Will the Falling Pound Cushion Brexit’s Blow?

Mike Riddell | 07/11/2016
Will the Falling Pound Cushion Brexit’s Blow?

Summary

Britain’s economy didn’t roll over post-Brexit, but the pound has dropped in response to increasingly tough political rhetoric about a “hard” exit. Mike Riddell wonders whether a further drop in sterling might prompt the government to soften its stance.

Key takeaways
  • Initial economic data helped those who feel Brexit is good for Britain, but things look far less rosy in the FX markets
  • Prime Minister May has said the UK is heading for a “hard” Brexit, but the falling pound may prompt her to soften her stance
  • Due to the fractious state of Britain’s political parties, the pound is now effectively functioning as the opposition to the government

Global financial markets were fixated on the Brexit referendum in the run-up to the vote in June, and uncertainty has only increased since then. There is still no clarity as to what Brexit may actually look like, with some market-watchers speculating whether or not it will even happen (we believe it will).

Britain’s economy was supposed to roll over in the aftermath of a “leave” vote. But based purely on the high-frequency UK economic data, one could make the case that Brexit looks to have been a good thing for Britain. That’s a very dangerous outcome for European Union (EU) politicians desperate to avoid an EU exodus. They now have an incentive to make Brexit as painful as possible for the UK, even if it means the ultimately self-defeating prospect of wounding a country that buys the secondhighest amount of euro-zone exports.

Things look far less rosy for the UK if you judge its health by the foreign-exchange market. Immediately after Brexit, the pound fell 7.6 per cent against the US dollar, the ninth-biggest daily move since 1862. This was actually a smaller drop than many had expected, which tells you a lot about the pound’s positioning going into the vote.

Three months of pound stability followed, but the first two weeks of October saw another sharp move lower. UK Prime Minister Theresa May suggested that the UK is heading for a “hard” Brexit, with the UK giving up access to the single market in order to restrict the free movement of people. She also stated that the Brexit process is anticipated to officially start in March 2017, with the triggering of Article 50; ironically, this could mean that the UK might leave the EU two years later – on April Fool’s Day, 2019.

Brexit uncertainty is not being helped by the fractious state of British political parties. The Labour Party is failing to provide sufficient opposition to the incumbent government due to an internal division between Labour’s leader, Jeremy Corbyn, and its members of parliament in the House of Commons. For its part, the House of Lords is unlikely to step outside of its historic role of refining proposed laws in order to effectively provide scrutiny over the government’s plans. This dysfunction means, as HSBC has noted, that the British pound sterling is now effectively functioning as the opposition to the government.

Financial markets can signal their opposition to this state of affairs, but they cannot formulate policy. While the pound’s further fall might lead May to be more attuned to the desires of the 48 per cent who voted to remain – or to the 52 per cent who in a recent poll revealed that they would prefer a “soft” Brexit – further political opposition will be needed to soften the government’s hard Brexit goals.

Investing involves risk. The value of an investment and the income from it will fluctuate and investors may not get back the principal invested. Past performance is not indicative of future performance. This is a marketing communication. It is for informational purposes only. This document does not constitute investment advice or a recommendation to buy, sell or hold any security and shall not be deemed an offer to sell or a solicitation of an offer to buy any security.

The views and opinions expressed herein, which are subject to change without notice, are those of the issuer or its affiliated companies at the time of publication. Certain data used are derived from various sources believed to be reliable, but the accuracy or completeness of the data is not guaranteed and no liability is assumed for any direct or consequential losses arising from their use. The duplication, publication, extraction or transmission of the contents, irrespective of the form, is not permitted.

This material has not been reviewed by any regulatory authorities. In mainland China, it is used only as supporting material to the offshore investment products offered by commercial banks under the Qualified Domestic Institutional Investors scheme pursuant to applicable rules and regulations.

