After the surprising UK referendum decision in June 2016 to leave the European Union, sterling has fallen in two distinct waves. The initial fall immediately after the referendum was more pronounced, with a 13 percent decline versus the U.S. dollar and a 10 percent drop against the euro. This was partly exaggerated by an element of surprise as the market had almost entirely discounted the prospect of a Brexit outcome. This was despite opinion polls suggesting a dead heat between the ‘Leave’ and ‘Remain’ camps all the way up to referendum day.
The second drop came after Theresa May, the prime minister, said at the Conservative Party Conference on October 2 that the UK will invoke Article 50 by the end of March 2017. In her speech, May said the country could go down the route of a ‘hard’ Brexit if EU negotiators do not budge on their requirement to uphold all four pillars of the EU framework to retain single market access.
Hard Brexit, or ‘Smexit’ – a single market exit – will likely concern investors who want UK exposure as a way to gain access to Europe. This is in addition to the uncertainties that any new tariffs and headwinds that the loss of EU free trade will bring.
For currency investors, the obvious trade at the moment is to sell the pound; however, on the few rallies we have seen so far, any positive gains have been anaemic and have quickly faded as market pressures once again force the currency lower. The cause of this might be investors’ ongoing struggle to find yield in an environment of high asset prices and low returns, where opportunities for so-called fast money are quickly seized upon.
Interestingly, May’s ‘hard Brexit’ announcement corresponded with positive economic data from the UK (in part supported by a weaker pound), with manufacturing and construction, and most importantly the key services sectors, surprisingly showing solid growth.
We’ll remain underweight
While recent economic data have been positive, this does not affect our preference to be underweight in sterling; we expect that UK economic activity will erode towards the end of the year and remain in a weak phase around the same time that Article 50 is invoked. With this in mind, we will pay much closer attention to UK economic data in the closing months of this year and the first quarter of 2017.
It’s likely to remain choppy for a while
For the time being, we expect choppy waters ahead for the pound. This was exemplified in overnight trading in the early hours of October 7, when the value of the pound briefly fell by around 6 to 10 percent in the space of two minutes as computerised trades shot through a market where there were not enough buyers to support the currency. Most of the drop was recovered quickly, although it left the pound around 1 percent weaker than the previous day. While economic data releases will likely see an uplift from the weaker pound, this will be offset somewhat by a market preparing for the economic damage that leaving the EU’s single market will bring.
There’s likely to be a rate hike in the U.S.
Viewing the pound from a purely technical perspective, given that the move below USD $1.2800 takes the pound below last summer’s post-Brexit low and to a 30-year low for the pound against the U.S. dollar, finding meaningful support levels becomes a somewhat pointless exercise. RBC Capital Markets expects to see a move to as low as $1.15 by the end of the first quarter of 2017 and that seems an entirely achievable target given May’s recent announcement. This outlook is further supported by what is likely to be a stronger U.S. dollar as markets position for a rate hike by the U.S. Federal Reserve at the end of this year – assuming a robust U.S. economic outlook and relative calm in global markets.
There will be a retail impact
While a weaker pound makes it harder for the UK to invest internationally, it has the positive effect of making the relative value of UK assets more attractive to overseas investors. This, in turn, brings investment into the country and will offer some support for the UK economy during the difficult and uncertain process of exiting the EU. However, people will feel the consequences of this in everyday life, mainly through higher prices for goods. The UK relies heavily on imports, so a weaker currency means that retailers will eventually have to pass on the higher price of goods to consumers.