RiskBrexitWhy sterling is poised to head back south

Why sterling is poised to head back south

The outlook for the UK economy is negative and the recent recovery by the pound is unlikely to last.

At SEB, we are negative on the UK economy going forward although it did well in H2 last year. In particular household and capital spending seem vulnerable from the impact of growing political uncertainty created by the upcoming divorce from the EU.

Retail sales have already showed signs of slowing and will likely continue to do so. However, these reasons for the pound’s (GBP) weakness are currently overshadowed by political risks elsewhere, which have caused a small recovery of the GBP. We argue this recovery is just temporary and is unlikely to last.

So far the country’s economy has remained resilient having avoided reacting negatively to upcoming potentially adverse Brexit talks. To date, forecasts that it would fall into recession following last year’s vote to leave the European Union (EU) have proved incorrect. Indeed, UK economic activity has been unchanged with gross domestic product (GDP) growing by 0.7% quarter on quarter in Q4 2016 despite the outcome of the referendum. However, Britain’s decision to leave the EU is still likely to slow growth, albeit subject to a time lag.

From a long-term perspective, the GBP is substantially undervalued against most other currencies; our own long-term fair value estimate suggesting by around 20%. In other words, most of sterling’s depreciation should disappear in the very long term. While we see good reasons to maintain a negative view on sterling over the medium term, the political uncertainty created by upcoming elections in several eurozone countries this year (and in particular the French election) and the political situation in the US currently seem to overshadow the troubles we believe will be facing the UK economy going forward.

In recent months speculative accounts have reduced their net short GBP exposure; nevertheless the net short exposure to GBP is still much larger than it has been historically. Consequently, sterling may well continue to recover in coming weeks as long as market players focus elsewhere – not so much because things have improved in any particular way in the UK, but more because political uncertainty and risks have increased elsewhere. This might well continue until the second round of the French presidential elections in May.

However,  a euro (EUR) to GBP rate around 0.83 would represent a compelling buy with a target closer to 0.90. Alternatively, we suggest selling GBP/Swedish krona (SEK) around 11.50-11.70 for the currency pair to reach levels below 10.50 in the second half of this year.

  • The full SEB report can be accessed here.

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