By calling an election, Prime Minister Theresa May is seeking a strong mandate for both her domestic agenda and the Brexit negotiations. Domestic policy changes are likely to have minimal market impact as fiscal flexibility is limited, and the focus will centre on a balanced society and selective education. What investors will focus on are the implications for negotiations with the European Union, with the currency being the barometer along the way.
Sterling – the initial reaction
The initial reaction in sterling has been a rally of 1.2% against the euro and 2% against the US dollar as traders cover heavy short positions. The pound has now decisively broken out of the basing pattern against the US dollar that has been in place since October 2016 and the trade-weighted index has reversed the downtrend since the referendum. The negotiating flexibility provided by delaying the next election until 2022 and the significant prospect of a super majority lowers the odds of a poor deal in the exit negotiations. It minimises the tail risk of a hard Brexit and gives the Bank of England (BoE) more latitude to set monetary policy on the basis of the economy.
How will the currency stabilise?
After the initial short covering, it will be interesting to see where the currency stabilises. The exchange rate will provide an important reference point for the BoE to reconfigure its forecasts and projections for the economy. The base case for the currency would be a trading range between US$1.30 and US$1.35, which is still 10% below the range prior to the referendum last year but a significant improvement of the 15% fall we have seen recently. A move to a higher trading range will moderate inflation expectations at the bank but also limit expected improvements in trade and dent the increasingly important support of tourism in the economy. With the UK consumer already over-stretched both in terms of leverage to income ratios and net savings at a cycle low, tourist-driven consumption is becoming increasingly important in maintaining GDP momentum.
Despite the rash decision to cut rates last year, Mark Carney is not known for being a reactionary governor and it is highly unlikely he will want to be seen to be political by changing policy any time soon. As such, the prospect for considering an increase in interest rates will likely move out to the autumn at the earliest, while the forecasters wait for some stability post-election.
The knee-jerk reaction
UK equities have sold off nearly 3%, reflecting a knee-jerk reaction to the jump in sterling. If, as we believe, the bounce in the currency will be contained, UK equities should stabilise and the fundamental picture will come back into focus. Global growth is critical to a significant proportion of UK companies and the election will not change the fact that the cyclical momentum in Europe, Asia Pacific and the US is improving. However, sentiment will be volatile in the short term.
This article was previously published on Tilney prior to the launch of Evelyn Partners.