK has the least regulated labour and second least regulated product market in Europe. 

Whilst some areas of the EU could and probably should be reformed, it is not unelected. The council is formed by the representative elected national governments and the European parliament is elected by the public. Given the low turnout at European elections, I find it ironic that this is one of the key arguments. 

As for being governed abroad, the U.K. has voted against EU legislation 57 times, abstained 70 times and voted for 2,474 times. Whilst not all legislation is equal in importance, this clearly shows that the UK is not being governed abroad. In fact the UK has lost 2% of times and the most restrictive regulations tend to be created domestically. Whilst clearly the UK can be out-voted on many issues, it rarely has, and I see no problems with democracy acted across nations and not just domestically, in fact I embrace it. 

As for trading sovereignty, the U.K.'s 1400 treaties with the UN, NATO, the WTO and the like are no different. You often agree bilaterally or multilaterally on legislation. This is not a bad thing. To be sovereign in the context of only having domestic laws is to be the most inward looking nation in the world. By this notion, I guess North Korea is the most "sovereign" nation in the world. 

So what next? 

Economically nobody knows. There are a range of estimates on the effects but I see no point in trying to put a number on it. It is an unknown. 

In the short term, uncertainty will rule both in the UK and Europe. In the long run, camps are divided and the outcome does fully depend on what type of deal the UK gets. 

However, the idea that the UK will retain all of its benefits without any of the costs is nonsense. So is the idea that the EU has as much to lose as the UK. 10% of the EU's exports go to the UK and 50% of the UK's exports go to the EU. The UK also relies heavily on foreign investment from the EU. So in effect, not only does the UK export a large share of its services to the EU but the EU partly funds the UK's successive current account deficits. 

A lot of people cite the Norway or Swiss deal. But let's remember that both Norway and Switzerland accept free movement of labour. In fact Norway pay fees almost equivalent to the fee per head in the UK. The only thing Norway do not have is the ability influence the legislation that it must abide by. If anything, Norway is the perfect example of giving up sovereignty for free trade. Switzerland do not have free trade in services, which is the key export from the UK to Europe. Canada's free trade deal took seven years to agree and once again covers very few services. The UK also has to renegotiate thousands of trade deals piggybacked via the EU with 50 countries around the world as well as the ones currently in negotiation, from a much weaker position on its own. 

There is no great trade deal in my opinion without paying into the EU budget, accepting EU laws and accepting movement of labour or at least some combination of these. The EU will not intentionally sabotage its relationship with the UK (unlike the UK has just done) however they will want to show the rest of Europe that the grass is not greener on the other side. Negotiating in their own self interest, it is absurd to suggest that EU will offer all the benefits without any of the costs. The UK is not in a position of power. 

In the long term, I see a UK with a much lower potential growth rate, lower productivity and investment, increasing burdens from an ageing society with increasing investor concerns over the UK's twin deficit (budget and current account). Furthermore the backward looking "Little England" mentality goes way further than economics. As the country isolates itself from the world, the spread of technology, ideas, cultures and mutual acceptance of others will fade. 

We won't have a counterfactual and it would not be fair to attribute everything bad that follows (or good) to leaving the EU. If I get hit by a bus tomorrow, it probably is not because we left the EU. Perhaps there are some positives to leaving that I have not considered, perhaps I am wrong. I hope I am. But everything I have learnt and believe in says this is one of the most disastrous decisions in postwar politics. The most frustrating part of it all is that the often cited migration and sovereignty issues have been so clearly misunderstood. 

Lady Luck

There is a reason I am far more impressed by a top poker player than a top trader in a bull market. There is a reason I admire a golfer who has a fantastic season more than a football manager fighting off relegation against all odds. There is a reason one-off star performances are far less exciting than a record of above average and why I would prefer to use maths to predict the future rather than a good understanding of history. That reason is luck.

