Where will Sterling go from here? Here’s a prediction…

At the Master Investor Show in London on 25 March, which many of my readers will have attended, one question came up again and again to the various luminaries gathered to dispense their insights and knowledge. Where do you foresee Sterling going? Overall, most of the assembled experts, including my friend Evil Knievel, were Sterling bulls.

I think they are right. Basically, all of the bad news and uncertainty around Brexit and the two years of tedious negotiations ahead of us have already been priced into the current value of Sterling (US$1.25 and €1.18 as I write); while a steady flow of positive economic data offers good potential on the upside. I am going to stick my neck out here and predict that Sterling will trend towards US$1.30 and €1.25 by the end of this year. (I am assuming that the US$-Euro rate will remain substantially stable). Here’s why.

Central banks are buying Sterling

On 02 April the Financial Times reported that 80 of the world’s central banks are dumping Euros amid concerns over political instability, the rise of “populist” political parties, weak growth and the European Central Bank’s negative interest rate policy. And they are buying Sterling as a long-term, stable alternative.

Despite the Brexit furore formally set in motion by Prime Minister Theresa May on 29 March, central bankers from around the world see the UK as a safer prospect for their reserve investments than the Eurozone. This was according to a survey of reserve managers at 80 central banks, who together are responsible for investments worth almost €6 trillion. The results, compiled by trade publication Central Banking Publications and HSBC show that many central banks have cut their cash and investment exposures to the Euro substantially.

Developing and emerging-market central banks, some of which are among the world’s biggest reserves holders, were more likely than those from advanced economies to have reduced exposures to the Euro. It seems that the UK’s decision to withdraw from the EU has not affected the popularity of Sterling as a reserve currency, with 71 percent of respondents saying the attractiveness of the Pound was undimmed over the long term.

While central bankers said they would become more cautious about investing in Sterling over the next few years, the survey showed many believe Brexit could provide an opportunity for them to diversify their portfolios. Almost 80 per cent of respondents said the election of Donald Trump had not changed their overall view on the US dollar.

The ECB’s negative interest rate policy — intended to spur growth across the Eurozone by forcing banks to lend — was identified as a key reason to sell Euros. This policy, begun in the summer of 2014, has aroused discontent amongst European banks which have had to endure falling profits. The deposit rate in the Eurozone is now minus 0.4 percent — meaning that lenders in that to hold reserves overnight at the ECB.

One reserve manager quoted in the survey said that the high credit quality of the UK, the liquidity of the gilt market, and the diversification benefits of holding Sterling made it an attractive reserve currency

Concerns about the future of the Euro are exacerbated by the potential European banking crisis which could precipitate itself, many believe, at any time. Add to the fragile European banking system the declining credit quality of the sovereign sector and you have a recipe for instability.

That said, the Eurozone economy has been pepped of late by better-than-expected growth figures which have gone some way to sustaining the Euro’s relatively strong performance against the Dollar. But the fundamental structural imbalances of the currency union will not go away. They are the noisy tin can cruelly tied to the dog’s tail.

Why Sterling’s devaluation was timely

Whichever way you look at it, Sterling is down by about 16 percent against the Dollar relative to pre-referendum levels – just as the doom merchants predicted before 23 June. The good news is that this radical and sudden devaluation has happened at a time of rising demand in the world economy, much to the benefit of British exporters. Figures out on 11 April suggest that UK exports are up about 6 percent relative to this time last year.

That might even be an underestimate. Heathrow Airport has reported that outbound freight business last month was up 13 percent on March 2016. This statistic is telling: Heathrow is the UK’s largest port and by value carries more freight than all other UK airports combined. Most of the growth was in exports to developing markets. Freight exports to Mexico for example were up 26 percent.

A more dynamic UK export sector is excellent news. The current account deficit – a long-standing weakness in the British economy – was down to “just” 2.4 percent of GDP in Q4 2016. That was partly because the Sterling value of overseas earnings is higher given Sterling’s fall. The capital account has also been boosted by buoyant foreign demand for UK assets from gilts to penthouse flats in up-market parts of London.

