Britain benefitting from its battered pound, but this is just the calm before the storm

The greater perception among companies, investors and the London-led financial services sector is that the country is heading for a hard and painful Brexit

PUBLISHED : Thursday, 06 October, 2016, 9:05am
UPDATED : Thursday, 06 October, 2016, 10:41pm

For traders and investors, British premier Theresa May’s assertion that “Brexit means Brexit” is starting to sink in.

On Wednesday, the pound was trading at its lowest level against the dollar since 1985 as financial markets began to come to grips with the implications of a so-called “Hard Brexit” following a speech by May on Sunday in which she insisted that the UK would not “give up control over immigration”, making it extremely difficult for Britain to remain a member of the European Single Market.

May also announced that the UK will invoke Article 50 – the exit clause that needs to be triggered by a member state seeking to leave the European Union (EU) in order to begin the two-year-long process of pulling out of the bloc – by the end of March.

Sterling is now trading below the level it stood at following the shock decision by Britain on June 23 to vote to leave the EU.

Having already slumped nearly 15 per cent against the greenback since the Brexit vote, the pound has become more vulnerable, with bearish bets on sterling’s direction over the next three months at their highest level since late July, according to data from Bloomberg.

For many currency strategists, the pound is an emerging market-type currency, driven mostly by politics and under strain because of the UK’s bulging current account deficit (amounting to 6 per cent of GDP at the end of June) which, in the words of Bank of England (BoE) governor Mark Carney, forces Britain to rely on the “kindness of strangers” to fund itself – a bigger vulnerability in a post-Brexit world.

The pound has become more vulnerable, with bearish bets on sterling’s direction over the next three months at their highest level since late July

The key question is whether the pound’s renewed fall is a foretaste of things to come, and whether investors are still underestimating the risks associated with a ‘”Hard Brexit”.

For the time being, it seems that investment strategists and market commentators have, if anything, been too bearish about the UK.

On Monday, the publication of a survey on Britain’s closely watched manufacturing sector showed that activity last month rose to its highest level since June 2014. On Wednesday, the publication of a separate survey on the UK’s dominant services industry showed that activity continued to expand last month, buoyed by an increase in new business and job creation.

Britain’s economy is benefiting from the sharp decline in the pound which has provided a fillip to exports.

UK equity markets hit record highs on Tuesday, with the FTSE 100, the index of large-cap stocks made up of companies which generate most of their revenue outside the UK, gaining the most. Even the mid and small-cap UK stock indices are rising, with many of their members deriving a high proportion of their sales from abroad.

Yet all this could be the calm before the storm.

The International Monetary Fund (IMF) revised down its forecast for growth next year to just 1.1 per cent – even lower than its projection in July. Business optimism in the UK, moreover, remains subdued, with the survey on the country’s services industry noting that “companies remain concerned about how Brexit might affect the business environment” and that “there’s a strong risk of the pace of growth slowing sharply in the coming months.”

The bottom line is that it is still early days as far as the economic effects of Brexit are concerned.

The UK government itself admits that the economy faces at least two years of economic “turbulence”, with business confidence likely to go “on a bit of a rollercoaster” as Britain gradually withdraws from the EU.

The greater the perception among companies, investors and, crucially, the London-led financial services sector (which accounts for a quarter of all EU financial services income and 40 per cent of EU financial services exports, according to the BoE) is that the UK is heading for a “Hard Brexit”, the bigger the scope for a sharp deterioration in economic and financial conditions over the coming months.

It is troubling that the pound’s nearly 15 per cent slide against the dollar since June 23 occurred when the vast majority of investors and traders believed a “Soft Brexit” was the most likely option.

This suggests there is ample scope for a more severe deterioration in sentiment towards sterling.

Still, the pound could yet benefit from more acute fears about a Donald Trump presidency and Europe’s vulnerable debt markets.

What is clear is that more and more investors believe May when she says “Brexit means Brexit.”

Nicholas Spiro is a partner at Lauressa Advisory