Probability is the key intersection between disciplines from finance and economics to philosophy. Yet the human mind is not equipped to fully understand and use probability. Most people, even with fantastic understanding of odds, still approach probabilistic problems from an emotional point of view. This blog looks at how people tend to massively underestimate the role of luck in their lives and attribute far too much of their success to talent.

Intro

Nassim Taleb’s Fooled by Randomness (strongly recommended) defines the concept of alternative realities. Everybody understands that when you throw a dice you have a 1-in -6 chance of rolling a particular number. However, few people think of past outcomes from a probabilistic point of view. What has happened has happened and that’s that. But just like throwing a dice, every real world outcome is one reality path chosen amongst a long list, if not infinite, number of alternative realities. 

The key to understanding Taleb’s book and what follows is to focus on the idea that the reality we live is simply a realisation of many possible realities. It seems odd to think about “paths that never happened,” so I provide some examples. Most simply, you roll a dice and it lands on a three. There are five other equally probable alternative realities even though the observed outcome is a three. Roll again and you are unlikely to throw a three again. Pushing beyond this, we must understand that we live in a stochastic world and that when there is uncertainty, there are alternative realities (with different probabilities of occurring). We wake up in the morning and decide to take the M25 to work rather than the train. Even though there was no traffic in the observed outcome, this is not necessarily a good choice for the future since the probability of heavy traffic at 8am on the M25 is extremely high; we just observed a low probability event. The guy that gets hit by lightning in a storm appears extremely silly for choosing to be outside, but there are a million more alternative realities where he doesn’t get struck.

From the Big Bang to the present day we have observed an individual realisation from an infinite pool of alternative realties. If we turned back the clocks to the start of the 1900s, we would see an entirely different realisation of the century. Some events with high probabilities may very well still occur, but just like in the movie Butterfly Effect, the new observed reality would certainly be different as probability at every decision node reshapes history.

Of course talent can affect the probability of random outcomes. However, apart from the sun rising in the morning, there are very few predetermined outcomes in the world we live in. Hence thinking without the benefit of hindsight rather than focusing on results is a good way to analyse performance, choices and outcomes.

Finance

The main feature of Taleb’s book is trading on the financial markets. Star traders earning mega returns tend to have short-lived careers and “blow up”. The most successful guys over a long period are more methodical, less extravagant risk takers. The guys that understand and use probability tend to do better if given the opportunity over a long period of time. That is because they shield themselves from risk according to that risk’s probability of occurring. There is of course a lower variance of returns for these more methodical guys. Sometimes protecting themselves against risks when those risks do not happen gets them fired. Hence these are not the guys you see all over the front of the FT and Time. These are the guys that make consistent returns over a long sample of time.

Efficient markets describe an environment where all information publically available is already priced into the market. This means there are no profit opportunities for investors and hence asset managers and traders are no more than monkeys throwing darts at a dartboard. If you believe in efficient markets then you should never admire a trader that has a good year. Although somebody made stellar returns betting against the consensus or “predicting a black swan”, given that markets are efficient, you are simply admiring the luck of his choice rather than talent.

If you do not believe in efficient markets then there opportunities to exploit the markets and make profits. That said, all future returns have a sampling distribution and hence you are always playing a game of probability.

It does seem immensely impressive when somebody predicts a recession but for one correct prediction there are always many more that are incorrect. Good performance does not necessarily reveal skill. In fact if the outcome was a low probability event, then the trader has to thank Lady Luck rather than his own ability. After all, you do not admire a lottery winner for his talent of picking numbers.

Hence a good trader is wrong when he is unlucky whereas a bad trader is right when he is lucky. A good trader who gets a decision wrong in highsight may be a victim of a low probability outcome path rather than a misjudgement. There are of course another group traders who understand and focus on probabilities of alternative realties and are simply not very good at it.