This document is being distributed by the following Allianz Global Investors companies: Allianz Global Investors U.S. LLC, an investment adviser registered with the U.S. Securities and Exchange Commission; Allianz Global Investors GmbH, an investment company in Germany, authorized by the German Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin); Allianz Global Investors Asia Pacific Ltd., licensed by the Hong Kong Securities and Futures Commission; Allianz Global Investors Singapore Ltd., regulated by the Monetary Authority of Singapore [Company Registration No. 199907169Z]; Allianz Global Investors Japan Co., Ltd., registered in Japan as a Financial Instruments Business Operator [Registered No. The Director of Kanto Local Finance Bureau (Financial Instruments Business Operator), No. 424, Member of Japan Investment Advisers Association]; Allianz Global Investors Korea Ltd., licensed by the Korea Financial Services Commission; and Allianz Global Investors Taiwan Ltd., licensed by Financial Supervisory Commission in Taiwan.

© 2016 Allianz Global Investors. All rights reserved.

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Mike Riddell

Senior Fixed Income Portfolio Manager

Countdown to the US Election: How Much Gridlock Is Good?

Peter Lefkin | 07/11/2016
Government Gridlock

Summary

The next US president’s deal-making skills will be severely tested in the aftermath of one of the most divisive campaigns in memory. Peter Lefkin says this could be a recipe for paralyzing government gridlock – or just the kind of “Goldilocks” scenario the markets like.

Key takeaways
  • Gridlock isn’t all bad: The three-branch structure of the US government was designed to maintain a certain amount
  • Gridlock can not only block bad ideas from being enacted, but it can facilitate meaningful discussion when everyone's back is against the wall
  • Gridlock has generally been viewed positively by the stock market, but it has gotten much worse in recent years
  • Recently Congress has illustrated repeatedly that it is incapable of reaching a compromise – remember the government shutdown of 2013
  • The 2016 elections could result in greater government gridlock, but it could also reshape the two major political parties

Gridlock: The bedrock of US politics

Well before the current US election cycle started, and before new scandals surfaced almost daily, government gridlock was one of the biggest political stories around. Historically, gridlock in the US can be loosely defined as when the executive branch is controlled by one party and the legislative branch is controlled by another party, which provides checks and balances that often thwart bills from becoming laws.

Government gridlock can be both a positive and a negative, although a lot of it depends on perspective. As Bob Dole, former majority leader of the US Senate, put it simply several decades ago, "If you're against something, you'd better hope there's a little gridlock". In other words, if one believes that “government is best which governs least”, then gridlock is a positive.

If one believes that “government is best which governs least”, then gridlock is a positive

President James Madison is arguably the founding father of government gridlock. Well before he became president, Madison was an author and proponent of the US Constitution. In Federalist Paper Number 51, Madison advocated for checks and balances and the gridlock it can create. The three-branch structure of the US government ensured that each branch would keep the others "in their proper places". Madison believed there would always be people and groups that sought to further their respective agendas. However, the Constitution would ensure that "ambition would counteract ambition".

Indeed, over time, government gridlock has generally been viewed positively by the stock market – the less that gets accomplished, the less the markets will see of regulation and government spending. However, that conventional wisdom has been challenged in recent years as government gridlock – which has always ebbed and flowed over time – has gotten much worse. This suggests a high level of dysfunction among America’s leaders.

Gridlock, historically viewed positively by the stock market, is now just viewed as dysfunctional

Origins of the current crisis

The current gridlock crisis began in 2011: Republicans had won a majority in Congress the previous year, helped by the popularity of the anti-government-spending, anti-tax Tea Party movement. Congressional Republicans focused on lowering the deficit, insisting that President Barack Obama reduce government spending to win support for an increase in the debt ceiling. The stakes were high: If the US exceeded its debt ceiling, the US Treasury would be forced to either default on its payments to its bondholders or stop payments to those it owed money to, including its employees, vendors and recipients of government benefits. Not surprisingly, this extreme gridlock was viewed negatively by the stock market and resulted in the most volatile week for financial markets since 2008. Either option on the table at the time – defaults or cessation of payments – would have led to a full-scale crisis, which was averted when legislators agreed to substantial spending cuts in the future.

However, the dysfunction and near-disaster resulted in Standard & Poor's downgrading US debt for the first time in history. In S&P’s words, "the downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges". Since then, Congress has illustrated on multiple occasions that it is incapable of reaching a compromise – the most glaring example of which was the spending bill that resulted in the government shutdown of 2013. However, this ended badly and Congress vowed that it would not happen again, and indeed it hasn’t.

