The pound was one of Tuesday’s big stories, having dropped below $1.20, an area frequented 34 years ago when the US dollar was surging on the tailwinds of Reaganomics. (US manufacturing activity contracting for the first time in three years was Tuesday's other headline.)
Sterling’s woes this time reflect in part a vibrant US currency and the pound’s fragility since British voters narrowly decided to leave the EU in 2016’s referendum. Against the euro, the pound sits near its weakest levels, as British holidaymakers found when they have taken sojourns across the Channel.
The pound’s weakness is certainly historic as shown below, with the $1.40 level representing a ceiling for sterling over the past three-plus years. From the Plaza Accord of September 1985 until June 2016, $1.40 represented a floor for the pound. Today the British currency is knocking on its post-referendum floor of $1.20 (aside from a 2016 flash crash below $1.18), with scope to head towards $1.10 in the event of a hard or chaotic Brexit.
Karen Ward, chief market strategist for Europe, Middle East and Africa at JPMorgan, sets out the current market range:
“Bank of England estimates suggest that the pound could fall towards $1.10 versus the US dollar in a disruptive Brexit scenario, yet if the prime minister does succeed in securing a deal and political uncertainty lifts, we see fair value for the currency closer to $1.40 versus the dollar.”
The post-referendum debate over how the UK leaves the EU has galvanised a starkly divided country and parliament. Members of parliament are now seeking to pass an emergency bill that would block a no-deal exit on October 31. Such a vote — explained here by the FT — is seen as triggering a general election as Boris Johnson is intent on Britain leaving the EU by Halloween. Some think the prime minister has overplayed his hand. One sticking point is that the Fixed-term Parliaments Act requires a two-thirds majority of MPs to back an early election but opposition parliamentarians may not oblige in granting another national vote.
As political junkies run through various scenarios, the tone in financial markets is utterly predictable. Investors despise uncertainty, more so when there are few signs of progress that warrants buying beaten-down UK assets such as domestic companies, courtesy of a weaker pound. The UK looks cheap but it can sure get a lot cheaper if the pound tests historic lows, a likely outcome should Brexit chaos usher in a Labour government with its redistributive agenda (as explored in depth in the FT series The Corbyn Revolution).
As this chart shows, the performance of the FTSE 100 index versus global equities (excluding the UK) highlights the damage already being inflicted by the protracted Brexit wrangling and one that shows little sign of abating:
No matter the idea that a weaker pound boosts foreign-based revenues of many FTSE 100 companies, the benchmark’s gain of 8 per cent this year trails the All-World index’s (excluding the UK in sterling terms) rise of 18.6 per cent. Over the past 12 months the FTSE 100 has fallen 3.2 per cent versus an All-World (ex UK in sterling terms) gain of 4.8 per cent. Within the FTSE 100, it’s worth noting that a hard Brexit hurts domestic blue-chips such as supermarkets and various banks. Run this performance in US dollar terms since the referendum and it further illustrates why global investors have shunned the UK in the past three years.
And investors will stay away, given the latest convulsion in the currency market. After plumbing a low of $1.1959 on Tuesday, followed by a shortlived climb above $1.21, there’s a clear message: expect plenty of volatility. In this regard, implied volatility for the pound over the next three months now sits above that of the Brazilian real and the Mexican peso.
That’s an impressive development for a G10 currency, but hardly surprising. Charles Hepworth, investment director at GAM, sees no need to change his three-year-old view of sterling: “avoid”. He notes the pound “behaves like an emerging market currency”.
“There are so many different ways this rapidly approaching cliff-edge Brexit showdown can play out. If a no-deal Brexit wasn’t bad enough for sterling, then a general election with a Labour win (albeit highly unlikely) would see it collapse even further.”
One of the most damaging aspect of this Brexit saga is the air of uncertainty it has created, which stands to keep choking the economy and markets.
Steen Jakobsen at Saxo Bank adds:
“Short of a solution therefore, the whole process will likely lead to a new general election. That election is an enormous risk for the Conservative party, but perhaps the worst risk is that it brings us no closer to any decisive outcome on Brexit.”
There’s plenty of grim stuff about Brexit, however here’s one silver lining for the UK unless you own gilts. Real and nominal yields have been pushed down sharply as economic clouds have darkened. While Germany considers fiscal stimulus, the UK 10-year real yield at minus 3.1 per cent shows that Westminster has far more room to loosen the purse strings.
As Fred Cleary at Pegasus notes:
“Ongoing stalemate over Brexit and/or a delay to an election being called allows for a healthy but not dangerous fiscal loosening. The more time that passes, the more the effects of fiscal loosening can be felt and can offset the possibility of ongoing delay to a Brexit outcome that prevents private sector investment recovering.”
“There are many jumping up and down calling for immediate German stimulus, but this has to be viewed in the context of the single-currency hegemony. Surely the argument can be made that the UK government has more flexibility to adjust policy in the name of social redistribution now as opposed to delaying it until 2021 and beyond given the level of real yields.”
Quick Hits — What’s on the markets radar
US manufacturing contracts — The Institute for Supply Management manufacturing purchasing managers’ index slumped to a reading of 49.1 in August (versus a forecast 51.2), with new orders easing to their lowest level in seven years at 47.2 from a previous month’s 50.8 and an expected 50.5. Readings below 50 indicate a contraction, so the US has joined the rest of the world in a manufacturing slump, courtesy of the trade war knocking business confidence. ISM noted: “Comments from the panel reflect a notable decrease in business confidence.”
The data sapped the dollar’s earlier gains, while kicking Treasury yields lower with the 10-year briefly below 1.43 per cent, marking a new low since July 2016. The data weighed on Wall Street, with its industrials and financials sectors under pressure along with transports and chipmakers.
Jim O’Sullivan at High Frequency Economics noted:
“While 49.1 is not weak enough to signal recession, as manufacturing tends to be more cyclical than the economy as a whole and the manufacturing index typically falls to the low 40s in recessions, the report will undoubtedly add to fears that more weakness is ahead.”
All eyes now turn to the ISM service sector reading due on Thursday.
The corporate debt rush has begun with more than 20 US companies lining up to sell paper on Tuesday. In spite of today’s “risk off” mood, the start of September is typically a boom time as borrowing requirements tend to get squared away before autumn deepens. Lower yields and the tide of money flowing into bonds would suggest this week’s high-end estimate of $40bn in corporate investment grade sales is likely.
The price of copper hitting a 2017 low is another important Tuesday story. As the FT’s Neil Hume writes, the metal’s dip in price reflects a combination of forces: from weakening global manufacturing, industry and construction aided by the trade war to a stronger US dollar, particularly versus the renminbi. With some calling for further renminbi weakness towards Rmb7.5 to the dollar, copper’s close link with this currency’s strength suggests the metal has room to fall further.
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