I must note at his point that going against a consensus opinion does not necessarily make you a bad trader. First of all the consensus may be agreeing (irrationally) on a low-probability event in the eyes of the trader betting against them. Furthermore, a good trader will trade according to risk and return. He may make a modest bet on a small but under-priced low probability event either to hedge himself against a potentially rising risk or as a way of making large profits in this unlikely state of the world.  Furthermore it must be noted that all alternative realities have an associated probability although these probabilities are never observed. A good trader will be trying to assess the true probability of each event occurring and trade accordingly. A fantastic trader will tend to get the true probabilities correct more often that he does not (even if the observed outcomes are the unlikely ones).

Poker

Poker is a game of luck, which is why it is truly an amazing feat to have “successful” poker players. The concept is very similar to finance. Poker is about decision-making given incomplete information and probabilities. Those that choose on emotions and superstition do not get very far in the game. The best poker players tend to be patient, playing the hands where the payoff odds exceed the odds of winning. Of course, the best poker players lose as well. (Two aces can lose to a 7,2 offsuit and often does in my experience)!

The point is that no poker game is predetermined and you of course need luck to win. The reason some poker players are famous is because they understand odds and positions themselves to win more hands than they lose. A bad beat is a low probability event and those that only lose to bad beats tend to be the best players over time. In any one game, these players may very well be the first to lose, but over a large sample of games, they tend to perform the best. This is because they bet on hands and in situations where they have a higher probability of winning.

As for bluffing, poker is also about observing player reactions and strategies. Some great poker players play the person rather than his cards. This is still a probabilistic strategy. Nobody can be certain the opposition is playing nothing or that he will fold a good hand. The best poker players read others around the table with higher accuracy and play their estimated probabilities accordingly.

Football Managers

Football managers often get far too much blame (or sometimes credit) far too quickly. There is no doubt that there are top football managers. Alex Ferguson and Arsene Wenger are clearly talented and are proof that there is skill in football management. But once again football results are stochastic outcomes. A great manager can be the victim of a low probability event that reshapes his entire observed outcome. Injuries and referee decisions can determine outcomes crucial to a manager’s career. Of course we can only rate managers on observed performances but it fascinates me how quickly decisions can be made given the stochastic nature of sport.

It is hard to attribute blame on a manager for any individual match. Of course managers can increase the probability of their team winning any given match with tactics and man management. However a low probability event can still occur. Swansea beating Man Utd on the weekend was a shock result, which will already beg questions of Van Gaal’s formation. However, to truly observe Van Gaal’s talent we would need to know what would happen if the match were replayed many times over. What would be an acceptable number of wins for Man Utd fans? How many wins define a good manager given the two squads?

A truly good manager increases the odds of winning a match over and above anybody else. That is why managers who have failed miserably are not necessarily bad managers. A manager that sends their team to relegation may have failed on their results but may have outperformed any other manager probabilistically. For example, a great manager of Cardiff may have increased their odds of beating a top four team from 10% to 20%. However, the likelihood is he will still lose. Furthermore, Man City’s 86 points last season seems fantastic at first look but is this a result of Pelligrini increasing the odds of his team winning or is it in line with your initial probability estimates given their squad?

It may be the case that Man City won the league in spite of Pelligrini. Two examples exist. The first is the simple case that Pelligrini was the success of a series of low probability events. The second is that Pelligrini reduced the odds of Man City winning any given match but their initial odds were so high that they were still strong favourites in most games.

History

To conclude, I want to talk about using history to predict the future as is constantly done in finance, sports and many other professions.

As constantly mentioned throughout this blog, history is a specific realisation of many different realities. You cannot therefore use this as a basis for the future just like a mathematician would not choose a sample size of 1. You may be using an extremely low probability event for your predictions.

Very rarely does the same situation occur again and again in same circumstances. Only in these cases, where you have a Monte Carlo type experiment, can you use history to help predict identical problems in the future.

