Markets

Where now for the pound?

It's been an eventful two years to say the least. As our negotiators go to great lengths to untangle Britain from the European Union, no asset reflects this tumultuous journey more than sterling.

In the fortnight after the June 2016 referendum, the pound plunged to $1.28 from $1.49. With most speculators pricing in a “no” vote, the outcome came as a huge shock – evident in the 14 per cent fall.

Many saw this as a much-needed correction following a long period of strength in sterling, but theres no question that the pound has had a rocky time ever since.

The most recent bout of turbulence came earlier this year when sterling climbed to a two-year peak of $1.43 in April, only to come crashing back down again last month when the country was struck by poor GDP data. Meanwhile, the political circus continues to dog the currency.

“Sterlings performance in the last month shows that foreign exchange remains the most fickle and sentiment-driven of all the markets,” says Thomas Wells, fund manager at Smith & Williamson.

What are the risks to sterling?

Unsurprisingly, concerns around Brexit continue to lurk in the background, leaving the pound susceptible to wobbles.

GAMs Julian Howard warns that the Europeans continue to call the shots, thanks to their stronger negotiating position over the UK. “Negotiations to come up with a better arrangement than the reluctantly agreed backstop will be fraught, and theres no guarantee of success before our official exit date. The end result could be the UK in a pale version of EU-lite, with no influence at the table.”

Theresa May managed to avoid an embarrassing defeat on key Brexit legislation last week, which was largely supportive for the pound.

However, while the Prime Minister tried to compromise with Tory rebels by tabling an amendment, the proposal was rejected by the House of Lords on Monday. The Lords want parliament to have a “meaningful vote”, and it is not yet clear whether May will be able to overturn their new amendment today.

While this does not help the uncertainty, Lee Hardman, currency analyst at MUFG, says that political developments mean the danger of a more disruptive “no deal” coming to fruition has diminished, and is reassured that “parliamentary pressure will remain in place to soften the Brexit outcome”.

While its difficult to separate the effects of Brexit, the other big risks to the pound are general weaknesses in the economy. Latest figures show the UK economy grew at its worst rate in six years.

And yet, the labour market has been showing some positive signs, which Hardman says provides some reassurance that recent economic weakness is temporary.

We expect there will continue to be bumps along the way as the details of the transition are fully worked out

Many analysts think that the bigger picture will continue to favour an upward trajectory for the pound.

In fact, Joel Kruger, currency strategist at the LMAX Exchange, says the pounds retreat against the US dollar since mid-April has done nothing to compromise its uptrend.

“While we expect there will continue to be bumps along the way as the details of the transition are fully worked out, we see the negotiations moving in the right direction and the pound in position to outperform in the months ahead,” Kruger says, suggesting that sterling could push towards $1.50 over the next six to 12 months.

“The UK economy has demonstrated its ability to operate with a stronger currency over time, and this makes the pound increasingly attractive in a world of trade wars, where even the US dollar is looking to soften up.”

While uncertainty remains, Brexit negotiations are also likely to delay the return to a normal monetary policy environment.

Indeed, Lukman Otunuga from FXTM warns that sterling remains highly sensitive to speculation around Bank of England policy shifts.

“If the uncertainty over Brexit negatively impacts economic growth, the Bank of England is less likely to move forward with raising UK interest rates.”

Economists are split on the possibility of a rate rise that once looked near certain. That means that investors need to protect themselves from the ravages of inflation, and Wells reckons that a further decline in sterling could cause inflation to creep up past the current 2.4 per cent mark.

So how should investors position for such a scenario?

The obvious – and sensible – strategy is to avoid being exposed to just one market, particularly as the UK works through its current turmoil.

“For a sterling investor, there is also the option of investing in a dollar (as opposed to GBP) share class,” says Wells. “This could provide an additional performance kicker in the event that sterlings recent rout turns into something a little more significant.”

While the pound is prone to bouts of instability for the foreseeable future, the picture isnt as bleak as it first appears.

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