I know I’m unloveable, you don’t have to tell me
Oh, message received loud and clear, loud and clear
The Smiths, Unloveable
A month ago I argued (see here) that better near-term UK activity data shouldn’t be interpreted as showing that the UK was out of the woods in it’s difficult Brexit journey. Rather, I opined that the market would likely eventually start focussing on the longer-term challenges facing the UK economy, probably provoked by the UK government starting to clarify it’s Brexit negotiating stance (which I’ve long expected to be of the “hard” variety), with consequently renewed sterling weakness.
So sterling’s recent falls to fresh post-referendum lows isn’t particularly surprising, given recent strong indications from the UK Government that a “hard” Brexit is likely. The reported aspirations for bespoke sector-by-sector trade deals appears optimistic while PM May’s reported less sympathetic view on the UK financial services sector (accounting for 12% of GDP) has got markets worried. Indeed, the apparent emboldenment of a hard Brexit appproach by the recent UK data resilience, alongside an underlying desire to firmly control immigration (with Amber Rudd’s proposals being strongly criticed by businesses and economists), will unfortunately likely be damaging longer-term.
Further sterling weakness seems likely in the months ahead, although if near-term data don’t crater the next large leg down may have to wait until the UK Government really shows its negotiating hand. But overall I stick with my long-held views that €/£ is likely to eventually rise above 0.90 while £/$ below 1.25 and toward 1.20 appears eminently possible and £/¥ seems most vulnerable in a risk-off environment. Such sterling weakness seems likely to be driven by a combination of:
(i) The medium-term UK economic challenges which the market has been increasingly focussing on, rather than better near-term UK data, will likely become more apparent as Brexit negotiations approach/proceed. France and Germany face electoral contraints in being generous to the UK and in any case have little incentive to depart from their firm stance on free movement given the objective of stemming exit temptations for other EU members.
(ii) Weakening UK corporate investment and hiring intentions are a worrying supply-side developments and consumers will likely pull back spending as real incomes growth is hit, with a lag, by higher import prices and weaker employment growth.
(iii) Signs of growing sterling risk premia (£ weakness independent of MPC easing expectations, see Chart) could well grow given the UK’s continued huge current account deficit (increasingly funded by more volatile flows) and global risk appetite’s vulnerability to US politics.
(iv) The market is underpricing the likelihood of further MPC easing i.e. less than a 30% chance of a further rate cut by February 2017 (Minouche Shafik’s renewed dovishness compares to Michael Saunders’ more positive tone).
(iv) Although Chancellor Hammond has abandoned Osborne’s fiscal targets, he’s unlikely to announce a large large fiscal support package in November. So there’s a risk of leaving too much of the heavy lifting to increasingly-constrained monetary policy.
(v) Sterling short positions have been extended despite nascent risk-off dynamics (see chart), indicating that FX traders regard it as a core short. Indeed sterling could become a funding currency, and hence weaken, should market risk appetite remain supported: it’s bit of a case of heads you lose, tails you don’t win for sterling with regard to risk appetite developments.
(vi) Three factors reduces the chances of the post-Brexit period being a replay of the positive early 1990s post-ERM departure experience. Sterling is not yet “cheap” on a long-term real basis, attempts to expand UK trade face the challenge of the WTO expecting the weakest world trade growth since the financial crisis and structura changes seem to have reduced the beneficial impacts of depreciations on net exports (BoC Governor Poloz’s recent paper complements existing BoE work).
Better than expected near-term UK data….
UK economic data have, at first glance, been surprisingly positive in the post-referendum environment. For example: (i) the July index of services was stronger than expected; (ii) the August manufacturing PMI was the strongest since June 2014 (see Chart, tomorrow’s services PMI is eagerly awaited but may be dominated by PM May’s speech); (iii) consumer confidence has recovered. Of course, the MPC’s timely policy easing has probably contributed to the rebound, helping meet it’s risk-management motivation (see my preview). And delaying triggering Article 50 can help mute some of the near-term damage to the economy – e.g. consumers may feel like “nothing has actually immediately changed”.
But overall it’s reasonably striking that the Citi UK economic surprise index has risen to the highest since mid-2013 (see Chart). But equally striking is the fact that the FX market has completely ignored this apparent positive news, driving sterling down sharply to post-Brexit lows as they instead focussing, as I anticipated, on the medium-term challenges facing the UK economy.
…but FX Markets rightly looking through it, although underpricing further MPC rate cuts
Another way of seeing this market focus on medium-term UK challenges rather than near-term data is the fact that recent £ weakness has been in excess of that implied by MPC rate expectations (UK OIS rates). The chart below illustrates this for £/$ but a similar picture holds for €/£ (see above). The implication is that there’s signs of sterling risk premia picking up – potentially related to the funding of the UK’s continued huge current account deficit (see below) – in a interesting deviation from the previously-close relationship between £ and MPC rate expectations. And such risk premia could well become amplified should global risk market conditions become more challenging in the coming weeks (e.g. if the US election remains too close call as November 8 looms).
That said, the market also looks to be underpricing the chances of further MPC action – OIS rates currently only price a 14% chance of a rate (25bp) rate cut in November, rising to 28% by Februart 2017. Indeed, expectations of further easing have been scaled back in recent weeks, in light of the better than expected UK data. While the direction of travel is probably right, subject the the large caveat that the near-term data don’t tell us much about the issues concerning the MPC i.e. they could well look through the better near-term data, resulting in 50%-plus chance of further MPC easing.