This blog is not intended to downplay talents. If anything, this blog can be used to argue that you have more talents than your results suggest (or vice versa). The idea is that we should be sceptical of using short-term results, in a stochastic world, to indicate talent. Unfortunately therefore, talent is hard to judge. We do not know the underlying probabilities of these abstract alternative realities. However, give somebody a large enough sample size (enough time) and consistently above average performances will tend to indicate talent (unless of course he is just really really lucky).

Calm Before the Storm

It was almost impossible for investors to lose money in the first half of 2014. Take your pick of any asset class at the turn of the year and you would almost certainly be in the black. The UBS index tracking 21 commodities has shown a total return of 7.1%. Long dated US Treasuries were a great bet returning 13% year to date despite the bearishness on long term bonds at the start of the year, whilst European periphery yields have fallen almost below US Treasuries. The S&P is up 7% so far continuing its stellar performance from 2013. Furthermore the CBOE Vix Volatility index, which is Wall Street’s so called “fear gauge” (using option prices to asses market volatility) has fallen below 11 indicating a market fearlessness. All this on the backdrop of continuing geopolitical tensions, European political and deflationary risks, expectations of a run on fixed income, China liquidity and growth concerns, a UK housing bubble and US stock bubble. I find it extremely hard to justify these returns and cannot see them continuing for the rest of the year. The BIS claim markets are ‘euphoric’ due to ultra loose monetary policy whereby liquidity rather than fundamentals is driving returns. Either way, I believe it will become increasingly important for fund managers to pick winners for the rest of the year. Below I focus on five areas where risks are being overlooked and threaten to destabilise the markets.

Geopolitical Risk

The most obvious place to start is geopolitical risks, which seem to be bubbling up ever more in the last few months. Despite the developments in Ukraine, the Russian Rouble is actually one of the best performing currencies in the last few months. That was until yesterday when Mr Poroshenko said, “we will advance and free our land” after the ceasefire was broken, sending the Rouble down 0.6%. ISIS insurgents in Syria and Iraq continue to advance towards Bagdad and at the time of writing had taken over Abu Kamal on the Syrian border, having previously declared the region held as a caliphate. A lack of Western intervention in Syria now leaves the West with the impossible choice between Asad and ISIS.  Islamic Extremism continues in Northern Nigeria and in Pakistan where the government are trying to flush out the Taliban. A Libyan civil war continues, hope for Palestian-Israeli talks hit a wall as teenagers died on either side and tensions with the new Egyptian president and the West reached a toll after the increasingly authoritarian General Sisi delivered harsh sentences to two pro-Muslim Brotherhood journalists. This follows the death sentences handed down to 182 Muslim Brotherhood supporters last month. 

The surprising common feature to most of the tensions is the market calm as if ultra loose monetary policy trumps all geopolitical risks. Oil barely touched $115 before falling back towards $110 after a pause in the Iraqi insurgency, as commentators believe ISIS are still very far away from damaging exports. Although the Rouble and MICEX suffered from Western sanctions, they were far too quick to recover following the brief ceasefire. The market optimism is staggering and it is hard to believe that all of these conflicts will fade away into the dust without damaging either commodity prices, emerging markets or even developed markets in the case of sanctions and commodity importers. All this before even considering the potential of a Black Swan sending this sectarian violence into full scale international conflicts. Building portfolios for the rest of 2014 will have to account for these potentially explosive collisions in the East and take the astonishing market optimism with a pinch of salt.

European Risks

Europe faces both political and economic risks. A rise Euroscepticicsm led to a damaging European parliamentary elections for the main national parties whilst a recent embarrassment for Cameron on the appointment of the Commission President, Jean-Claude Juncker, lead to the alienation of the UK worsening the prospect for the 2017 referendum. Along with a Scottish referendum later this year and tensions bubbling over in Catalonia, the future of the European Union has been thrown into doubt.

