Money and markets: a weak pound will be good for manufacturing and engineering
The markets think that Brexit has cut 10 per cent off the value of the UK, hence the fall in the pound. Our market commentator explains how this could lead to an engineering boost.
The efficient market hypothesis states broadly that the market is always right. It is an axiom that has a number of Nobel prizes for economics perched on its pedestal.
Most players in the market hate the idea and vehemently disagree that the market is efficient and always right. To agree with the theory would mean their input is mainly worthless, so it is no surprise they say, “it ain’t so”.
Trying to prove the theory wrong by trading against it is consistently the road to ruin, which heavily suggests that the theory is correct enough to win the shirts off dissidents’ backs by the end of the game. Living at one with the idea that the market instantaneously prices all knowable information is therefore advisable if you want to stay solvent.
The biggest market this applies to is the currency market. With trillions swilling through the financial pipes of the world economy every day, the foreign exchange, or Forex, trade has all the requirements for a perfect market and is about as close as you can get to the efficient market ideal. To influence the foreign exchange markets, as the Swiss found out, takes billions and can end up extremely costly and disruptive.
The only way to steer currency is through interest rates and this is where modern financial manipulation happens. QE, quantitative easing, is where governments, via their central banks, play the ultimate game of chicken with global markets. So far they have managed to keep their economies on the rails by tightly managing the reins of money supply. Not everyone agrees with that diagnosis but people often forget the potential of a terrible accident that was only missed by a whisker.
Central banks set money supply by fixing interest rates, literally, and with that lever currency levels follow based on that key factor in the interlinked demand for foreign exchange. If those interest rate fixes are too far off from reality, economies become distorted until something snaps and the inevitable step-change of realignment suddenly occurs. The Swiss franc was a case in point this year, with a precipitous rise leaving a trail of destruction in its wake.
With this in mind, the current slump in the British pound, sparked by the Brexit, sets the scene for what is to come. If the market is efficient and nigh on perfect, it has calculated the ‘what ifs’ and rolled up the result of that cone of probability into a price. It implies that Brexit has sliced a significant value from the total wealth of the UK.
Depending where you want to draw the past and current levels, Brexit has taken the UK down from 1.45 to 1.20 in terms of the US. It’s broadly equivalent to cutting pound-denominated wealth 17 per cent versus the dollar and 13 per cent in terms of the euro.
That’s what the global market thinks the Brexit has done to the UK – chopped 10 per cent+ off its value.
Like a Feynman diagram, all futures are meant to be factored into this valuation but even without this finesse many people will think it a fair estimation. After all, the decision to leave was based on the political demerits of EU membership, immigration and governmental independence, rather than the benefits of a membership of a benign economic and customs union.
Is this economic haircut bad news? I would say no.
In markets there are two halves: the active and the passive. There are the price takers and the price makers. Price takers take the price on offer while price makers passively offer to buy or sell at a broadcast price. Price takers are active; those offering, passive.
Price takers, the active components of the economy, can be nothing but ecstatic at a collapse in the pound. As engineers actively making things, the sudden catapulting of competitiveness delivered by a weak pound is a shot in the arm. For price makers, for example, those offering out their capital passively or savers living off their interest, it is an instant global cut in their wealth.
This is why manufacturing countries are always fighting each other to devalue their currencies. A cheap currency drives commerce.
If a real Brexit happens, then it will only be for the best if the active component of the British economy can step up to the challenge of being part of a lone trading nation. A weak pound will be critical to this.
The recent Jean-Claude Junkers comment on the Brexit as ‘Pffft,’ is clear notice. With a Brexit, gone is the prospect of a rentier subsistence from the dirigiste policies of a European superstate. The UK will be on its own. The pound will remain weak and with it interest rates near zero. Everything else will follow from that.
So it’s boom times for manufacturing and engineering, which while forced to wrestle with new bureaucratic paperwork, will find that easier than wrestling with lack of demand.
Significantly, this possibility is showing itself in record levels in the FTSE 100. The markets are telling us that on balance the UK will take a body blow but that this will lead to an economic renaissance.
As fortune cookies go, this is not a bad one.