Sterling risks surrounding Article 50 fade, uncertainty still a major factor
Prime Minister May’s Brexit speech on 17 January of 2019, clarified the UK negotiating stance. The clear commitment to pulling out of the single market has removed an important downside Sterling risk surrounding the triggering of Article 50, which is planned for late March.
There will still be a high degree of uncertainty, and there could be further delays with risks associated with a tough EU stance also a significant factor. Overall, the performance of the UK economy is likely to be the pivotal factor for Sterling.
Prime Minister May removes uncertainty
During the fourth quarter of 2016, there was continued speculation and uncertainty whether the government would look for a ‘hard’ Brexit which would put the UK outside the single market or whether it would look for a ‘soft’ Brexit with the UK looking to remain inside the single market.
Attempting to stay inside the single market would require complex negotiations and, crucially, it would have been highly unlikely that the other EU members would allow single-market access without the UK accepting freedom of movement. Controlling immigration was, however, a key objective of the government, which made continued single-market access very problematic.
In general, a ‘hard’ Brexit was seen as negative for the Sterling while investors saw a ‘soft’ exit as more positive for the currency. Primarily, this was due to expectations of more substantial short-term damage to the economy if the UK left the single market.
In this context, there were particular fears that a hard Brexit would damage the financial services sector, as banks and financial service companies could choose to relocate away from London.
May’s speech has certainly clarified the situation as she announced that the UK would leave the single market once it leaves the EU. She also confirmed that the UK would not look to use an existing model such as Norway or Switzerland in formulating a deal and would look for a unique arrangement.
This clear commitment will remove a considerable downside risk associated with the actual triggering of Article 50 as it is now already priced in. A promise that parliament would vote on any final deal also eased immediate concerns.
From the UK perspective, global negotiations will also be important. President-elect Trump has indicated that he will look to reach a quick deal with the UK. A positive global stance on trade deals would boost overall confidence in the medium-term UK outlook, which would boost confidence.
Legal challenges still a threat
To a great extent, there has still been a phony war between the UK and EU officials before the triggering of Article 50. EU members, in particular, have insisted that there will be no negotiations until the UK formally starts the process.
Once Article 50 is triggered, the real negotiations will get underway, and the underlying tone from EU officials will give a meaningful impact. If EU negotiators led by Barnier immediately take a tough stance towards the UK and indicate that there will be tough negotiations, there will be a negative impact on confidence.
Given the dynamics of negotiations, there is a high risk that the EU will look to open with a hard-line stance and only move to make concessions gradually during the negotiating process. In this context, there will is the potential for increased short-term fears that the UK will not be able to secure an acceptable deal.
Political risks from other EU members will increase with the French Presidential elections expected to be in full flow by March. With established political parties battling to contain the increase in populist sentiment and increased support for the National Front, there will be intense pressure for political parties to promote a tough stance against the UK.
The UK financial services sector will also be an important risk, given the chance of relocation away from London. If there is a series of negative announcements once Article 50 is triggered and increased fears over job losses, there will tend to be downward pressure on Sterling.
UK economic trends extremely important
Overall, Sterling trends will also be determined to a significant extent by trends in the UK economy. Growth overall has been stronger than expected over the past few months, boosted by a very loose monetary policy and Sterling weakness.
This combination is likely to provide further near-term support. If the economy maintains a robust underlying tone with the Bank of England looking to reverse August’s interest rate cut, overall confidence in Sterling will tend to improve, and markets will be much less vulnerable to political concerns.
If the economy is showing signs of weakness, however, market sensitivity to political setbacks would be more acute with the currency more vulnerable to selling pressure.
UPDATE: what flavour of Brexit awaits the UK in October 2019?
More than two years passed since the invocation of Article 50 – and the UK is still part of the EU. The United Kingdom was supposed to leave the European Union on 27 March 2019. However, repeated rejections of Theresa May’s Brexit proposal led the EU to extend the withdrawal deadline to 31 October 2019.
Since the triggering of Article 50, the Sterling has mostly been in a state of suspended animation. A brief period of optimism gave away to reality, with GBP/EUR hitting its 2-year low of 1.0850 in August 2017.
Since then, the Pound has come nowhere close to pre-Brexit highs. It briefly rallied in early 2019 in expectation of Parliament and Theresa May reaching a deal. Instead, the two parties reached no consensus – after flirting with ‘no deal’ in March 2019, Brussels granted an extension.
In recent days, the mood surrounding Brexit has gotten considerably gloomier. In May 2019, Opposition leader Jeremy Corbyn broke off talks with May, citing a lack of meaningful progress. Despite Corbyn’s vows to fight May’s deal, she is poised to bring her latest version of Brexit before Parliament in June.
This turn of events has unsettled currency markets. The value of GBP/EUR fell from 1.17654 on 5 May 2019 to 1.13746 as of 17 May 2019. With a plunge of 3.3% in 12 days, the investment climate around the Sterling has gotten downright icy.
What actions should UK investors take in 2H 2019?
This wasn’t the outcome anyone wanted, but here we are. With the hope of a Brexit compromise gone, what action should (a) UK investors and (b) foreign investors take in the coming months?
First and foremost, those with significant Sterling holdings should be opening hedge positions now. It appears the collapse of bilateral talks between Corbyn and May has already triggered this action among investors. If you wait until September, the price of a hard or ‘no-deal’ Brexit may get baked into currency pairings.
Secondly, check your stock portfolio for UK exposure. If it is weighed heavily in favour of British firms, diversify your holdings to include European, American, and international firms. Hold companies with good long-term prospects, but consider selling vulnerable industries like finance. Refrain from panic moves like moving your portfolio into cash, as you risk negative returns.
There’s a reason institutional investors have mostly been holding their fire the past two years. With a lack of coherent direction from political leaders, investors have been left to flip a coin. Of course, smart people don’t do this, especially when safer markets exist elsewhere in the world.
In short, hold off on making significant investment decisions in the UK until Parliament announces a deal. Anyone pretending to know the outcome is essentially gambling. Unless you have access to inside information, you’ll be putting your capital at undue risk.