As Brexit negotiations begin to unfold, the media remains pre-occupied with the differences in view between the main UK political heavyweights; pitting them against one another in disagreement and disarray, because that makes a printable story. The reality so far in Brussels appears to be rather more sensible, in that very little is coming out for the media to get their teeth into. This suggests that the important conversations are being kept very much behind closed doors.
In turn, this means that as time ticks along and with the summer recess approaching, as well as the German election on 24th September, there may be very little resolution. However, it should not be lost on any of the political players that the electorate are expecting some sort of sensible deal which provides security and comfort for people’s livelihoods, even if that is initially in just one area such as the car industry. The appeal of this in the corridors of Westminster and Brussels should be considerable, not only to try to restore some credibility to Theresa May, but also to the EU itself. A grand falling out serves no real purpose and will likely infuriate the electorate, who will start to protest at the unelected EU officials prioritising their political ego over, for example, German jobs in the car industry, let alone those in the UK.
I read a report this week from an economics outfit that I regularly read and rate highly, which argued that we had probably seen most of the weakness in sterling that we are likely to see, but that a recovery from here is difficult to envisage in the short term as Brexit pans out. It also noted the potential for more weakness if negotiations should break down. In our own asset allocation meetings, we look at the sterling trade weighted index, which is more relevant than a simple measure against another single currency and we would concur that sterling does look cheap at the current time and is around the same level as it reached at the height of the credit crisis when the UK financial system was in peril.
Working this through, we see three Brexit scenarios, starting with the most likely and the least: The first is that there is an announcement of a deal on one of the matters of issue, whether it be foreign citizens’ rights, finance, trade or a transition deal. Whatever form it takes, the political players will want to present it as an historic achievement for their own ends. Theresa May will want to prove she has what it takes and the EU will want to prove that they can find a way through Brexit to satisfy all. With Macron in the room, which introduces a positive pro-EU influence, there may be less motivation to make the UK pay through fear of others wishing to do the same. Either way, this will likely support sterling and provide some clarity and assurance. After all, the last thing the EU wants is a weak UK economy whose consumers then demand less of its exports.
The second is that time ticks along and there is very little of substance until next year. Markets will become increasingly agitated that nothing is being achieved and pressure will build on the process. Eventually this will deliver a deal of some sort after significant media vilification. This is where the media are powerful and have the ability to stoke up a storm of anti-political feeling at officials failing to perform. Again, although delayed and with some pain along the way, this will eventually deliver a deal which both sides can laud as a success.
The third is a no deal scenario which descends into acrimony and disagreement. This is in nobody’s interests and would likely require emergency measures in order to stop chaos and utter confusion. Again, politically this would be highly undesirable as the electorate will become angry with those charged with the responsibility to find a way through Brexit. This is the potential nightmare scenario to Brexit which is causing much of the weakness in trade weighted sterling. One would hope that as both sides have so much to lose, both sides will step back from this one to find a solution before we get to this point. It cannot be ruled out but the level of trade weighted sterling would suggest this scenario is being priced in.
I also saw another report last week which looked at the sterling effect on the earnings of large international businesses quoted in the FTSE-100 that would otherwise have earnings growth of between 5 and 10%. These earnings have been boosted beyond this by the effect of sterling translation but when this reverses that gives the prospect of zero earnings growth in that period. If a business disappointed the market by reporting no earnings growth via a profit warning the effect on the share price would be dramatic. Whilst management credibility comes into play with a profit warning, the effect on earnings is similar and calls into question valuations on such earnings where there is a real risk of currency impact if and when sterling recovers.
For now, the market continues to hover and defy any form of gravity, despite the clamour of voices calling for a correction based on over-valuation. We have previously written that investors are reluctant to sell equities as the alternatives offer significantly inferior returns and this is likely to remain until interest rates normalise. However, as the global fixed interest markets are somewhat rigged by the central banks to prevent any sort of downside risk for investors, it looks unlikely that any potential event will appear that is allowed to disrupt the current status quo. This goes a long way to explain why yields on developed market government bonds are so low – where is the risk if we know the central banks will still step in?
So, for now, we see upside risk to sterling and this needs to be thought through in terms of portfolio positioning. UK GDP could well come under pressure the longer Brexit uncertainty continues, as caution sets in with the consumer. However, this should work against any interest rate rises, especially as inflation peaks as the sterling effect of the Brexit vote works through the year on year numbers. The next predictable significant market data release is the first cut of second quarter US GDP due on 28th July which needs to deliver around 3% to offset the weak Q1 figure of 0.7%. All forecasts suggest this will be the case but the markets are pricing this in as a foregone conclusion, which suggests caution. That said, sterling is priced for calamity and we would suggest that Brexit rabbits are there for those willing to wear several hats and focus on a solution rather than winning arguments at all costs.
Guy Stephens, technical investment director at Rowan Dartington