Ground Zero for Brexit: The Fate of Pound Sterling

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1 NOV Ground Zero for Brexit: The Fate of Pound Sterling J. Patrick Bradley» Introduction Much has been written about the impact Brexit may have on the U.K. and its trading partners across Europe and the rest of the world. Economic data emerging from the U.K. post-brexit suggest that the U.K. appears to be holding up well in the aftershocks. However, the pound sterling may be ground zero for Brexit, which has been on a steep downward trajectory since the vote, even as the economy continued to defy forecasts of a recession. How low can pound sterling go? Or is it already plumbing the lower depth? A Breathtaking Decline Since June 23, 2016, pound sterling has fallen nearly 18%. Following the referendum, the currency seemed to have found a low at just below $1.30, and even managed a small rebound near summer s end. Then came the U.K. Conservative Party Conference in October in the weeks following, hard Brexit crept into the discussion. A hard Brexit refers to a complete break from the European Union (EU), with more dire consequences assumed for the U.K. economy. The currency took another leg lower.

2 Pound sterling has not reacted positively to the news that the U.K. economy appears to be heading away from the recession that was so commonly forecast following the decision to leave the EU. The Citi Economic Surprise Index (see Chart 1) tells us that the reported economic data is exceeding forecasters estimates, yet the pound has not reflected this stronger-than-expected U.K. economy. Even the broadest measure of the U.K. economy, real Gross Domestic Product (GDP), is growing some 2.3% year-over-year, through the second quarter of 2016 (see Chart 2). Yet, sentiment toward the pound remains extremely bearish, and traders are generally short pound sterling (see Chart 3 and Chart 4). Sentiment and trader positioning provide support to the thesis that the pound has further to fall. Is that a correct assessment? Further depreciation in the currency usually focuses on the need for the U.K. to correct a gaping current account deficit. Let s explore that theory.

3 Examining the Current Account Deficit

4 A current account can be viewed as barometer of economic health. The current account includes trade, income earned on investments abroad, and any unilateral transfers. A current account surplus tells us that the surplus country is a net supplier of capital to the world; a deficit indicates that a country has to borrow typically from the surplus countries in order to support consumption. The U.K. has run a current account deficit more often than not since the 1960s (see Chart 5). The country consumes more than it produces and therefore must borrow. Currently, that deficit is roughly 6% of U.K. GDP. The Remedy The remedy to correct such a deficit is for pound sterling to depreciate which is happening. Currency depreciation would improve the U.K. s competitive position by lowering the price of its exports, resulting in its trading partners buying more U.K.-produced goods. Additionally, foreign-produced goods become more expensive for U.K. consumers and businesses to buy. Imports fall, and those consumers and businesses substitute U.K.-produced goods for foreign imports. The result is an improvement to the trade balance and a correction in the current account imbalance. Suppose, however, that the current account deterioration is not the result of a widening trade deficit. Would further depreciation in the currency need to occur? There appears to be some evidence of a structural force affecting the U.K. current account. Evidence of a Structural Shift Chart 5 above suggests there has been a structural change in the current account since A closer examination of the more recent period adds further support to this view (see Chart 6). The historic levels of the current account show the U.K. trade deficit, represented by the green line, stayed constant while the primary income balance the difference between what U.K.-owned assets abroad earn versus the amount foreigners earn on their domestic investments in the U.K. switched from a surplus to a deficit. The return on U.K. assets has been less than that on U.K. liabilities. Therefore, the fall in income is almost solely responsible for the structural deterioration in the current account in recent years (see Chart 7). Simply put, foreigners earn more on their U.K.-owned assets than the U.K. earns on its foreign-owned assets.

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6 Primary Income Changes from Surplus to Deficit For nearly the last 20 years, the U.K. recorded positive primary income. A closer look at the historical income balance and the contributors to that balance shows that the country earned more on its overseas investments than it paid on its liabilities (see Chart 8). Earnings on foreign direct investment (FDI) offset any shortfall in earnings on other assets equities, fixed income securities, and loans contributing to an income surplus. However, from 2012 onward, that is no longer the case. In fact, FDI earnings are now negative. Presently, all investment categories are negative, resulting in a sharp decline in the U.K. s external balance, unrelated to trade. A number of factors are at work here: 1. On the FDI side, commodity prices, notably oil, have been sliding, affecting earnings on those investments. 2. The countries in which the U.K. invests had been slower-growing economies, as shown in the comparison of U.K. growth to eurozone growth (see Chart 9). Foreign investors benefited from the U.K. s better growth prospects. 3. Assets owned abroad are denominated in the respective local currency. Assets in the eurozone are denominated in euro. Hence, the income a U.K. investor receives is denominated in euro. The euro since the end of 2010 has depreciated against pound sterling. For example, a U.K. investor would be negatively affected by the currency translation. In sum, the U.K. Office of National Statistics (ONS) reports that U.K. liabilities exceed U.K. assets abroad; the return on the liabilities is higher and the earnings on those liabilities are greater than earnings on U.K. assets.

7 Conclusions 1. Pound sterling has shouldered the brunt of the Brexit vote, as the market remains sour on the U.K. s prospects for life outside the EU; 2. Thus far, economic indicators belie the negative economic future of the U.K. Certainly, the U.K. could experience much slower growth in the face of deteriorating confidence. 3. If the economic indicators are correct, one is left to wonder whether or not pound sterling needs to depreciate further, as we believe a sizeable valuation anomaly exists now for the currency. 4. One proposed argument is that further currency depreciation is needed to correct the imbalance in the U.K. s current account. That would be a valid argument if a trade imbalance was the primary contributor to the external imbalance. The trade imbalance should improve due to the weak pound. But, the main factor behind the external imbalance is the primary income deficit, and that is not corrected by a weaker currency. Instead, it is corrected by better returns on U.K. assets owned abroad, relative to those available on U.K. assets owned by foreigners. The weakness in the pound, however, should produce a positive currency translation impact. 5. Finally, we believe the massive oversold position of pound sterling could set the stage for a powerful snapback, as it has resulted in a sizeable valuation anomaly. Groupthink is bad, especially at investment management firms. Brandywine Global therefore takes special care to ensure our corporate culture and investment processes support the articulation of diverse viewpoints. This blog is no different. The opinions expressed by our bloggers may sometimes challenge active positioning within one or more of our strategies. Each blogger represents one market view amongst many expressed at Brandywine Global. Although individual opinions will differ, our investment process and macro outlook will remain driven by a team approach.

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