Economically, the EU still suffers high government debt, staggering youth unemployment, double-digit total unemployment and diverging economies at its very core. Diverging economies makes policy responses that much harder. France’s stagnating economy is filled with alienated voters and is in dire need of labour market reforms. Spain is faring better although still has a 25% unemployment rate whilst Germany seems to be leading the way with more optimistic data releases. The key issue in the Eurozone however is low inflation and policy responses. Eurozone inflation was unchanged at 0.5% this month well below its 2% target despite a negative deposit rate and new LTROs. Fittingly, yields have progressively fallen across Europe. Germany sits at a low of 1.29% and France at 1.76% whilst Italy’s and Spain’s ten year government bonds yield 2.93% and 2.64% respectively closing in on the US which stands at 2.63%. Even Irish yields sit below 3%.

The falling spreads between peripheral Europe and the US partly reflect economic outlook and diverging policy. The US is currently tapering off its QE and the UK is expecting a rate rise in the near future whilst a strong euro and threat of deflation has lead the ECB to expansionary monetary policy and the potential for its own form of QE. That said, these yields seem to be mispricing the inherent default risk in these countries. Low DM rates, high liquidity and high inflation in EM have lead the search for yield to Europe. Investors are betting on EU QE and a smooth recovery.  Yet Greek debt and Italian debt still stand at 175% and 132% of GDP respectively to name a couple. To give an example of the risk-off attitude, in April, Greece raised 3 billion euros after a five-year bond sale attracted 20 billion in orders leading to yields of 4.95%.

Investors know and understand these risk but excess liquidity is pushing yields down regardless. A change in sentiment is not the only inherent risk here but also low yields encouraging governments and corporates to scramble for debt can ironically amplify the debt crisis further.

 

Bubbles

A London housing bubble continues to threaten the UK’s recovery and has most recently been addressed by new powers handed down to the Bank of England. A bigger concern is the much-debated US stock bubble.  The 12 month forward p/e ratio stands at 15.6 compared to a 10 year average of 13.8. More striking is the Shiller p/e ratio (that compares prices to 10 years of profits) which is at levels only seen before the 1929 and dotcom crashes. Gains in US stock markets have been evenly distributed which is indicative of global liquidity rather than fundamentals driving prices. Despite the S&P at record highs the US economy shrank at an annualised 2.9% in the first quarter mainly due to bad weather. The concern however is if the market is attributing too much of the decline to bad weather and overestimating the size of the US recovery. If revenues and earnings do not rise in line with predictions we will surely see a large correction at some point. 

Even if 2014 returns are justified, it is unlikely this broad based rise will continue as US liquidity is reduced (especially if it is not replaced by Eurozone QE). It will be much more important to pick winners in the second half of the year which is all the harder when most stocks seem expensive.

Fixed Income & Commodities

The biggest surprise so far this year is the gains made on US 10 year Treasuries. Consensus was to avoid long dated US bonds at the start of the year as the Fed taper off their asset purchases. However long term yields have managed to stay low. The question on investors' lips is whether the second half of the year will bring lower bond prices (and higher yields) as the US finishes its taper and begins to think about rate rises. Intuition says losses are afoot as the US tightens but it is becomingly increasingly apparent that there is a disconnect between monetary policy and US Treasuries. Fed demand for Treasuries has been replaced some way or another thanks to geopolitical risk, emerging market sell offs and matching of long term liabilities at pension funds. Taking a step further, if you believe Dooley, Garber and Folkerts that the world still follows a Bretton-Woods system whereby periphery countries (such as Asia) are happy to underwrite US deficits to focus on export orientated growth then US bond yields may stay low for the foreseeable future as these countries target US capital.

