After another horrible week for Sterling on the foreign exchange markets, it has become all too easy to be overly bearish. There can be little doubt that the UK faces unprecedented political challenges in exiting the European Union. With the likelihood that Brexit will ultimately mean no access to the single market, the economic challenges will be large as well. Nobody knows exactly what the future holds, but everyday business and investing life is full of uncertainties. Given all of this, here are some thoughts on the prospects for the Pound.
Even before the Brexit vote, the case for weakness in the Pound Sterling was easy to make. Indeed, we wrote a special report in April this year (see link here) outlining why Sterling had to weaken, although the Brexit vote made the timing of weakness extremely difficult to predict. So, with a weaker Pound being part of the required rebalancing for the UK, should we be embracing the 20% fall in recent months or panicking? Chart 1 below shows the Sterling trade weighted exchange rate back to the 1980s. The current weakness is the third period of accelerated weakness in the last thirty years, and is very in line with the magnitude of previous declines.
Chart 1 – Sterling Trade Weighted Exchange Rate
The best case scenario for the UK is that the weakness in Sterling helps reduce our burgeoning current account deficit, and that our access to the single market remains open for as long as a trade deal (or compromise that focuses on certain key sectors first) takes to negotiate. The probability of this seems low at the moment as European leaders seem intent on punishing the UK as a way to discourage other countries from following this path. That said, the UK does have over two years of access to the single market whilst negotiations are ongoing, and a positive scenario is possible. It is our view that Sterling is undervalued in a positive scenario.
The worst case scenario is some sort of Armageddon. As the UK loses access to the single market, our exports suffer despite a weak currency. Furthermore, the city is cut off and the financial services sector collapses. The shock to the economy would be enormous, inflation would pick up as imports become more expensive. The current account deficit would remain stubbornly wide, and the Pound would continue to fall as international investors shy away from UK assets necessitating a rise interest rates to attract capital to fund the deficit. This cocktail would further impact the economy and also financial and real estate assets.
As with the best case scenario, the probability of some sort of Armageddon scenario seems low as well, at least to us. The 20% decline in Sterling has already given the UK a competitive advantage in global trade. The UK also has the benefit of a well educated workforce and a legal system that is very stable and used widely in international transactions. The decisions taken by our political masters will either protect these advantages or undermine them; we suspect that pragmatism will prevail.
So, the likely outcome is somewhere between the best and worst case scenarios, and from a currency point of view, we are trying to work out whether a 20% decline is enough to help in the rebalancing of the economy, or is there worse to come? Well, the trite answer is we simply don’t know because the uncertainty is so high at the moment. That said, what we do know is that investor sentiment can be a great contrarian indicator, or as Warren Buffett says, “Be fearful when others are greedy and greedy when others are fearful”.
This last week, the sentiment around Sterling has reached proportions that can best be described as near panic like. We have seen predictions that Sterling will fall to parity with the US Dollar (another 20% fall), comparisons of Sterling as an Emerging Market currency and comparisons with the Titanic ship breaking up just before it sank. The BBC also jumped on the bandwagon when the top story on the evening news last Wednesday was the decline in Sterling. In our experience, when a financial trend finally becomes the main topic on national news, that trend is close to exhaustion, at least for a short period of time.
Given the current, and in our opinion, excessive bearishness towards Sterling, we are in fact looking for Sterling to try and form a base around current levels. At the moment, our weapon of choice is to sell Euros versus Sterling in the FX Strategy UCITS fund – SEE DETAILS HERE. We have always been in the camp that the Euro is a flawed currency project, and we have also been in the camp that ultimately what is bad for Sterling from the Brexit process is also bad for Europe and the Euro. This is very much dipping a toe in the market as experience also tells us that markets can easily overshoot. We are not risking a huge amount of money on this trade, and will also look to trade some of our position actively to try and maintain as much flexibility as possible.
As for other trades on our radar, we have been bearishly positioned in selected Asian currencies as we see the global risk-on mood from recent months shifting towards risk aversion. If Sterling is able to gain a more stable footing in the weeks ahead, we may well buy a little against selected Asian currencies as well.
To try and wrap things up here, we simply do not adhere to the Armageddon outlook for the UK resulting from Brexit. The case for Sterling weakening as a natural way of rebalancing the UK’s huge current account deficit was easily made before the Brexit vote and what we do know is that when everyone is fearful of an asset, we should be looking to buy. As always, we need to be measured in the amount of risk we can take on any individual trades, and so the current position size in our bearish Euro/Sterling trade is necessarily small. If we are wrong on this view, then so be it, however, with so many now utterly bearish of Sterling, it will not take that much to see a shift back in favour of Sterling.
Stewart Richardson
Chief Investment Officer
