Brexit and the future of Sterling

For the past four years, the fortunes of the pound sterling, the stock market and the wider UK economy have been shackled to Brexit - Britain's decision to leave the European Union after almost half a century of membership.

Relentless speculation over whether the UK ends up with a so-called ‘hard’ or ‘soft’ Brexit has taken its toll, begging questions about UK equities and sending the pound into a helter-skelter existence.

But as the deadline for agreeing the overall shape of Britain's relationship with the EU finally draws to a close, investors are starting to wonder just how much of the uncertainty will actually be lifted.

"It's a reshaping of a relationship that has evolved over more than 45 years," says Chris Beauchamp, chief market analyst at trading and spread betting platform IG. "Regardless of what happens in the short term, redefining all of its parts will take a long time."

Trade

The biggest unknown affecting sterling and the stock market is trade - and with good reason: in 2018, the UK sent almost half of its exports to the rest of the EU compared with just 13 per cent to the US – and barely six per cent to China. EU exports to the UK were almost four-fifths of its exports to the US, even though the US economy dwarfs that of the UK.

Daniel Lacalle, chief economist at Spanish fund manager TressisGestión, argues that such mutual dependence almost guarantees that a ‘hard’ Brexit, in which the two sides fail to agree any trade deal, would be a huge blow for the future of sterling and the stock market.

"The pound would fall and there would be a flight away from equities into fixed income," he says. "It would be a very negative outcome."

But like many analysts, Lacalle believes a much more likely scenario is a slow, negotiated Brexit in which the two sides reach a bare-bones agreement in the short term while leaving a long ‘to-do’ list for the future.

Bumpy times ahead?

If he is right, the future could end up looking much like the past, and that is not necessarily good news for sterling. Since June 2016, when Britain voted to leave the EU, the pound has endured a particularly rough ride, suffering a record fall against the dollar, a quick recovery and then another fall to its weakest level in more than 30 years.

The buffeting has been so relentless that in June, Bank of America said that the resulting volatility and liquidity of the British currency since 2016 was starting to make it look and behave like an emerging-market currency along the lines of the Turkish lira or the South African rand.

"A more bespoke view of the pound is required and one that would take an EM-esque view,” the bank argued in a research note. “Brexit is likely to permanently alter the way in which investors view the pound.”

FTSE 100 gains

By comparison, the stock market has fared considerably better. Even with all the uncertainty, the FTSE 100 gained ground quickly after the landmark referendum, climbing from just over 6,000 points in June 2016 to more than 7,700 points by January 2018. Yet much of that resilience stems from the fact that about 70 per cent of the revenues of companies in the index come from abroad – and not just the EU.

UK stocks with greater exposure to the domestic economy, such as those represented in the wider FTSE 250, tell a different story: a basket compiled by JPMorgan Cazenove of large-cap companies whose revenues come from the domestic market lost about 5 per cent between June 2016 and the last quarter of 2019.

Peter Dixon, chief economist at Commerzbank, argues that his default scenario of a basic agreement requiring plenty of backfilling in the months ahead would be far better than a 'no deal'. But he also says that it would do little to improve the UK's equity-risk premium.

"In world trade terms, might prevails," he says. "The UK is a small actor and, whatever happens in the coming months, it will be more alone than it was before."