InvestmentsMay 31 2016

Sterling to rebound if Remain vote wins

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Sterling to rebound if Remain vote wins

Sterling has declined 6 per cent against the euro for the year to date to May 17, while the currency has slipped almost 2 per cent against the dollar in the same period, data from FE Analytics shows.

However, it has had its ups and downs, with HiFX economist Andy Scott noting that sterling’s recent rally of more than 1 per cent against the euro and the dollar had only been “marginally” affected by weaker-than-expected inflation figures released in mid-May.

Mr Scott explains: “Consumer prices rose at a slower pace last month, which is likely to keep interest rates lower for longer, typically making a currency less attractive. But sterling was buoyed by two EU referendum polls [on May 16] that showed a healthy nine-point lead for the Remain camp, with the odds of the UK staying now around 70 per cent, according to some bookmakers. This helped sterling to recover from a three-week low against the US dollar, and hit a two-week high against the euro.

“With just over a month to go, there seems to be a little more confidence in terms of the outcome, which is leading to more buying interest in sterling. Nevertheless, taking account of the margin of error in polling and the number of still-undecided voters, nothing should be taken for granted and protecting against the potential for significant volatility should remain a priority for businesses and individuals with currency exposures.”

Sterling and Brexit: Expert view

Neil Williams, group chief economist at Hermes Investment Management, comments on the threats to sterling if the UK votes to leave the EU:

“Our inflation simulations suggest a fall in the pound to $1.20 from June would push the consumer prices index [CPI] back above the Bank of England’s [BoE] plus 2 per cent target by [2017]. In our base case [no Brexit], the CPI does not breach 2 per cent until 2018. Further sterling weakness would bring this 2 per cent forward to November 2016, leading to 2.5 per cent before next spring. But we doubt it would trigger a BoE rate hike, given Brexit’s feared hit to growth.

“With rate hikes deferred, short-term conventional gilts may benefit initially, especially on a hard exit. But this could be short-lived, given about one-third of the £1.3trn gilts outstanding is backed by international investors sensitive to currency and ratings risks, particularly if Brexit reignites the risk of Scotland breaking from the UK.

“In which case, it’s possible that dealing with Brexit and a hit to growth may need the BoE to again be a sponsor of gilts, via quantitative easing – potentially intensifying the pressure from lower-for-longer yields on pension schemes.”

Uncertainty over the referendum result means that sterling has been one of the worst-performing major currencies this year, notes Archie Tulloch, investment analyst at Argonaut Capital.

“While the currency movement may not be entirely attributable to Brexit fears it is a major contributor – when Boris Johnson declared his Brexit decision the pound fell almost 2 per cent, the biggest one-day fall since 2010,” Mr Tulloch says.

“As the uncertainties surrounding the referendum undermine UK economic growth, it is worth considering what the economic consequences of any future result might be. In the event of a pro-EU result, a positive market reaction would be expected as investors’ fears are allayed, with a reversal of the sterling versus euro trend seen in the past few months.

“The extent of any bounce back is itself difficult to gauge, but given the level that sterling has fallen from in such a short period a definitive move following the result [would be expected]. A strong rebound in the market might be expected where pent-up demand is subsequently released following a holding period.”

EdenTree Investment Management’s Robin Hepworth, manager of the Higher Income fund, suggests there is a sense of growing confidence the UK will vote to stay in the EU, and sterling’s implied volatility has dropped as polls show support for the Remain camp firming up.

“With sterling close to a 30-year low versus the US dollar, the risks of a Leave vote appear mostly priced in and a recovery in sterling therefore appears more likely,” explains Mr Hepworth.

“This scenario will favour companies with sterling-based revenues and assets as the pound recovers some of the steep falls seen in recent months. It will also favour UK firms that are significant importers, such as retailers. It would also be a positive for overseas companies with large exports to the UK, though there will not be many of these.”

Economic projections: Risks to sterling

The National Institute for Economic and Social Research’s economic review for May 2016 included a number of projections and research into the near-term implications of a Leave vote, including the effect on sterling. In the paper ‘The short-term economic impact of leaving the EU’, the eight authors note: “Heightened risk and uncertainty will cause sterling to depreciate by around 20 per cent immediately following the referendum, which will result in an intense bout of inflationary pressure.”

It adds: “[A vote to leave the EU] will widen the risk premium associated with sterling. The question is by how much? To calibrate our shock, we look to the options-implied, three-month sterling volatility. This series rose sharply on the day that the three-month contract first encompassed the date of the referendum, and remains elevated. Comparing this increase with that observed in the recent financial crisis we observe that it has been roughly two-thirds of the size.”

Therefore it models the shock to the exchange rate risk premium by scaling the effect that occurred in the fourth quarter of 2008 by two thirds. “The shock then decays by 50 per cent a quarter. It reaches zero by the end of 2017 so that by the time the negotiating window [to leave the EU] has been concluded the sterling risk premium has returned to its baseline level,” the report adds.

While there would be uncertainty should the UK vote to leave the EU, there is a possibility that the pound would fall further. John Anderson, manager of the Smith & Williamson Fixed Income fund, points out the current uncertainty, and a subsequent vote to leave, is negative for both sterling and the euro.

Mr Anderson explains: “The UK has a large current account deficit, which will come sharply into focus if the vote is to leave. The Bank of England is unlikely to be able to raise rates aggressively to protect sterling as there are signs that economic data is rolling over even without a Brexit. The terminal level of interest rates in this cycle is likely to be much lower than we’ve seen in the past.

“A vote to leave will also be negative for the euro as the future of the EU and the single currency project will be called into question. The natural beneficiary of all this uncertainty is the US dollar, particularly as Japan would like a weaker yen.”

With just weeks left, it is possible the volatility in the currency could increase, but whether the vote is to stay or leave investors need to carefully consider the effect on their sterling exposure.

Nyree Stewart is features editor at Investment Adviser