The UK currency could recover from its recent poor performance
• The three drivers behind sterling’s fluctuations are Brexit, the current account deficit and monetary policy.
• The Brexit negotiations are stumbling.
• The UK has a large current account deficit.
• The Bank of England is to relax monetary policy.
When currency valuations fluctuate, they normally revert to fair value like a rubber band; the further you stretch it, the more force is exerted in its return. This elasticity does not kick in immediately, however, and the length of time spent in misvalued territory is as important as the misvaluation.
“It’s hard trading the next headline,” warns James Binney, head of currency EMEA at State Street Global Advisors. Timescales operate on multiple levels. In the short term, the foreign exchange market moves rapidly because it is so liquid. For example, sterling plunged immediately after the Brexit referendum. Longer term, if a currency becomes undervalued it becomes cheaper to buy assets based in that currency, and those transactions do not take place overnight.
Among G10 currencies, sterling was the weakest in 2016, falling from $1.50 to $1.18. “Brexit is now priced in, and the pound should prove stable against a basket of currencies,” says Momtchil Pojarliev, deputy head of currencies at BNP Paribas Asset Management. “Year-to-date, the dollar has been weakest, with sterling in the middle,” he notes.
The drivers behind sterling are Brexit, the current account deficit and the trajectory of the Bank of England’s monetary policy.
First, Brexit negotiations appear to be stumbling. The process is obviously “not going swimmingly at this point”, says Roger Hallam, chief investment officer, currencies at JP Morgan Asset Management (JPMAM). The UK critically needs a transition period to avoid a disorderly crash out.
Ultimately, the value of sterling will reflect the political debate over the benefits or disadvantages of Brexit. Its supporters maintain that the UK’s ability to forge its own independent trade agreements and take back regulatory control will provide a long-term boost. Opponents of Brexit contend that new trade barriers drag on growth.
Several factors will affect the currency if the UK remains in the EU’s single market and customs union including access to key service industries and progress in achieving high quality trade deals with the rest of the world. “Right now, sterling still carries a risk premium because the negative tails are fatter than the positive,” says Hallam.
Yet, why has the post-Brexit UK economy surpassed expectations? After the referendum, little fundamentally changed prior to the triggering of Article 50, except the jolt to confidence. The Bank of England helped to shore up sterling’s value by easing monetary policy. The shape of the transition period is becoming more visible, along with the challenges of negotiating a deal. A two-to-three-year transition may still be a long period for planning decisions by small businesses.
The second driver is the current account deficit. The International Monetary Fund estimates that the UK has the largest deficit among the world’s principal economies. Mark Carney, Bank of England governor, warned in early 2016 that a break with Europe might test “the kindness of strangers”, which have been funding the deficit. According to the Office for National Statistics, the deficit in the final quarter of 2016 narrowed to 2.4% of GDP from 5.3% in the previous quarter. The weaker pound has begun rebalancing.
Huge flows in assets and liabilities to and from the UK manifest in the current account, and the UK has been receiving less investment income from abroad. “Because assets are priced in foreign currencies and liabilities in sterling, the income aspect of the current account is readjusting to a more sustainable level,” says Andrew Bloomfield, associate director research at
Record Currency Management. Although those moves may leave the UK less exposed to sudden reductions in capital inflows, he adds, “losses from sterling deprecation may discourage investment in the long term”.
In fact, sterling was already declining by the time of the 2016 referendum, points out Marc Chandler, New York-based head of Global Market Strategy at Brown Brothers Harriman. He sees its valuation more as a “divergence story”, as markets watch the relative monetary policies from central banks. “The UK is headed to the downside of the business cycle, which may lead to a shallow economic contraction around 2020,” Chandler says, and he expects sterling to follow.
Inflation, now 2.9%, is overshooting targets, but underlying price pressures remain low and wages subdued. Brexit has been as much a supply as a demand shock, causing a decline in the supply of labour, which is feeding into a lower unemployment rate and a pick-up in wages. As long as wages remain low, the BoE might leave monetary policy unchanged. So far, says Bloomfield, “the BoE may view inflation as transitory, which informs their actions, and keeps them reluctant to tighten”.
Purchasing power parity (PPP) is a standard model for relative inflation rates which reflects the level that currencies should gravitate towards in the long run. Shorter-term signals may indicate inaccurate dislocations or be ruled by noise. “Another way to estimate valuation employs triangulation, by taking the long-run moving average,” Chandler suggests. The current sterling-dollar 10-year moving average of $1.57 indicates a 20% undervaluation; the OECD measure of PPP shows it 10% beneath fair value.
Currencies trade in pairs. Looking at the dollar, interest rate differentials will work against sterling. “With the dollar under broad devaluation pressure gravitational pull may help raise sterling,” says Hallam. He foresees the euro outperforming sterling over the next year, as the ECB tapers and assets flow back to Europe. The euro’s vigour has surprised, as the end of quantitative easing loomed and French and Dutch election jitters resolved political anxieties. Yet, over five years, the euro could weaken, since a strong currency would conflict with the ECB’s goal of creating inflation.
Swedish monetary policy follows a similar pattern, and the Rijksbank is staying dovish to prevent krona appreciation. “The krona has disappointed in recent years, even when the economy picked up. The central bank wants to keep the currency weak and not get ahead of the ECB,” Binney says. The Swiss franc remains overvalued and analysts expect it to depreciate. Since the 2008 financial crisis, and subsequent concerns about a euro breakup, it has received safe-haven flows, but these are decelerating.
Pension funds employ various strategies to manage currency risks, such as active overlays through dynamic strategic hedges. Binney, who describes those ploys as “winning by not losing”, notes that for sterling-based investors who were not highly hedged last year it makes sense to lock in windfall profits. Using this intelligent risk control, they can also generate returns in the low-yield environment.
The rationale is that dynamic programmes allow a lower proportion of a portfolio to be hedged, which can outperform those 100% hedged. Bloomfield says, “our process dips a toe in the water and takes it out again if the programmes start to lose money. A passive hedge over a full cycle reduces the volatility of returns, but a dynamic hedge is more like insurance and pays off when sterling is strong.” If this group of predictions transpires, sterling might continue to gain traction in the medium term.