According to analysts from Brown Brother Harriman, the sharp decline in the pound after the Brexit referendum has significant impacts on the UK economy.
“Something has changed with sterling. It is not just last week's flash crash that seems now to be more of a mark down than fat-finger, liquidity or micro-market structure explanation that has been written about in the press.”
“One important take away is that dramatic changes in foreign exchange prices can overwhelm total return calculations for international investors. John Authers at the Financial Times finds that when stripped out the currency component, UK Gilts have generated practically no return to investors this year, while US long-term Treasuries have returned 11%.”
“In the equity market, the FTSE 100, which is now recognized as a currency play given the heavy reliance of those companies on foreign earnings, has returned 13% for sterling based investors, but has lost unhedged dollar based investors 6.4% this year. The return on the more domestic oriented FTSE 250 is worse. It has returned 3% to domestic investors and has taken 14.4% from dollar-based investors.”
“Sterling's decline will boost exports. That is what these observers have emphasized. It is true. UK farmers, for example, have seen strong demand from the Continent for grains. However, sustaining strength in exports through currency weakness is a different story. It did not work well for Japan, and there are now a number of studies that suggest the currency impact on trade flows may have diminished.”
“Another way that sterling's decline will reduce the UK's external deficit is through a lower demand for imports (…) imports may weaken also because of demand compression.”
“The dramatic drop in sterling will boost UK inflation. This will undermine real income and wages and weaken domestic demand. The UK reports CPI next week. Headline CPI bottomed last year after flirting with shallow negative readings (deflation). It finished last year at 0.2% and was at 0.5% at the end of Q1 16 and Q2 16. In July and August it was at 0.6%. It may have risen to 0.8% in September.”
“It is true that the rise in energy prices are also at work here. UK core rate bottomed last July at 0.8% and had nearly doubled to 1.5% in March. It was at 1.3% in both July and August. Sterling fell 1.25% in September, the fifth consecutive monthly decline. Sterling has only risen in two months this year (March and April). It rose four months last year and three months in 2014.”
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