Of course exporters are benefiting from the cheap Pound while we still trade as an EU member without impediment in the Single Market. The current level of the Pound suggests that the foreign exchange markets suppose that the post-Brexit regime will be less favourable to British manufacturers who wish to export to Europe. A more sanguine view was recently expressed by Lord King, the former Governor of the Band of England. In a recent interview he said that, in the long run, Brexit is not going to make a great deal of difference to the British economy one way or the other. He said: “30 or 40 years down the road, if you give people a chart of British GDP and ask them to point to where we left the EU they won’t be able to see it.”

Lord King is not alone in thinking that the economic disadvantages of Brexit will be finely balanced with new opportunities. But there will be benefits that do not show up in the GDP figures. We shall regain control of our borders – though talented migrants will always be welcome – and of our laws. And we shall no longer be shackled to a dysfunctional currency union.

The bankers vote to remain – in London

I have always suspected that sentiment in the foreign exchange market is partially driven by the stories that bankers and traders tell each other. Just after the referendum last summer the popular wisdom in the City was that a large part of the UK financial services industry would be lost to Paris, Frankfurt, Dublin and the rest. They no longer all think like that.

JP Morgan CEO Jamie Dimon, who was amongst the doomsayers during the referendum campaign, wrote in a letter to shareholders last week that the bank would move “hardly any” jobs across the Channel in the next two years. This despite the fact that JP Morgan was preparing for a “hard Brexit” – “it would be irresponsible to presume otherwise”, he wrote. Thereafter, he anticipated constant pressure from the EU not to outsource financial services to the UK but rather to move people and resources to European subsidiaries. But his wording was extremely careful – he did not say that JP Morgan (and others) would have to give in to such pressure.

Furthermore, Mr Dimon expressed the view that political and economic risks in Europe were so high that the EU itself could break up. “While we are not predicting that this will happen the probabilities have certainly gone up”. He hoped that Brexit would be an opportunity for the EU to reform itself. If only.

Back in January Mr Dimon opined that Paris was an unfavourable banking location due to its inflexible labour market regulations and high payroll taxes. It is interesting that, after much bluster, Lloyds of London has now opened its Brussels subsidiary which is likely to cost the London market just “tens of jobs”. There is growing confidence that London will remain the world’s premier financial centre – and that is good news for the Pound.

Good news, bad news

Devaluation can be a helpful adjustment mechanism but it does not add up to a medium-term economic policy. The UK still has to address the gap in competitiveness and productivity that has opened up with benchmark economies like Germany. Investment in infrastructure and upskilling alone will not be enough.

The fall in Sterling has also stimulated inflation at a moment when it was on the rise anyway as the economy approached full employment. Imported goods cost more in the shops, not least food and clothing. The ONS reported on 11 April that prices are rising faster than wages. Prices are now increasing in the UK at 2.3 percent while wages are growing at only about 2 percent. As a nation, we should now be tightening our belts; but the belt-tightening has been postponed as consumer borrowing (mostly on credit cards) rises to dangerous levels.

Finally, we need to think about interest rates. With inflation now well above the Bank of England’s official 2 percent target, in a normal world rates should be hiked – probably in successive tiny increments of one quarter of one percent. That would put further upward pressure on the Pound.

The housing market will probably slow further when and if rates rise, but the most serious casualty, as I have argued previously, will be government finances. The UK government, remember, has to service the outstanding £1.7 billion (and rising) stock of national debt.

As the Pound edges up over the course of this year and the growth outlook gets gloomier we might look back at the first year after the referendum as a sweet spot when Britain got its export mojo back. Henceforth, we shall have to worry more about growth than the exchange rate. To borrow Mark Twain’s famous line, rumours of the death of the Pound have been greatly exaggerated.