IN BRIEF

  • The pound appears cheap relative to long-term estimates of fair value, but likely requires clarity on long-term trade arrangements before convergence to purchasing power parity estimates is possible.

  • We see no support in the House of Commons for a “hard” Brexit outcome and thus scope for a limited recovery when the political situation becomes clearer and negotiations on the future relationship resume.

  • We assume a modest (2%-3%) rally in the pound if the withdrawal agreement is finalised, with significant downside (~-10%) on a “hard” Brexit outcome.

  • The announcement of a second referendum would likely send the pound higher (10%- 15%) as the market would discount a substantial probability that Brexit would be avoided.

How cheap is the pound?

Having fallen by around 14% since the start of 2016 the pound appears cheap when considered against long-term valuation frameworks. Purchasing power parity estimates suggest the pound should average in the low 1.60s against the dollar and around 0.80 against the euro over long periods of time. However, these valuation estimates do not include the potential long-term economic effects of Brexit, which could be significant if the UK loses competitiveness as a result of post-Brexit trade arrangements. In the event of a second referendum on European Union (EU) membership, the market would need to discount a significant probability of a remain vote and hence a possibility that the pound could return to these longer-term estimates of fair value.

To validate any assessment of valuation we look at dynamics of the balance of payments, where a cheap currency should allow a trend improvement in the trade balance and attract long-term inward direct investment. These trends are slow moving but in the two years since the initial fall in the pound we have seen a significant improvement in the current account due to a re-valuation effect on investment income followed by a slow, but steady improvement in the overall trade deficit. Foreign direct investment flows have been less supportive, moving from a period of inflows from 2014-2016 to outflows since 2017, suggesting that the effects of Brexit uncertainty on long-term capital flows have been real.

The balance of payments data also highlight the risks to the pound in the event of a disorderly “no deal” Brexit. The stock of foreign investment in the UK is around 320% of GDP. While the net deficit is smaller, it is unlikely UK investors would be as quick to repatriate assets as foreign investors could be to sell. We estimate the downside to the pound to be around 10%, recognising a significant level of uncertainty around this figure.

Sterling real effective exchange developments

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Source: Bloomberg, J.P. Morgan Asset Management.

Viewing the pound through a Brexit prism

Brexit uncertainty continues to dominate the outlook for sterling, but most likely paths eventually (with some volatility) lead to relatively soft Brexit outcomes. The prime minister Theresa May has finally agreed the text of the UK’s withdrawal agreement with the EU after a series of difficult political decisions but there remain significant obstacles to the passage through the House of Commons.

However, our short-term views surrounding the ratification process are guided by a conviction that there is no majority in the House of Commons for a hard Brexit outcome and therefore very negative outcomes for the pound are likely to be avoided. Upside to the pound is likely to be limited to a modest 2%-3% gain by the lack of clarity on the UK’s future unless a failure of political parties to reach any agreement sends the country back to the polls for an opportunity to reverse the referendum result. In this case we would expect the pound to rally substantially, based on current polling and our estimates of the “no deal” and “remain” outcomes we estimate a 10%-15% gain for the pound.

Re-focusing on policy cycles in 2019

Under a reasonably benign outcome focus is likely to return to the relative policy cycles of the Bank of England and the European Central Bank (ECB), which typically drive currency markets. The UK economy is likely to see some pickup in investment activity as Brexit uncertainty is reduced and tight labour markets are generating more inflationary pressure in the UK than in Europe. The Bank of England looks well positioned to begin tightening policy ahead of the ECB.

Currency Management

Since our first segregated currency overlay mandate funded in 1989, J.P Morgan Currency Group has grown to manage a total of USD 361 billion in bespoke currency strategies. Our clients include governments, pension funds, insurance clients and fund providers. Based in London, the team consists of 20 people dedicated exclusively to currency management with an average of over 15 years of investment experience.

We offer a range of hedging solutions for managing currency risk as well as a tailored optimal hedge ratio analysis:

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  • Dynamic ‘intelligent’ currency hedging aims to reduce currency volatility from the underlying international assets and add long-term value over the strategic benchmark. A proprietary valuation framework is used to assess whether a currency looks cheap or expensive relative to the base currency and the hedging strategy is adjusted accordingly.
     
  • Active ‘alpha’ currency overlay strategy offers clients’ passive currency hedging, if required, combined with an active investment process to deliver excess returns relative to the currency benchmark. Our approach is to build a global currency portfolio combining the output of fundamental models and incorporating the qualitative views of our strategy team.

Opinions, estimates, forecasts, projections and statements of financial market trends are based on market conditions at the date of the publication, constitute our judgment and are subject to change without notice. There can be no guarantee they will be met.