As for tapering on emerging markets, focus will eventually be shifted back to the Fragile Five (India, Indonesia, South Africa, Turkey and Brazil) who have been rewarded since the summer sell off last year for improving their current accounts and productivity. Indonesia had gained a lot of ground thanks to a big step towards a current account surplus as well as optimism regarding the leading candidate and reformist Joko Widodo in the elections. That said, the country still suffers from high inflation and the nationalist Prabowo Subianto is narrowing the gap in the polls. High inflation reducing real rates of return and current account deficits may lead to capital outflows as global rates rise and the US reduces liquidity. Turkey seems most a risk having recently reduced their interest rate by 0.75% to 8.75% with the independence of the central bank being thrown into question. India has made huge gains since Modi’s win in the national elections but could face capital outflows if his reforms do not begin to meet expectations. The big issue facing fixed income markets is a run could cause a collapse in prices. ETFs with illiquid assets are eligible for daily redemptions and regulation in banking has reduced market making in these industries. Investors heading for the exits could cause huge panic and massive capital losses; hence the talk of imposing exit fees on fixed income funds.

As for commodities, gold is up 6.4% since the start of June due to geopolitical tensions, US inflation expectations and a weaker dollar. Copper shot up after concerns regarding Chinese financing deals faded and platinum saw some gains after the South African strike ended. Commodities are a real opportunity for the remainder of the year as their correlation (and general downward trend) from last year is broken down and investors can focus more on how supply and demand will be affected by these geopolitical risks.

Currency

Logic and reality do not always meet eye to eye when it comes to currency. The most recent bet is to be long the pound given the recent hawkishness of Carney and a strong UK PMI release. Sterling reached a six-year high yesterday. Expectations of rate rises this year have lead to a surge in short sterling contracts (i.e. bets on rate rises). That said, a week later the governor of the Bank of England released a dovish tone explaining rates will not rise unless wages advance. Perhaps he is trying to inject some unpredictability into the central bank to pop the housing bubble (in stark contrast to forward guidance). Either way, the UK is looking most likely to be the first to tighten hence the currency gains. That said, the pound trade is already looking overcrowded especially given the mixed signals from the central bank.

The Euro, whose strength was continuing to threaten a Eurozone recovery, was expected to fall dramatically after the ECB introduced expansionary measures. That said, the fall in the euro-dollar has almost been entirely wiped out due to poor first quarter results in the US  (weaker dollar) and reduced likelihood of QE in the Eurozone. It seems intuitive to believe that as policy diverges in the US and Europe that the dollar will strengthen against the Euro but this logic has been proved wrong again and again.

As for China, the recent depreciation of the Renminbi was a shock to all. The easiest trade last year was a carry trade in low yielding currencies, such as the Yen, to the Renminbi. Gains due to interest rate differentials were amplified by the appreciating Renminbi. The source of the depreciation is key to understanding the direction of the currency for the rest of year. It could be that the fall is market related. China is suffering from sliding house prices and slackening investment. Overcapacity in old-fashioned industries, dangerously high local government debt and a clamp down on corruption may be sending billions of dollars of capital out. More likely however is that is was a manoeuvre by officials to prevent a one way bet on the currency as they attempt to liberalise. After all labour costs are much more important in determining overall costs rather than a slight depreciation, China is still a large importer of inputs and officials would prefer to move up the value added chain boosting domestic demand rather than export orientated growth. Furthermore, growth was 7.4% is Q1 against the target of 7.5% and a Chinese liquidity crunch has been tackled by mini stimulus packages. Recent PMI data also shows expansions in manufacturing, all providing optimism that China’s growth run is not over yet. Strong data in China also benefits Australia and Canada. In fact a new carry trade from the US to Australia has been a big winner this year. The Australian and New Zealand dollar have gained 5.7% and 6.8% against the dollar respectively this year.

