Pound as Brexit safety valve can't save economy on its own

[EDINBURGH] The pound can only go so far in propping up the UK economy as Brexit looms.

While sterling's 11 per cent drop since the June 23 referendum boosts exports, which will help narrow the country's record current-account deficit, its broader effects will be limited, particularly given the unknowns of the European Union exit talks.

That's the view of BlueBay Asset Management LLP and currency specialist Millennium Global Investments Ltd, which between them oversee US$75 billion.

HSBC Holdings Plc said sterling would need to keep falling for the economic benefits to persist. And that may be another stumbling block.

Europe's biggest bank sees the currency weakening 13 per cent to US$1.15 by mid-2017, yet others, while pessimistic, are starting to raise their forecasts. Options prices also suggest another leg lower in the pound can't be relied upon, with the cost of hedging against losses at about the least this year.

"Absolutely, the decline in the currency is part of the solution," said Richard Benson, managing director and co-head of portfolio investment at Millennium in London, who sees the pound falling 5 per cent to 10 per cent on a trade-weighted basis in the next six months.

"But in no way does the currency's decline mitigate the slowness in growth which we're likely to see. Brexit hasn't even happened yet. The malaise that's likely to set in is going to be a slow drag."

The warnings are a timely wake-up call as the Bank of England meets for the first time since its interest-rate cut last month, which was explicitly designed to cushion the economy from the result of the Brexit referendum.

The investors also underline how a weak currency alone can't repair an economy - if that's all it took, then South Africa and Mexico would have been transformed into economic powerhouses during the past decade.

How much the weaker pound is helping the economy is difficult to judge, particularly at this early stage, when the government is yet to trigger the formal process for leaving the EU.

Policy makers have provided some clues. BOE Governor Mark Carney predicted last month the pound's drop thus far would, during the next three years, halve the current-account shortfall, which reached 6.9 per cent of output in the first quarter.

Before the referendum, he said a 10 per cent shift in the effective exchange rate would probably have a 0.75 percentage-point impact on inflation after two to three years.

Data on everything from house prices to retail sales, from manufacturing to jobs have beaten forecasts since the referendum - resulting in a sterling rebound to US$1.3254 as of 6:01am on Thursday in London, compared with a three-decade low of US$1.2798 set in early July, when investor jitters about the result were at their peak.

The pound is still the worst-performing major currency since the vote, and in this way it's acting as an economic pressure valve: weakening in a time of crisis, which boosts competitiveness while preventing the deflation that can sap growth. Yet HSBC said it may not be enough.

"Weaker sterling is a necessary part of the cure for the economic shock of Brexit," said Daragh Maher, head of US currency strategy at HSBC in New York.

"The difficulty is that, rather than having a one-step depreciation, and that provides the medicine, what you need is a consistent, ongoing depreciation because the UK's vulnerability is on its balance of payments."

That ongoing slide has become less likely, according to the options market. The premium on three-month contracts to sell the pound, over those to buy, has narrowed since the referendum to 0.89 percentage point, close to the lowest since January. The gap widened to 6.39 per cent in the run-up to the vote, the most on a closing-price basis since Bloomberg began compiling the data in 2003.

JPMorgan Chase & Co this week raised its year-end pound forecast to US$1.32 from US$1.28, citing positive economic data, while Japan's Nomura Holdings Inc. said buying sterling versus the Swiss franc was among its top-five foreign-exchange trades.

Median estimates in Bloomberg surveys put the UK currency little changed at US$1.31 and 2 per cent stronger at 83 pence per euro by the end of 2017.

Companies including drugmaker GlaxoSmithKline Plc and luxury-goods specialist Burberry Plc have reported windfalls from the weaker pound as they either repatriate earnings or benefit from the increase in inbound tourism. Yet BlueBay points out that the spoils won't be shared equally.

"If you think, does a weaker pound help banks, insurance, financial services more generally, a weaker pound is not a particularly big help," said Mark Dowding, a partner at BlueBay in London, who sees US$1.20 as a "completely realistic" medium-term level for the currency.

"We haven't seen the full impact of Brexit. Looking forward, we'd expect to see more evidence of the economy surprising on the downside."

BLOOMBERG