Is Redwood right?

Frances Coppola points out that whilst John Redwood the politician is talking up the benefits of a hard Brexit, John Redwood the financial advisor is telling us to invest outside the UK.

There’s a danger here of Mr Redwood’s opponents seeing a conspiracy – that he’s talking pish about Brexit but the telling the truth in his capacity as a financial advisor. I’m not so sure. It might be that he’s wrong in the latter capacity, and that investing overseas isn’t in fact such a good idea.

I say so because Brexit isn’t the only consideration here. There’s also this paper (pdf) by Martin Eichenbaum, Benjamin K. Johannsen and Sergio Rebelo. They say:

the current real exchange rate is highly negatively correlated with future changes in the nominal exchange rate at horizons greater than two years.

My chart shows this for the $/£ rate. The correlation between the real rate (the nominal rate multiplied by relative CPIs) and subsequent three-year changes in the nominal $/£ rate is minus 0.68. By the standards of exchange rates, this is enormous. For example, a high real rate in 1990, 1997, 2006 and 2014 led to sterling falling, and a low real rate in 2001 and 2009 led to it rising.

Sterling’s rise from last October’s lows is consistent with this pattern.

This is, essentially, a variation on Rudiger Dornbusch’s theory of exchange rate overshooting. Which in turn is a generalization of the idea that asset prices tend to over-react.

With sterling’s real rate now low, this relationship points to the pound rising. It’s quite possible therefore that even if foreign shares out-perform UK ones in the future – as they have for years – this out-performance will be offset by exchange rate losses. It’s not clear, therefore, that Mr Redwood is right.

What might cause sterling to rise? It could be that FX markets are already discounting a hard Brexit, so there’s not much more downside on this score; sterling’s trade-weighted index is 12% below its pre-referendum levels. And it could be that the same interest rate rises that concern Mr Redwood might help drive the pound up.

Now, I don’t say this with much confidence. For one thing, non-sterling cash is a useful hedge against the risk of either global crises or UK recessions, because sterling tends to fall in both. And despite this evidence, a bit of me cleaves to my priors that exchange rates are largely (pdf) unpredictable and that only fools try to forecast them. 

My point is instead a weaker one – that we should not assume that, in this case, Brexiters have especial wisdom that they are withholding from the electorate.

Comments

[joe]

John Redwood the politician will not be fully blamed for Brexit. John Redwood the "adviser" will be directly blamed and lose bonus on poor financial advice.

Sterling has weakened not risen since last October 2016 and is slightly up since October 2017 as the Bank of England was signalling bank rate rises. It has fallen again on further political uncertainties at Westminster. The rate is most sensitive to Brexit negotiation good or bad news. Once UK finally gives up trying to outwit the EU then the £ will fall heavily. That is good for FTSE shares as earnings are enhanced by the weaker exchange rate.

You possibly have made a classic mistake of using regression over years that are irrelevant to today's circumstances. That UK is breaking with its biggest trading partner is unprecedented so any past data won't help predictions. In the same way the Brexit and Trump votes were unique unprecedented situations and forecast incorrectly - presuming incorrectly that voters would act as they had in the past.

The wisdom of Brexiters is not something I have come across before.

[chris]

Joe - I'm not saying we should apply that regression blindly. Obviously, Brexit is bad for the economy and therefore £: the qn is how much of that bad news is already in the price. I was pointing out that Brexit isn't everything.
Another issue here is that a loosening of fiscal policy - either next week or later - would be £-positive.
You're right about incentives. But I'm not sure this is relevant to Redwood's financial advice. What stops people investing well isn't a lack of incentive, but (inherently) bounded knowledge and rationality.