Will sterling sink or swim?

Following the recent news of progress on the Brexit “divorce bill”, sterling hit a two-month high this week, and was up against both dollar and euro.

Customers of failed DFM paid out

Last week, the UK offered to pay up to €50bn (£44bn) as part of its exit deal from the EU and investors saw the value of the pound jump significantly.

However, on Monday afternoon the pound faced extreme volatility during Prime Minister Theresa May’s visit to Brussels.

Sterling was up during the early hours amid hopes of progress on Brexit negotiations but quickly fell after May was unable to come to an agreement on the question of the Irish border.

Although the pound is fluctuating, the main question still remains, will sterling continue to strengthen or is it in danger of collapsing at the sign of political turbulence?

"The pound was always likely to become a Brexit barometer..."

Lee Wild, head of equity strategy at Interactive Investor argues that this could just be a “temporary boost” for the currency.

“Agreeing a divorce bill with the EU is one thing, finding a solution to the Irish border problem is quite another. Negotiations have a long way to go, and businesses still have little choice but to make contingency plans for a hard Brexit, which means less investment until we get greater clarity on the likely outcome,” he says.

Is Brexit to blame?

In the past few weeks, investors have seen a glimpse of both the pound strengthening and depreciating, depending on the political circumstances.

Jamie Clark, co-manager of the Liontrust Macro Equity Income fund believes sterling will continue to strengthen “assuming continued support from macro data and ongoing progress in Brexit negotiations”.

He adds: “However, the government’s fragile grip on power, an obdurate EU and the risk of another election (along with victory for a less market-friendly party) mean this isn’t a given.

“In our book, political turbulence is sterling’s biggest tail risk. The government is weak by numbers and reliant on a coalition partner with its own agenda. This makes for unstable, vulnerable government.

“It isn’t an expression of political bias to suggest that another election and a victory for Jeremy Corbyn would see the pound retest post-Brexit lows. Whilst this is only one of several outcomes and scientifically attributing a probability is imprecise, it would be imprudent not to mitigate such risk.”

The role of Brexit is key in how sterling appreciates or depreciates as Rathbone’s assistant manager of multi-asset portfolio funds, Will McIntosh-Whyte says “the pound was always likely to become a Brexit barometer.”

After the leave vote last year, sterling fell more than 15% against major currencies and McIntosh-Whyte argues that recently sterling has become “a much harder game to play”.

“We think that, on a long-term view, sterling remains significantly undervalued. But a lot can happen in the shorter term: unclear and shifting political stances are vying against changeable UK monetary policy; a strengthening European economy is clashing with continued political uncertainty in the EU; and unclear US fiscal spending is making it more difficult to determine the likely path of US rates,” he says.

Lifespan of the pound

Historically, the value of the pound has gone down compared to both the dollar and euro. Over a five and ten year period, it has declined 16.25% and 33.9% against the US dollar and 8.8% and 19.2% against the euro.

Despite this, sterling is up by 5.5% against the dollar year to date, although it is still down 4.2% against the euro.

John Bilton, global head of multi-asset strategy at J.P. Morgan Asset Management, says: “Ultimately the UK’s ability to move towards trade talks with the European Union will have a significant bearing on where sterling goes.

“If we consider year-to-date performance of the UK index as a whole, sterling has been up about 8% relative to the US dollar. Therefore, it’s hardly surprising that the FTSE 100, which earns 70% of its revenues from outside the UK, is one of the worst performers of the major markets, up by only approximately 3.4% compared to nearly 11.5% for European equities.

“Up until the last few days at least, sterling has been near the upper end of its trading band relative to the US dollar. If we were to see sterling weakness from here as a function of Brexit concerns, internationally exposed sectors such as pharmaceuticals and energy and resources may benefit more from the direction of sterling.

“Conversely, if sterling were to go higher, that might bode well for more domestic sectors.”

Agreeing with Bilton, Wild said that blue-chip exporters could receive “little love” as a result of the pound being back above $1.34 this week, the first time since September.

He adds: “Attention yesterday shifted to the FTSE 250 and to stocks which rely more on the domestic economy than overseas, although selling has become more broad-based.

“Movements in the pound will remain a big driver of share prices. Retailers like Next and M&S will benefit from lower import costs, and a strong economy is good both for housebuilders and the banking sector whose margins improve as borrowing costs rise.

“Solid companies like these are currently among the cheapest and highest yielding stocks around and will outperform if there’s a whiff that Britain can secure a fair Brexit deal.”

Hope still remains

Despite the uncertainty around Brexit, it seems investors still have hope that the divorce bill deal will eventually go through, with the potential to see a further rally in the value of the pound.

Wild says: “Optimism that our Brexit negotiators can do a deal at December’s summit and move onto crucial post-Brexit trade talks is greater now than it has been.

“Logically, given agreement will cause likely trigger further appreciation in the value of the pound, investors who think it’s a done deal will keep selling blue chips and buy the mid-cap index.”

 

 

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