Investment Clock insights

Fade sterling strength


Ian Kernohan

29 June 2017

Over the past 12 months sterling has traded mainly on Brexit developments: depreciating sharply on the shock referendum result, falling further in the autumn when the government appeared to signal a “hard” Brexit approach, then rallying when a snap election victory was deemed a shoo-in for the Prime Minister.

Meanwhile, developments on the monetary policy front appeared to take a back seat, with markets content to assume a long period of inaction.  This situation has changed in recent weeks.  
The Brexit process actually looks more uncertainty than before the election, with the government losing its majority in the House of Commons.  We still have no clear idea what the UK’s trading arrangement will be after leaving the EU in 2019, and it is this large known unknown which sets confidence in the UK’s short-term economic outlook somewhat apart from its peers.
Since the spring, the Bank of England (BOE) has appeared more uncomfortable about the richness at the short end of the yield curve, with markets at one point not expecting a rate hike until early 2020, and some City commentators actually calling for a further easing.   They have sought to knock this complacency out of the market, and have largely succeeded, but does the evidence stack up for a rate hike at this stage?
Inflation has indeed risen above target, although nowhere near as much as in 2011 when the BOE was still easing policy.  The major reason for the rise in inflation is the impact of sterling devaluation.  While this is continuing to feed into the Consumer Price Index, its impact will fade eventually: sterling is close to its level of 12 months ago and the year-on-year change should soon turn positive.
 

Meanwhile, developments on the monetary policy front appeared to take a back seat, with markets content to assume a long period of inaction. This situation has changed in recent weeks.  

The Brexit process actually looks more uncertain than before the election, with the government losing its majority in the House of Commons. We still have no clear idea what the UK’s trading arrangement will be after leaving the EU in 2019, and it is this large known unknown which sets confidence in the UK’s short-term economic outlook somewhat apart from its peers.

Since the spring, the Bank of England (BOE) has appeared more uncomfortable about the richness at the short end of the yield curve, with markets at one point not expecting a rate hike until early 2020, and some City commentators actually calling for a further easing. They have sought to knock this complacency out of the market, and have largely succeeded, but does the evidence stack up for a rate hike at this stage?

Inflation has indeed risen above target, although nowhere near as much as in 2011 when the BOE was still easing policy. The major reason for the rise in inflation is the impact of sterling devaluation. While this is continuing to feed into the Consumer Price Index, its impact will fade eventually: sterling is close to its level of 12 months ago and the year-on-year change should soon turn positive. 

There are few signs that the recent rise in inflation is feeding through into more general inflationary pressures: wage growth, cited by the BOE as a key inflation indicator, remains very subdued and far below the BOE’s own expectations of a sharp recovery.

On economic activity, the news has not been especially positive either, with the UK data surprise index falling rapidly.  

We have yet to see any impact on business confidence from the shock election result, but this may yet appear in the next set of Purchasing Managers’ Indices. Ahead of the election, the BOE downgraded their growth forecasts, and consensus GDP forecasts have begun to slip back.

A consumer slowdown is underway, as household incomes face a squeeze from higher inflation. This mid-term squeeze in real incomes would not have played well during the election (unlike 2015, when real incomes were rising), and is one reason why the government performed badly at the polls. Consumer spending accounts for the largest share of GDP and as yet it is unclear whether a slowdown here is being offset by investment and net trade. This issue has been cited by both Carney and Haldane and I don’t think their positions are as far apart as some are suggesting. Carney suggests that some removal of monetary stimulus is likely to become necessary if weaker consumption growth is offset by other components of demand, and wages and unit labour costs begin to firm. Haldane decided against a rate hike in June for two main reasons: there are still few signs of higher wage growth, and the election has created “a dust-cloud of uncertainty”. 

What does this mean for sterling? The UK faces a major watershed moment in the shape of Brexit. Opinions on the likely outcome may vary, but as yet we have little clarity on how the trading arrangements of a relatively large and open economy will look less than two years from now. Talk of an August hike is very premature. I would expect sterling to move back to trading on the uncertain political situation, and would fade this latest rally.

The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. The views expressed are the author’s own and do not constitute investment advice.