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Sterling: Pounded Down Far Enough?

Tuesday, August 08, 2017

The British pound has been the subject of repeated doom-mongering since the Brexit referendum more than a year ago. Joachim Corbach, GAM’s Head of Currencies and Commodities, questions whether there really is more material downside for sterling from the prevailing depressed levels. This article originally featured in Fund Strategy.

If there is one thing currency markets hate most of all, it is uncertainty.

Of course, the last decade as a whole has been a hugely uncertain period, with sentiment gyrating from risk-on to risk-off, while huge swings in the prices of natural resources have exerted a significant impact on the relative valuations of so-called commodity currencies.

However, over the last year or so, sterling has proved something of a ‘special case’ because the UK economy has become the subject of ‘certain uncertainty’. This time last year sterling depreciated by almost 15% following the outcome of the Brexit referendum, having already shed roughly 5% ahead of the vote, as the clouds of unease gathered.

As a result, the currency shifted from a fundamentally fair valuation, on a purchasing power parity (PPP) basis, to an undervaluation of approximately 20%. This is not a truly exceptional movement, even for one of the world’s major currencies, but, while it can be described as falling within a ‘normal’ range, further downside clearly starts to become limited once we have witnessed 20% depreciation from fair value.

Nevertheless, we are living in non-normal times and the obvious counterbalance to the fair value argument is that investors are fully entitled to expect a significant discount (or risk premium) for holding sterling, given the highly uncertain future of the UK economy. As a consequence, this is proving something of a tug of war in which neither side is holding sway.

With the exception of a short period around the turn of the year, sterling has actually traded in a narrow range (EUR/GBP of 0.83 – 0.90) for a whole year now. So, what can we infer about its likely future trajectory?

From an economic perspective, the UK surprised positively in the aftermath of the referendum, although this can probably be attributed to the immediate and positive effect of a lower currency, while the Bank of England also promptly intervened with further policy accommodation. However, macro data releases have deteriorated substantially over the past few months.

Having been firmly rooted in accommodative mode, we are at last seeing signs of a change of sentiment on the part of the Bank of England’s Monetary Policy Committee (MPC). At their last meeting the MPC was split with three (out of eight) members voting for a hike, while Governor Carney also hinted at support for less expansionary policy in the near future. However, this shift in stance comes at a time when other central banks, notably the European Central Bank, Bank of Canada and Norges Bank, are also delivering more positive assessments, so we would expect only a limited effect on sterling from the MPC’s rhetoric shift.

As an FX investor, I find it, on balance, difficult to build any great conviction towards sterling, as the currency is currently dominated by politics rather than fundamentals – and even the fundamentals are in danger of becoming dominated by politics! However, it is also difficult to envisage why sterling should make a sustained break out of the range (EUR / GBP 0.83 – 0.90) that it has been held captive within for so long.

In fact, given that we are currently trading at the upper end of that range (0.885) there appears to be more scope for sterling to strengthen from here, even if further positive news from the continent prompts a (short-term) break through the top end.

Consequently, while many can make a coherent argument for switching from sterling to euro, such a trade appears to be lacking in positive asymmetry, involving the absorption of too much risk for too little in the way of return potential.

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