It promises to be an interesting few months
Despite opposition in Parliament, Prime Minister Boris Johnson and his Cabinet have made a no-deal Brexit appear increasingly likely, particularly if one considers it is the default option according to current legislation if no exit agreement is struck with the European Union (EU) by the Oct. 31 deadline. Sterling’s recent tumble—it’s fallen nearly 8% since May and is hovering around 33-month lows—suggests a no-deal Brexit could take the pound into unchartered territory. The recent relationship between changes in the British pound/U.S. dollar exchange rate and the evolution in the probability of a no-deal Brexit in betting markets indicates the currency pair rate could collapse to 1.05-1.10 in a no-deal Brexit scenario, and could even push the pound to parity with the dollar, which has never happened before.
Such a sharp currency depreciation would act as a supply-side shock to the U.K., driving a spike in inflation, a squeeze on income and a drag on consumption. Savings would fail to provide an ample buffer as consumers already have eaten deeply into their kitties of cash since the June 2016 EU exit referendum. In fact, the savings rate is close to a record low. Business investment also may slow as a falling pound and the potential for further depreciation could spook investors. Adding insult to injury, the benefit of rising exports that’s usually associated with a weaker currency has yet to be felt by U.K. businesses, suggesting we may see little boost to exports if the pound weakens further.
If the no-deal scenario comes to pass, the Bank of England would face a trade-off between reining in high inflation and stabilizing economic activity. It would probably look through the temporary spike in prices and focus on activity instead, but it ultimately would depend on relative developments in demand and supply, as well as inflation expectations and financial markets’ confidence in U.K. assets. In investment terms, each of the options the U.K. currently faces presents its own challenges. In the coming months, a parliamentary impasse or a no-deal Brexit present the most adverse possibilities for risk assets. Even though these assets may look undervalued from a historical perspective, it’s hard to consider them attractive as long as there is no clarity on the Brexit outcome. The next few suspenseful months promise to be critical to changing this clouded view.