Conclusion

Investors and fund managers know and are concerned by these risks. Yet global liquidity, as the BIS argue, is driving returns. Broad based rises across all sectors and asset classes will surely have to end at some point this year, especially if the US finishes its taper and UK raises its base rate. It is time for fund managers to start earning their money…

The Dangerous Rise of Eurosceptiscism

As an Economist it frustrates me when anyone suggests an exit from the EU would benefit the UK. In a truly integrated world where 30 countries can take part in the manufacture of one t-shirt, it is absurd to believe general increases in protectionism can improve welfare. Nigel Farage’s (UKIP’s) xenophobic, blame-thy-neighbour rhetoric is currently gaining a lot of attention. I thought it was time I laid out my beliefs regarding the EU. I first look at the insurmountable costs of an EU exit and then discuss some of the so-called benefits of leaving the EU.

THE COSTS OF AN EXIT

1) Trade

Let’s start with the basics – trade. Regardless of what Farage claims, leaving a Free Trade Union will inevitably lead to lower trade with Europe and the rest of the world pushing us closer (even if by a small amount) to our autarkic equilibrium. You are on your own if you believe less trade with the rest of the world will improve living standards. There is as overwhelming agreement in the profession regarding the gains from trade. Trade leads to increased choice and variety, lower prices, increased competitiveness and the ability to exploit a comparative advantage. You may quite correctly argue that the gains from trade are severely unequal and globalisation leads to an increasing gap between the rich and poor. But the issue here is not with trade itself but with the subsequent redistributions. Free trade increases the size of the pie and it is up to government policies to redistribute this accordingly.

As for the firm perspective, small firms or the less productive (higher cost) firms do suffer from globalisation, being replaced be global MNCs with low costs and high market share. So perhaps leaving the EU may improve the bargaining power and market share of small businesses albeit at the cost of lower competitiveness and higher priced goods. However, in reality this is not what would happen. Large MNCs are globally integrated international firms and would brush off a UK exit, perhaps locating their headquarters elsewhere. The ones that will suffer are the small businesses and manufacturers that will see rising inputs costs and a diminishing export market. The idea that an EU exit will return the UK to a manufacturing powerhouse is nonsensical and living in the past. If anything, manufacturing will suffer the most whilst financial firms, which are the epitome of globalisation, will be just fine. As competitiveness falls, firms locate elsewhere, prices rise and incomes fall, the current account deficit will almost certainly enlarge as UK exports become less attractive whilst the needs for imports remains.

Capital and Property

What about investments? Put simply, FDI and hot money inflows will almost certainly fall. A choice between two equally productive manufacturing firms in the UK and Germany has only one winner. The firm that has access to the EU market with harmonised rules reducing uncertainty and the ability to export more cheaply will win. Being outside the EU will almost certainly lead to an increased risk premium on UK fixed income and equity as growth expectations become more uncertain and access to European free trade and all the bilateral/multilateral agreements that go with it disappear. 

As for property, the recent surge in house prices in the UK is partly driven by foreign capital, especially in London. Whilst this capital is partly responsible for creating a bubble in London, its reversal over time will cause large capital losses in the property market and we all have seen what decreasing house prices can lead to. It seems unlikely, but London property is an asset class like any other and its popularity may decrease over time as the UK shuns the rest of the world. Property prices will rise much more in line with UK incomes which in turn will be lower. Foreign capital will find its home elsewhere as other property bubbles emerge across the globe.

As capital inflows fall, the real exchange rate will depreciate making imports even more expensive. Less access to financing, borrowing and lower liquidity will hurt small businesses. Despite setbacks during most recessions, the world is only going in one direction – towards globalisation. Turning your back on it now is a mistake.

Immigration

I have written a blog on immigration previously so I will keep it short and sweet. The gist is simple. Immigration brings ideas, innovations, lowers costs, fills jobs that UK residents do not, reduces the debt burden of the economy and improves public services such as the NHS. The cited economics costs of immigration are often factually incorrect or simply xenophobic. Of course there are some costs such as welfare tourism but these must be viewed against the indisputable and overwhelming benefits of immigration.