After all, the September MPC minutes reaffirmed that most MPC members remained likely to vote for further easing if the economy turns out broadly in line with their August IR forecasts. While they acknowledged that “a number of indicators of near-term activity had been somewhat stronger than expected” this came with the strong caveats that it was “difficult to draw any strong inferences from these data about the Committee’s projections for 2017 and beyond” and that “The Committee’s view of the contours of the economic outlook following the EU referendum had not changed” and that “the Committee still expected a material slowing in UK GDP growth in the second half of 2016.” Potentially more important, however, was the statement that “the immediate impact of the U.K. policy package on asset prices had been greater than expected, and the committee would monitor closely the extent to which those asset price movements would be transmitted through to the broader economy.” And MPC may want to maintain something in reserve, given underlying concerns about potential adverse side effects on Banks and pension funds.
But Deputy Governor Minouche Shafik’s 27 September comments that MPC could Ease again before the 23 November Budget were “risk management” writ large. She remains worried about the adverse impacts of uncertainty on investment and aiming to minimise the chances of a likely slowdown turning more pernicious. Her bottom line was that “There is no doubt in my mind that the UK is experiencing a sizeable economic shock in the wake of the referendum. Any reduction in openness or need to reallocate resources will necessarily imply a slower rate of potential growth for the economy.” Her reported “never say never” view about negative rates is potentially provocative given the contrast to the previous MPC view that the effective lower bound is slighly positive (with Governor Carney “not a fan”). By contrast, Michael Saunders’ comments thus far indicate that he’s more optimistic on growth – but we’ll hear his more detailed views in speech tomorrow.
Medium-term challenges remain: further sterling weakness likely
Brexit likely represents, as MPC have previously argued, a significant medium-term shock to the UK economy. But within that there reman several mechanisms via which it’s likely to pull down on the UK economy, and consequently sterling, and for which there is negative recent evidence.
First, the persistent uncertainties about the UK’s future economic direction will adversely impact (lumpy and hard to reverse) corporate fixed investment and hiring. And the BoE Agents’ survey reports a sharp weaking of investment intentions (see Chart and here) and employment plans. That’s consistent with broadly flat capex and employment over the next 6-12 months, even before the reality of the post-Brexit world really dawn, in contrast to the recent continued labout market stability (although the survey’s track record is limited). But BoE data show weak PNFCs only raised £1bn in external finance in August, down from an average of £2.7bn over the previous 6 months, again consistent with weaker capex prospects. And reports of Nissan witholding further investment in their Sunderland plant until there’s greater certainty about UK single market access, or they received government recompense for any tariffs eventually incurred, is concerning. Moreover, A KPMG survey reported that 76% of UK CEOs were considering moving operations abroad post-Brexit. That said, Apple and Siemens have recently committed investment.
Second, there’s also signs of “lumpy and hard to reverse” consumer purchases slowing. Mortgage approvals fell to their lowest since November 2014 as (Halifax) house price inflation slowed to 6.9% in August (from 10% in March) despite mortgage rates hitting fresh record lows (2-year fixed rate only 1.66% on BoE data) after the MPC’s easing. New car registrations are also subdued, despite consumer confidence reovering in August/September.
Third, the more general impact on consumption was always going to be more delayed – refecting the hit to household real real incomes from higher import prices following sterling’s depreciation feeding through (Apple products are already up to 23% more expensive!). Plus, as discussed above, employment prospects could well weaken (the August Inflation Report anticipated the unemployment rate rising , even if near-term labour market data have also been ok.
Fourth, the UK’s huge current account deficit hangs like a Sword of Damocles in the background around the UK’s Brexit negotiations. The headlined deficit, 5.9% of GDP in Q2, is concerning enough – marking the UK out as an outlier in the major economies. But the real issue is how (types of inflows into the UK), and at what price (exchange rate), that huge deficit is funded. This is BoE Governor Carney’s “kindness of strangers” concern. And the bad news buried in the details of the Q2 data is that: (i) the current account funding moved away from relatively-stable FDI inflows to more volatile net portfolio inflows (see Chart); (ii) there was a large (£11.7bn!) “errors and omissions” component i.e. we don’t know how 45% of the current account deficit was funded! That said, the August Inflation Report anticipated the current account deficit halving over the next three years, presumably because improving Euro Area prospects reverse some of the deterioration in FDI income which has driven most of the deterioration (see here).
Fifth, even though Q2 growth exceeded market expectations (0.7% q/q) that was helped by a +0.6pp contribution from stockbuilding which seems unlikely to persist while net exports again dragged on growth (-0.8pp contribution, see Chart). The latter illustrates the challenging start point for obtaining a meaningful net trade boost from sterling’s depreciation, although the improvement in export orders reported in the August manufacturing PMI should be acknowledged (subject to the caveats of such qualitatitive surveys I discussed here).
My accompanying post (see HERE) takes a longer-term look at the issue – arguing that sterling is not yet “cheap” on a long-term real basis, world trade prospects are the weakest since the financial crisis and structural changes such as offshoring seems likely to have dulled the beneficial trade impacts of depreciations (while raising the adverse inflation impacts). On each metric the situation is very different from after sterling’s 1992 ERM exit. So optimistic Brexit conclusions based upon that experience seem flawed, although there is clearly immense uncertainty about eventual trade deals.