Whatever you think about Brexit and the effects it is having and the effects it will have I can’t think of a more sudden and bigger impact on most people’s lives than the depreciation of Sterling.
An approximate 20% fall in the currency since the heights of 2015.
Most people I know are able to accommodate this in some way, cutting back on the non-essentials and saving in other areas. However, if it falls further how will that affect us?
So, I thought I would do some digging around and contact some financial institutions to find out their opinion on the future of Sterling.
Let me start with a caveat to this article: Currencies are notoriously unpredictable. Most industry professionals accept that they can’t control them and have little ability to predict them. Predictions are about as effective as looking at ‘Il Meteo’ to see what the days weather is going to be!
HEDGE FUND MANAGERS
Whilst it is impossible to predict currency movements you can guarantee that behind the scenes there is plenty of activity and big positions being taken. I avidly remember when I spoke with someone in the financial markets the morning of Brexit vote +1. The person on the other end of the line told me that he had no idea how the markets were going to react but that fortunes had been made the morning of 24th June 2016 with currency speculators betting against GBP v EUR and USD.
These same speculators love uncertainty as it gives them more influence over the market…in theory. However, given the fact that recent key announcements don’t really seem to be devaluing Sterling any further it gives you the impression that it may have found a level of equilibrium that prices in any current uncertainty…for now.
FAST FORWARD TO MARCH 29TH – BREXIT DAY
I think it is safe to say that post Brexit day Sterling is likely to suffer marginally, purely due to the negative economic notions associated with it. The news flow during this period is, in the main, likely to be negative (unless you read the Daily Express or Daily Mail) and therefore it is reasonable to assume this will have an impact on Sterling and push it further down.
LONG DRAWN OUT NEGOTIATIONS
The negative news is probably already being prepared as I write and therefore we can expect a gush of it next week. However, stretching the time horizon out further into the process the news flow will probably slow to a trickle with occasional floods, dependent on political news on any given day. It is absolutely clear that an advanced economy which has been involved in an economic union for the last 56 years cannot extract itself from this same union in only 2 years and therefore the negotiations ‘could’ continue a lot longer than expected. A long drawn out negotiation with the EU could work in Sterling’s favour and we could see a significant rally.
INVESTMENT PSYCHOLOGY
I think it is also useful to never forget the psychology of people and our cumulative tendency to be over anxious in times of stress and over confident when times are good. This is a classic investment bias and no one is immune to it, not even the greatest minds. Our currency biases are no different. We can easily anchor to an exchange rate that we feel is a ‘natural level’ based on our own experience, but on what basis are we making these assumptions? Are we seeking out all opinion, even that which is contradictory to our own thinking or are we making these assumptions based on information that we seek out to confirm our own opinion?
Maybe Sterling is overly devalued merely on the preconceived notion that its choice to leave the EU is a bad thing. Unfortunately for us we are about to enter uncharted territory and our biases will soon be tested.
LONG TERM FUNDAMENTALS
In reality, it is good to look at the facts, even though understanding our own psychological processes around exchange rates is probably more important. But BEWARE:
What I am about to write may just allow you to ‘anchor’ your perceived idea of where Sterling should be valued based on what you already think. I would encourage you to not let my musings influence your thoughts!
Using long term macro-economic modelling, Sterling looks very undervalued versus the Euro. Without Brexit, you could easily argue that fair value should be around 1.4 euros to the pound, taking into account structural economics only. Assuming Brexit, we can work on the basis of c.1.25 but it could take years to get there.
Productivity is the key driver of this long term model – particularly productivity in the tradable goods sectors. This is likely to suffer after Brexit due to non-tariff barriers to trade (think about the additional overseas regulation and customs regimes that need to be implemented post Brexit). That said productivity growth in the EU is and has been weak and it is unlikely to surge ahead whilst the UK economy recalibrates, which should ultimately limit the damage to Sterling.
Over the medium term, the exchange rate trades within a range of values where 2 or 3 year interest rate expectations would imply it should be.
So the next time you speak with someone and you hear yourself quoting a post Brexit level of 1.25 or a long term rate of 1.4. Make sure you remember where you heard it first and pinch yourself. It’s all theory. The rate is what it is on any given day and there is nothing you can do to influence it!
Currency swings have a major impact on people’s lives. Therefore, it is important to make sure that the rest of your financial affairs: investments, pensions, tax planning etc., are working to maximum effect. If you would like to ensure that all your other financial affairs are in perfect working order then don’t hesitate to contact me on gareth.horsfall@spectrum-ifa.com or call me on +39 333 649 2356 for a FREE consultation.