A view from the Macro perspective
The UK has seen an avalanche of events over the past couple of years and the resulting uncertainty has brought it into the spotlight. The Scottish referendum narrowly passed in late 2014 (55% “No”) but the EU referendum brought a big surprise as “Leave” edged it in June 2016 with a 52% vote. Uncertainty in the UK was further compounded by the Conservatives’ inability to form a majority government in the June 2017 general elections, wasting a massive lead within only a few weeks.
Sterling has been very volatile and talked about, but what is the big picture? Let’s have a look at the positive & negative aspects and try to assess its future direction.
- Inflation has been steadily rising, due mostly to Sterling’s ~15% depreciation following the EU referendum. Inflation is currently running at 2.9% YoY with upward momentum over the past few months. It’s worth noting that the BoE has a history of dismissing transitory inflation, but it has recently voiced concerns about a significant overshoot. Proof of this is the June MPC vote split, with 3 members now voting for a rate hike. Forbes (the biggest MPC hawk) is retiring from her post before the next meeting but there are clear signs that the tide is changing. The bottom line is that the BoE’s mandate is to keep inflation at 2% and they will not allow it to stay at elevated levels for prolonged periods.
- Unemployment is running at very low levels, with total employment registering record highs. 4.8% unemployment in the UK is practically on a par with the US and significantly lower than the EU average.
- GDP and other economic data are still running at decent levels, despite the Brexit-related uncertainty. GDP registered 2.0% growth in 2016 while other indicators such as PMIs continue to be very resilient. The Pound’s post-referendum devaluation has proved to be a very strong balancing force and should continue to be an automatic stabilizer for the UK economy.
- The current 0.25% base rate level is at all-time lows. Near zero rates – together with QE – were supposed to be emergency measures to counter the big recession following the 2008 GFC. Furthermore, the final 25bp cut was a pre-emptive move after the EU referendum and it’s becoming clear that it probably wasn’t necessary. These factors point to the fact that base rate normalization could commence in the near future.
- Finally, GBP positioning has been very short for a long time. There has been significant accumulation of short positions and when things turn these may take a while to be unwound. As a result, a major short squeeze will always be on the cards.
- There is significant political uncertainty following the 2017 general elections. PM Theresa May looks particularly weak and vulnerable, as she has been unable to maintain her party’s considerable lead from only a few weeks ago. Her response to difficult political and social situations has been greeted with broad disapproval and her popularity ratings have dropped. She now faces the possibility of having to step down for a new Tory leader to renew the party’s strength. Furthermore, there is a real chance of another general election before year-end, which she could easily lose to Labour. All this uncertainty comes at the worst possible time, as Brexit negotiations are about to begin; the UK government needs to be united & strong in order to achieve a good result for the British people. Last but not least, the Scottish independence referendum may have yielded a “No” outcome in 2014, but there is always a possibility that another may take place in the future.
- The biggest economic problem is probably inflation vs. wage growth. With annual inflation currently at 2.9% and wage growth at 2%, real incomes are being squeezed and that will probably put the brakes on consumer spending.
- The UK continues to have large twin deficits, similarly to the US. There is obviously leeway for the government to borrow more, but at nearly 90% the debt/GDP ratio is reaching worrying levels.
- While other MPC members are slowly turning towards raising rates, the Chairman (Mark Carney) remains dovish. He recently stated that “now is not the time to raise rates” and naturally he has some influence over the other MPC members.
Due to all of the above points, it’s difficult to hold an absolute directional view on Sterling. There are many potential obstacles that could lead to further GBP downside. However, there are also reasons why it might stage a strong recovery. The pound has lost a lot of ground since June 2016, as many negatives are already priced in. Looking at GBP vs. the Euro, the pair seems to be at a critical level (see chart A, below). A convincing break of the 0.87-0.88 zone opens the door to new highs above 0.92, or a deeper pullback with a 0.80 medium term target. On a more short-term basis, the daily GBPUSD chart (chart B) shows that Sterling is trying to bounce above a long-term TL. A successful test of this support should take it towards the 1.35 resistance zone; conversely a failure will bring it back inside the wedge below.
Trading the Sterling can be tricky as volatility is high. Risk and reward can be equally significant.