Cable under tension from upcoming UK-EU talks

Amongst financiers, particularly forex traders, the term ‘cable’ denotes the exchange rate between GBP and USD or even just GBP itself. The name is derived from 1800s transatlantic cables used to transmit the GBP/USD exchange rate. Downwards cable equals sterling depreciation and dollar appreciation and upwards, the opposite.

Much has changed since the 1800s, including the strength of the dollar. It is now the world’s reserve currency and US dollar credit and integral to global markets. Sterling has depreciated over the long-term against the dollar, in line with its diminishing role as a reserve currency.

The term cable has remained and is used to assess both USD and GBP strength, or weakness. Much like its electrical counterpart, cable has two ends, either one of which can lead to a fault. From the UK side, short-term risk of cable downside hinges on both, UK-EU politics and the budget deficit. In the long-term, however, there could be room for cable upside as the relative value of GBP appears undemanding.

Chart 1: Long-term history of cable (GBP/USD)

Source: BOE/Smith & Williamson Investment management 28/05/2020

On the political front, COVID-19 has partially masked the uncertainty caused by Brexit, however, this remains a key risk to sterling. UK-EU trade negotiations are in their third round and sticking points remain sticky. The UK is demanding that regulatory policies and rules are set independently, whilst the EU wants a “level playing field” for regulations and state aid arrangements. Northern Ireland continues to be problematic with minimal customs checks vs a local technical office overseeing checks being debated between the two parties. Nevertheless, there is hope of a deal being reached. Fisheries appeared to be an adhesive point in these negotiations but concession of the need to shift from the “maximalist” mandate on fisheries demanded by France, Spain, Belgium and the Netherlands, by the EU’s chief negotiator, Michel Barnier, was reported recently. As deadline day draws closer, both sides may begin to soften on contentious issues.

Chart 2: Sterling is vulnerable to UK politics

Source: Smith & Williamson Investment management 28/05/2020

The 30th June is a key date to watch. It represents the deadline for a standard extension of the UK’s transition period (currently the end of 2020). Given the impacts of COVID-19, valuable negotiation time has been lost and there is a valid reason to extend the transition period. However, if this deadline is missed, an extension becomes materially harder and the risk to sterling greater. Beyond the 30th June, an extension is technically possible but may require a treaty change and would move the situation to one where unanimity among all 27 EU members states is required. Currently this is not needed, with decisions being by “consensus”. For example, France failed in its bid to take a hard-line stance on Article 50 extension in April 2019. In a scenario where unanimity is required, a single member state has a far greater degree of autonomy and ability to block an extension. Individual countries may see their own motive beginning to creep into the limelight. Spain may start considering Gibraltar, France might stand against UK exclusive fishing waters, Greece may want the Elgin Marbles back. Essentially, once the June deadline passes the legal and political obstacles to Brexit and ultimately clarity for GBP are significantly higher. Investors may opt for opportunities with less idiosyncratic risk, decreasing demand for sterling.

On top of these political risks, is the issue that the UK is reliant on foreign investors to fund its budget deficit. The UK government borrows from foreign countries, which in doing so lowers the value of the GBP. Currently, around 30% of UK debt is held overseas. Moreover, the economy is in weak shape. The independent Office of Budget Responsibility forecasts a near 13% real GDP decline for 2020. If correct it will be the biggest decline since the Great Frost of 1709, which was the coldest winter in Europe for more than 500 years.¹ Public sector borrowing is set to increase with the UK government having implemented furlough schemes and other measures to protect against COVID-19. With GDP decreasing and fiscal spending increasing, the budget deficit is set to worsen to around 14% of GDP, its widest since WW2. Consequently, from an economic perspective, sterling could be vulnerable over the coming months due to budget deficits and reliance on foreign debt holders. The lack of clarity on the UK’s future relationship with the EU could be a potential catalyst for a steep drop in the sterling exchange rate.

Chart 3: Widest UK budget deficit since WW2

Source: BOE/Smith & Williamson Investment management 28/05/2020

Reference Scenario = COVID-19 adjusted forecast of public sector net borrowing

GFC= (Global Financial Crisis)

The long-term outlook for cable may be more positive however, with sterling currently being undervalued. The Economist’s ‘Big Mac index’ is based upon the theory of purchasing-power parity and provides a layman’s indication of whether currencies are at the right level. Currently, you can buy a McDonald’s Big Mac in the UK and US for £3.39 and $5.67, respectively². This implies an exchange rate of 0.6 whilst the actual rate is 0.77, leading the index to suggest that the pound is 22.2% undervalued. A slightly more complex analysis, looking at rate differential of UK-US 2-year government bond yield spreads vs GBP/USD rate, supports this. Generally, interest rates and exchange rate differentials should be broadly correlated. Our analysis indicates that UK-US government bond spreads have increased, whilst cable has fallen, showing an undervalued GBP. Given that sterling is cheap, if UK political risk clears and capital may begin to flow into GBP denominated investments and there may be significant upside for cable.

Chart 4: GBP is 22% undervalued vs USD

Source: Bloomberg/Smith & Williamson Investment Management LLP 28/05/2020

In summary, given the political uncertainty caused by Brexit, which is increasing the vulnerability of sterling, there is likely to be a continue weakening of cable, for now. However, over the long term, as the global economy reopens and if a satisfactory conclusion to the UK’s relationship with the EU is concluded, sterling may provide an attractive opportunity to foreign investors.

Sources:

1. Refinitiv Datastream, data as at 29/05/2020
2. The Economist, Big Mac Index, https://www.economist.com/news/2020/01/15/the-big-mac-index, as at 29/05/2020

DISCLAIMER
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of writing.

Please remember investment involves risk. The value of investments and the income from them can fall as well as rise and investors may not receive back the original amount invested. Past performance is not a guide to future performance.

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