Now that the UK government has dismissed the possibility of an extension to the transition period, a ‘no deal’ Brexit is back on the table.  With sterling already trading at a substantial discount to fair value, it is tempting to conclude that further downside is priced in.  However, there are four reasons (including Brexit) why I now feel that the pound could re-test its lows before the end of the year.

Of the value traps, the most widespread and pernicious is value rigidity. This is an inability to revalue what one sees because of commitment to previous values. In motorcycle maintenance, you MUST rediscover what you do as you go.

Robert Persig, Zen and the Art of Motorcycle Maintenance, 1974

Sterling volatility, as you would know, is at emerging market levels and has decoupled from other advanced economy pairs for obvious reasons.

Mark Carney, Bank of England Governor, 2019

I formally confirmed the UK will not extend the transition period and the moment for [an] extension has now passed. On January 1, 2021 we will take back control and regain our political and economic independence.

Michael Gove, Chancellor of the Duchy of Lancaster, June 2020 (via Twitter)

In the world of equity investing, a ‘value trap’ is a stock that trades cheaply based on conventional valuation metrics, but is a bad investment anyway.  In other words, it is cheap for a reason.  Looking at the FX market, there is no doubt that sterling is one of the ‘cheapest’ currencies out there – depending on what measure you look at, it is between 10% and 20% undervalued versus the US dollar – so the question is whether this discount represents value, or is the pound the currency market’s version of a classic value trap? 

In the interest of full disclosure, I was leaning more towards ‘value’ at the start of the year (GBPUSD is down about 5% YTD).  Yes, Brexit still loomed on the horizon, but this was largely priced in, and it seemed that sterling would claw back at least some of the ‘Brexit discount’ as both sides followed the incontrovertible logic that a good trade deal was in everyone’s best interest. 

Furthermore, despite concerns over Brexit, the UK economy had continued to perform strongly, at least relative to the rest of Europe, since 2016, continuing the trajectory established since the launch of the euro in 1999 (Chart I).

Chart I: Real GDP Growth since 1999, UK versus Euro zone

Source: Bloomberg

Admittedly, this outperformance is less impressive once the weakening of sterling relative to the euro (Chart II) is considered.  But there are still arguments to be bullish on sterling.  There is some optimism that a trade deal with Europe will be reached this year (betting markets currently place these odds at slightly better than 50/50) and there has been anecdotal evidence that Brexit will not mark the beginning of the UK’s ostracization from global markets that many had feared.  Major international businesses such as Unilever, Nissan and Goldman Sachs have all made recent and substantial commitments to the UK despite fears, in each case, that Brexit would derail such plans.

Chart II:  Sterling has weakened >25% versus the euro since 1999

Source: Bloomberg

Yes, things were starting to look brighter for sterling in 2020.  And then COVID happened.  Paradoxically, despite the fact that the global pandemic may actually diminish the economic significance of Brexit (who cares about a one or two per cent knock to annualized economic growth when you are already down 20% in a month), there are four major reasons why the COVID crisis has caused us to change our bullish view on sterling.

1.  The UK will be disproportionality impacted by COVID.  

According to the OECD, the UK will be one of the worst affected, if not the worst affected, of all major economies by the COVID crisis.  It estimates that the projected hit to 2020 GDP for the UK will be –11.5%, rising to -14% in the event of a second wave of infections.  This compares to -9.1% / -11.5% for the euro zone and -7.3% / -8.5% for the US.

The reasons for this disproportionate impact include the relatively high degree of openness of the UK economy, with a heavy reliance on international trade and investment, as well as a bias towards services (which make up about 80% of the UK economy compared to only about 73% for the euro zone).

2. UK monetary policy is loosening more rapidly than the Fed or the ECB.

As we highlighted a couple of weeks ago (link) the Bank of England appears more willing to experiment with negative rates than the Fed.  In addition, the UK has dipped its toe into the dangerous waters of direct monetary financing of government deficits   – something explicitly forbidden by both the Fed and the ECB. 

Now, it is true that the competition for the most ‘innovative’ central bank is a furious one, with the ECB well into negative rate territory already, and the Fed appearing keen to buy everything from high yield ETFs to single name bonds.  So it is not yet clear that relative monetary policy is a reason to sell sterling, but the noises emanating from the Bank of England are enough to make us nervous.

Chart III: GBPUSD (green) vs. MSCI World Equity Index (Blue)

Source: Bloomberg

3.   Sterling is a ‘Risk On’ currency in a fragile market 

As Mark Carney alluded to last year, sterling tends to trade like a hybrid between an emerging market currency and its G7 peers.  In other words, at least until the Brexit vote in 2016, when financial markets are copacetic, sterling does well (Chart III).

While Brexit did disrupt this relationship in 2016, the logic behind sterling’s ‘Risk On’ nature remains.  The UK, with an economy that is highly dependant on financial services and with a large current account deficit (financed by international capital flows), is probably not where you (or your capital) want to be when markets take a nosedive.  As discussed last week (link), we feel the chances of a generalized financial crisis remain acute, despite the current success of central bank activism in keeping markets propped up.

4.  Brexit and the risk of ‘No Deal’

As mentioned above, while there may be reasons for some optimism following yesterday’s meeting between Boris Johnson and the three EU presidents, a deal still does not look any more likely than the 50/50 chance offered by the bookies. And weakened by COVID, the UK government is not in a great position to manage any negative economic fall-out caused by a ‘no deal’ Brexit.  Whilst COVID may dilute the impact to some extent, on balance, sterling’s ‘Brexit discount’ looks set to remain for a while yet. 

On balance, while sterling looks cheap (at least against the dollar, less so against the euro), we would see it more as value trap than a bargain.  However, unlike stocks, currencies do tend to demonstrate a degree of mean reversion over very long time horizons.  There will come a time to go long sterling, just not yet.  

Author: Kevin Lester