Brain Drain

All of the effects above will lead to a brain drain where the best minds leave the UK. Those that add to the economy the most will have the incentive to relocate elsewhere where growth is higher and firms are more integrated. Movement of physical and financial capital will be followed by its complementarity in labour. Even if labour stays put, the UK will miss out on the benefits of skilled immigration that makes the UK so competitive, especially in financial services. Comparative advantages will fade away alongside skilled labour.

REASONS TO EXIT

National Sovereignty

It is true that globalisation and a political union leads to less national sovereignty. But for me this is not a cost. A lot of laws and decisions require international cooperation such as tax avoidance, climate change and international security. Geopolitical issues such as Ukraine and Syria rely on multilateral cooperation (even if the response is poor). Furthermore, do not get mistaken; the UK still has a lot of national sovereignty. It is the global issues that are and should be dealt with centrally. The idea of Germans setting UK law is a terrible way of viewing international cooperation and simply not true. I hope that views will change over the next few decades. Hopefully one day, people will consider themselves as much European as British. Harmonisation of laws, such as in financial services, can increase capital flows, decrease uncertainty, improve tax revenues and improve global growth. Some laws should be left to the national governments of course but the idea of solely unilateral laws in an integrated world no longer works.

Furthermore, whether you like it or not, the world is becoming more integrated and decisions are made increasingly at a cross-national level. Outside the EU, the UK will become increasingly less influential in the global arena. An outsider.

Culture

The view is that globalisation and the EU leads to increasing cultural fragmentation, changing British values and a “white middle class” that loses out the most to quote Farage. To some extent this is undoubtedly true. In the EU, the UK has and will become an ever-increasing mixing pot. Yet a mixing pot to be proud of. A mixing pot of different talents, skills and interests. A mixing pot of skilled and unskilled workers with a range of ideas, innovations and experience. My big issue with UKIP is the constant mention of this “white middle class.” If you consider being white and middle class as being British you are not living in the 21^st century.

Let’s remember that cultures have been developed over years of immigration all over the world. The idea of trying to preserve a specific culture of the past is the sort of conservatism that will stand in the way of not just economic development but also racial integration and decreasing ignorance of others. We should be happy to embrace different cultures. Preventing immigration is not the solution. The solution is breaking down the fragmentation between cultures.

What may have been very British a hundred years ago may not be very British today and the same goes for the next hundred years. Cultural changes happen slowly over time alongside increasing living standards. Do not fear them but embrace them.

Contagion

Of course being part of the EU means European recessions flow quickly to the UK increasing costs and damaging incomes in downturns. However I would respond with two points. Firstly, financial markets are highly integrated globally and therefore any financial recession is, in its very nature, contagious. The UK is one of the financial capitals of the world and hence will suffer from global recessions regardless of being in an economic union or not.

As for the sovereign debt crisis, whether we are in the EU or not, UK banks and investors will always hold EU debt. Bailing out European sovereigns will always be in the interest of the UK and its deposit holders. The recession and subsequent debt crisis led to a large blame-thy-neighbour rhetoric in many countries. It is always easy to blame outsiders and this often happens in recessions. Most of the time however these views conflict with reality.

Secondly, whilst recessions are exacerbated by globalisation so is both short term and long-term growth.

NO REFRENDUM

If the arguments are so convincing then why not let the people vote in a referendum? That would be the democratic thing to do after all. Let the voters decide. My reason for not wanting a referendum is that the public are not properly informed and the results may be disastrous. A lot of the benefits of global integration are slow and not visible until they are gone. Unless you are an economist, in finance or business, or just take a genuine interest in the subject your views may be distorted by the political rhetoric. The UKIP view is convincing if it is the first you have heard the subject. However, more often that not it is fantasy and driven far more by xenophobia than good Economics. Providing voters with a referendum is an easy way to win votes and lay blame, but it is dangerous. Furthermore, just because one party offers a referendum does not mean all the others should. A referendum can theoretically be used for any issue. The reason we don’t have a referendum on banning taxation is because the result may just be yes.