Congress has illustrated on multiple occasions that it is incapable of reaching compromise

Girding for more gridlock

Of course, there is another side to gridlock: It not only blocks bad ideas from being enacted, but it also can facilitate meaningful discussion when everyone's back is against the wall. This might sound peculiar until you realize that public policy debates require compromise, and this usually occurs when the political centers of both political parties agree to something that they both can live with.

No one wants extreme gridlock: The country is dependent on having a government that can manage its public affairs, which includes paying its bills and keeping the economy operating. Yet recent history also shows that one-party control of government creates the potential for a misguided appetite for aggressive programs that might go too far. Instead, the “Goldilocks approach”, with power evenly divided and well-meaning leadership, produces just enough tension for government to get things done – albeit not in a very inspirational way.

Unfortunately, given the fact that America’s two major political parties have become increasingly ideological, compromise is occurring less frequently as individual legislators and both parties decide that the politically safe option is to dig in and not anger one's rigid political base. However, when there has been a need for action in recent years because of the threat of a government shutdown, the expiration of tax cuts or a default on government debt, the executive and legislative branches have been able to reach agreement and have even periodically produced good public policy.

This presidential election has the potential to result in greater government gridlock, but it also has the potential to reshape the two major political parties in the US. Donald Trump has not been able to win the support of some moderate Republicans, so it remains to be seen whether he would be able to work effectively with them – let alone Congressional Democrats – if he were elected president. Similarly, Hillary Clinton has had difficulty winning support from the left wing of the Democratic Party. If she pursues a more centrist agenda, she may meet opposition from this faction.

The divisiveness of the election may translate to even more government gridlock over the next presidential term

At the end of the day, this election could result in a greater fracturing of the two major political parties in the US and perhaps a reshuffling of alliances across party lines. We will find out on 8 November when, after a long and loud campaign, the American electorate will determine the composition of the executive and legislative branches of its government. If current trends continue, the divisiveness of the election looks to translate to even more government gridlock over the next presidential term.

Investing involves risk. The value of an investment and the income from it will fluctuate and investors may not get back the principal invested. Past performance is not indicative of future performance. This is a marketing communication. It is for informational purposes only. This document does not constitute investment advice or a recommendation to buy, sell or hold any security and shall not be deemed an offer to sell or a solicitation of an offer to buy any security.

The views and opinions expressed herein, which are subject to change without notice, are those of the issuer or its affiliated companies at the time of publication. Certain data used are derived from various sources believed to be reliable, but the accuracy or completeness of the data is not guaranteed and no liability is assumed for any direct or consequential losses arising from their use. The duplication, publication, extraction or transmission of the contents, irrespective of the form, is not permitted.

This material has not been reviewed by any regulatory authorities. In mainland China, it is used only as supporting material to the offshore investment products offered by commercial banks under the Qualified Domestic Institutional Investors scheme pursuant to applicable rules and regulations.

This material is being distributed by the following Allianz Global Investors companies: Allianz Global Investors U.S. LLC, an investment adviser registered with the U.S. Securities and Exchange Commission (SEC); Allianz Global Investors GmbH, an investment company in Germany, authorized by the German Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin); Allianz Global Investors Asia Pacific Ltd., licensed by the Hong Kong Securities and Futures Commission; Allianz Global Investors Singapore Ltd., regulated by the Monetary Authority of Singapore [Company Registration No. 199907169Z]; and Allianz Global Investors Japan Co., Ltd., registered in Japan as a Financial Instruments Business Operator; Allianz Global Investors Korea Ltd., licensed by the Korea Financial Services Commission; and Allianz Global Investors Taiwan Ltd., licensed by Financial Supervisory Commission in Taiwan.

AGI-2016-11-07-16830

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Peter Lefkin

Senior Vice President of Government and External Affairs
Peter Lefkin is the senior vice president of governmental and external affairs with Allianz of America Corporation, which he joined in 1988. He leads the firm’s state and federal lobbying efforts in the US and has 27 years of industry experience. Mr. Lefkin has a B.S.F.S, cum laude, from the Georgetown University School of Foreign Service, and a master’s in public administration and a J.D. from Syracuse University.
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