Stock Market and GBP crash
What was intended as a response to a lot of questions I’ve been getting about the GBP on facebook — whether it’s a good time to buy and why it has depreciated so suddenly against a currency like the EUR, keeping this concise is turning out to be a lot harder than I had initially thought so I’ve resorted to writing my first piece on Medium. Also, I should mention that I’m just someone who became passionate about financial markets in recent years and not an investment professional, and this is simply the highlights of events as I saw it unfold that may help to explain some of the questions I’ve been seeing recently.
To set the scene, we first take into account the state of the global economy which was sitting on a knife edge due to uncertainty created by the Trade war. Global PMI showed depressed economic activity in 2018 (particularly in manufacturing) and continued to decline since. Copper prices, being considered a reliable macroeconomic indicator of global industrial activity also followed the same trend. As the Tariff Man continued his games with “Chyeena”, high geopolitical tensions saw increasing demand for US dollars well into 2019.
But despite declining global activity, US equities kept roaring higher, mostly owing to cult-like interest in tech companies and share buy-backs — the practice of which keeps stock prices elevated. Erik Townsend of the podcast Macrovoices said it best calling this “the greatest mispricing of risk in history”.
Uncertainty created by the trade war saw increased demand for the USD (safe-haven, as well as US out-performance) and a 10% rise in the US dollar index for 2018. Optimism for global reflation at the end of 2019 saw Capital flowing back into emerging markets (EMs) and riskier assets in anticipation of new trade deals resulting in dollar demand to subside briefly.
As the stock market continued to make record highs, USD liquidity was systematically sucked out of the system to create excessive leveraging of dollar denominated assets and propping up asset prices even further. Signs of USD liquidity tightness was beginning to be felt evidenced by a couple instances in 2019 in the short term funding (repo¹) market where the overnight cash rate spiked out of control signalling a lack of dollar liquidity in the system. This is akin to the panic of finding out your bank is out of cash, taking away your credit line/card, or worse — unable to honour your cash withdrawals and transfers. The consequences could be disastrous if left unaddressed.
STOCK MARKET CRASH & KING DOLLAH
Earlier this year, recession concerns sharply escalated due to virus outbreaks and spat between oil-producing nations sending markets into a negative feedback loop of decreased global demand, supply chain disruptions, deteriorating credit quality as result of lost business, less investment, and therefore less economic activity and so on. A massive repricing of assets followed and the US stock index S&P500 (SPX) went on to sell-off for 3 weeks dropping 34% from peak to trough!
As the market sold off in panic, investment portfolio liquidations took place across the board including assets like Gold and the Japanese Yen which are incorporated into portfolios as a hedge to protect against uncertainty/volatility via risk parity — i.e. JPY and Gold tend to appreciate when stock prices decline and vice versa. But in the event of a market crash, risk parity collapses due to these hedges being forced to unwind to cover losses in portfolios; thus we saw the extraordinary case of Gold and JPY collapsing with stock prices when they would ordinarily move in the opposite direction and portfolio returns would have remained protected. The wide-scale liquidations triggered a mad dash for cash and capital flight back to USD from EM’s that led to the dollar index soaring 8% in less than 2 weeks.
The unprecedented magnitude of the crash may be less surprising to some as it wouldn’t have taken much for the precarious market to buckle considering 1) artificially high stock prices from corporations buying back their own shares with excess cash, 2) global activity being in decline, and 3) Trump’s tweets constantly supplying the market with false hopes of imminent deals.
THE GREAT BRITISH POUNDING
After the initial leave vote, GBPUSD established somewhat of a price floor at 1.20 after which market was became hopeful of the progress in brexit negotiations seeing the GBP rally back to 1.40+ pre-vote levels. Complications in finding suitable Brexit solutions for a single customs union among other things, as well Trumps trade war in 2018 lowering prospects for global growth, saw the GBP slump against a rising safe-haven USD back to 1.20.
At this point in Q2 of 2019, the GBP was perceived to be massively undervalued and when Boris Johnson and co. tabled a fresh brexit proposal going forward, the market increasingly upped their bets as uncertainty started to abate as a resolution of some sort was looking more likely. GBPUSD rally to as high as 1.35 by Dec to then settle around the 1.30 handle going into 2020.
When disaster struck, and given the apparent lack of dollars in the system, the stock market collapse and sudden surge in USD forced these massive volumes of bullish bets to unwind leading to GBPUSD going from 1.32 to as low as 1.1450, a whopping 15% depreciation in just 9 calendar days, making the GBP one of the worst affected currencies by the dollar short squeeze.
SO IS IT A GOOD TIME TO BUY THE POUND?
While we are historical lows — I believe it is, particularly from the perspective of buying it with US dollars. Though there is tremendous added uncertainty at the moment, the GBP still remains to be greatly undervalued.W ith the US Federal Reserve expected to commence its QE program (money printing in layman terms) by flooding the market with dollars, USD strength and short-term funding pressures should alleviate and GBPUSD ‘should’ go higher from here.
This does depend on a few moving parts such as the speed of containment and recovery of the global economy from the corona virus, and the extent of QE by the US Federal Reserve. The faster the virus clears and larger the QE package by the Fed, the more supportive it is of a stronger GBPUSD view and that the bottom is indeed behind us. An example of things I’m looking out for to gauge the scale and speed of recovery which would provide more confidence to the above view are:
- comparing the curve of outbreak containment to say Wuhan China and South Korea, and looking for a decline in the rate of change in new corona cases
- signs of life returning to normal such as traffic congestion levels, https://www.tomtom.com/en_gb/traffic-index/;
- any other news and economic business activity indicators such as Visitor New Arrivals, business confidence and sentiment surveys etc.; and
- upcoming QE announcements by the Federal Reserve.
Thanks for stopping by. Please feel free to get in touch if you have any comments or questions.
¹Repo market is a USD liquidity pool held and managed by the US Federal Reserve where banks and large institutions can obtain liquid cash on short term basis. This is essentially the lifeblood of the financial system where liquid cash may not be readily available when needed, thus enabling the smooth running of banks and economy at large. https://en.wikipedia.org/wiki/Repurchase_agreement