GBP: Valuations and positioning are at extremes - RBS

Research Team at RBS suggests that the sterling’s decline over the past eighteen months will certainly make UK assets (relatively) more attractive.

Key Quotes

“The UK will become a more attractive destination for manufacturing FDI given the currency’s fall more than compensates investors for the likely size of tariffs and possible disruption to supply chains from Brexit.”

“UK assets continue to benefit from strong property rights and law. This means there is demand from many sources, most obviously currently better supported emerging markets. The pool of assets remains small in the context of global wealth generation and continued central bank liquidity injections.” 

“Before the UK voted to leave the EU, we estimated that Sterling’s long-term equilibrium was 1.45 for GBPUSD and 0.80 for EURGBP. Current rates therefore imply that investors have marked Sterling significantly below its traditional equilibrium. This is a one (or two) standard deviation move, so is a historically large move. It’s a similar story in Purchasing Power Parity (PPP) terms.” 

“The end-17 Sterling (Bloomberg) consensus forecast has fallen 20% for GBP/USD from 1.56 to 1.26 since the start of the year. It wasn't so long ago that many appeared to see 1.65 as the new post financial crisis equilibrium. This is a dramatic deterioration.”

“Whether this is appropriate will ultimately be a function of the impact of Brexit has on the supply side and the relative attractiveness of UK assets in the context of a current account deficit.”

“We believe that currently investors have priced in a “Hard Brexit”, with no access to the European Single Market on exit from the EU. While a hard exit with an even more serious impact on the economy can ultimately be priced, we believe that this requires more information that will only become known over many quarters, if not years in the future. For now, we believe the distribution of negotiable outcomes imply that current market sentiment is too extreme.”

“We do not believe Brexit will reduce GBP’s equilibrium by 20%. For example, average EU tariffs are 5% and not all services exports go to the EU. As the risk premium adjusts, we believe Sterling will recover modestly. At the very least, it should arrest the decline in the currency.”