Sterling: Lower for longer as the EU strikes back

The UK’s new Prime Minister Theresa May’s honeymoon period is clearly over. Days after emphasising the importance of national sovereignty and appearing to lean towards a ‘hard’ Brexit, a dawn raid on sterling and subsequent weakness has given opponents ammunition to attack the UK’s plan to leave the EU. Furthermore, tough talk from the UK government has been reciprocated from EU leaders and European heads of state. President of the European Council Donald Tusk may even have given the game away by linking the concept of a ‘hard’ Brexit to ‘no Brexit’. For sterling, we believe investors should look through the politics and focus on the economics.

It remains in our view highly unlikely that the UK will suffer the fate of North Korea for having the audacity to exit the EU. There is too much at stake, especially for Germany which has the largest goods surplus with the UK. A strict Chinese wall around the EU’s financial services market would represent a move towards the protectionism that the EU claims to abhor. Such a development would effectively force the UK’s hand in terms of closing the trade deficit by substituting UK produced goods for imports. We believe this very adverse ‘no agreement’ scenario should be weighted in investors’ minds with its modest probability.

We recognise the problem the EU faces in keeping other member states on board. The weakened status of the EU project in other – and not just peripheral – European nations is clearly a concern. This is why the EU has to play tough with the UK in our view, as the reasons that UK voters rejected the EU – loss of sovereignty, concerns over immigration and a sense of dissatisfaction with the lack of economic growth are being felt across the region.

Political uncertainty in Europe is likely to remain elevated at least until the UK’s Article 50 negotiations converge towards a reasonable exit strategy for both sides. We do not believe the recent formal constitutional or legal challenges will ultimately derail the process of the Article 50 notification but recognise that there is a sharp divergence of views on Brexit within the UK Parliament. There also appears to be a significant residual corporate interest in delaying, blocking or softening any Brexit; very public challenges to the leadership at various points in the process should therefore be expected and will only increase FX volatility.

The risks to sterling which we highlighted prior to the Brexit vote have clearly materialised. Sterling had been supported by perceptions of relatively faster UK growth, expectations for interest rate increases as recently as last year and significant capital inflows which supported the UK’s fiscal deficit. As a result, the currency had risen in value on a real effective (inflation adjusted and trade-weighted) basis to as high as at any time in the last 30 years by mid-2015, Exhibit 1. Since the UK’s EU referendum and a double-digit decline against other major currencies, the question now is whether this has further to run.

Exhibit 1: Over to under valued – sterling real effective exchange rate

As Exhibit 1 shows, a move in the real effective sterling exchange rate of nearly 20% since the start of the year is large in a historical context. This represents move which takes the currency from 1.5 standard deviations above its long-run REER average to 1 standard deviation below.

While the swing may be second-largest on record since the 1980s, we note that both after 2008 and after sterling’s exit from the ERM, the currency traded at an even greater discount to its long-run average for a number of years after the triggering event. Sterling is therefore not strictly in uncharted territory, as a result of higher long-term inflation rates compared to other regions such as the Eurozone, despite the all-time lows reached against the dollar in recent days.

Furthermore, Bank of England governor Mark Carney has recently reaffirmed the Bank’s view that an overshoot in inflation is preferred to a tightening of monetary policy in response to the decline in sterling. This is in our view the correct strategy and over the longer-term will be supportive of the currency if successful. However, in the short-term, sterling short-sellers appear to face little risk from a hawkish switch at the BOE.

It is also easy to point to the vulnerabilities within the UK economy, which have arguably been exacerbated by promoting domestic demand in recent years while ignoring a steady rise in the real effective exchange rate and the resulting loss of competitiveness. In addition to the fiscal deficit, household savings rates have also been falling sharply in recent years, creating incremental demand in the short-term but also exacerbating the current account deficit.

Exhibit 2: UK current account deficit

We believe investors have now started to focus on both the widening current account deficit and its composition, Exhibit 2. The UK’s current account deficit has reached a record share of GDP in recent years, led by a sharp shift in the contribution from the net international investment position (NIIP) component rather than a deterioration in trade. However, due to the decline in sterling the weakness in NIIP is likely to partly reverse in coming quarters.

The UK’s key pressure point is the large UK surplus in the provision of international services such as banking, law and insurance and how this might be affected by Brexit. The UK has a £18bn surplus in the provision of services with the EU alone; any diminution of London’s role with the EU would be likely to have a significant knock-on effect on London’s role in other international financial markets. However, the ‘Chinese wall’ option – a failure to reach a post-EU agreement on services- is likely to be sufficiently unpalatable to all sides as to be unlikely in our view.

In our view, the recent decline in sterling to levels well below long-run average real exchange rates has now simply priced in the factors we have discussed above. In the circumstances, the real mystery was why sterling was trading at such an overvalued level in the first place, hampering the closing of the deficit in traded goods. We are therefore reluctant to join the crowd which is predicting parity for sterling against the euro or the dollar – but also do not expect a rapid rebound. In addition, sterling volatility is likely to remain elevated at least until the market perceives that agreement has been reached, in an outline form, on the terms of the UK’s exit from the EU.

Exhibit 3: UK wages/hour significantly lower than Germany post-sterling decline

For stock market investors, sterling depreciation of such a large magnitude will have already had a meaningful impact on the competitiveness of the UK’s industrial base. According the EU’s own databases, UK wages are now materially below those of the Netherlands or Germany, Exhibit 3.

Exhibit 4: Underperformance of UK industrials with international sales v US peers

If we are correct that sterling is likely to continue to trade at a lower level for the an extended period of time then UK industrials with overseas sales exposure may benefit from a profitability windfall for longer than investors currently expect. We note that UK industrial companies with over 50% of sales overseas have underperformed US peers over the last two years in US dollar terms, despite the robust local currency performance, Exhibit 4.

Quick conclusions

1. The Brexit political drama will be part of the investment landscape for some time but the lose-lose scenario remains unlikely in our view.

2. Sterling was an accident waiting to happen and the adjustment is likely to persist. Currency volatility is likely to remain high until the outline terms of a Brexit agreement become clearer.

3. UK exporters are likely to enjoy several years of windfall profitability, yet have underperformed international peers. We believe investors should be screening this segment of the market for quality franchises which may also benefit from M&A activity in 2017.