- British pound now the second-worst major currency (AUD takes the crown this year)
- UK inflation past its peak, while UK growth outlook now improving
- Despite improving data, pound to weaken further as safe havens shine
In our previous piece on pound sterling, we wrote that the currency was likely to weaken thanks to (1) slowing growth across Europe, (2) excessively bullish speculator sentiment and (3) Brexit-related woes. Thanks to the UK’s significant trading ties with the EU, we wrote that the pound was unlikely to escape a slowdown across the region. Furthermore, speculator positioning in the pound looked excessive at the time, exacerbating any potential downturn.
Following the publication of our last commentary, the pound has fallen by almost 6% against the US dollar. Specifically, GBP/USD was trading at 1.3550 on May 7 and traded as low as 1.2740 on August 20. While the pound’s performance against the US dollar (-5.5% year-to-date) is nothing to celebrate, the Australian dollar (-6.4%) has fared even worse. While we expect the pound to weaken further (especially against safe haven currencies such as the US dollar), there are some hopeful signs for the future.
Inflation set to weaken as base effects catch up
Following the Brexit referendum vote, pound sterling fell sharply against its major peers. In turn, this led to a significant acceleration in inflation as the price of imported products (such as commodities) surged when priced in pounds. Going forward, we argue that UK inflation is past its peak and is more likely to decelerate over the coming months. An overview of historical UK headline inflation is shown below:
Inflation: tough comparables
As can be seen above, UK inflation rose sharply in 2017 in response to a weaker pound. Thanks to rising prices of imported products, headline inflation peaked at 3.1% in late 2017 (indicated in red above). The GBP/USD exchange rate is inversed and shown with a 7-month lag for effect.
Going forward, we see three drivers for weaker UK inflation. Firstly, the arithmetic behind accelerating inflation is becoming more challenging. Thanks to steepening base effects, year-over-year inflation is likely to keep slowing as the toughest comparables from late 2017 are directly ahead. Secondly, a weak pound is less of a factor today (as shown on the graph), despite recent weakness. Lastly, commodity price growth (the main historical driver for UK inflation) has run out of steam with crude oil now in a bearish trend.
As UK inflation decelerates, the odds of further rate hikes is likely to fall accordingly. In turn, falling monetary policy expectations are likely to weigh on the pound. This may explain the market’s reaction to the Bank of England’s last rate hike on August 2. Despite all nine members of the Monetary Policy Committee voting for the hike, as well as fairly upbeat guidance, the pound ended the day lower. The message from currency markets is that slowing inflation is likely to tie the BoE’s hands for the foreseeable future.
While not exciting, UK growth outlook is improving
Looking at UK economic growth, the UK mostly missed out on last year’s rebound thanks to Brexit-induced economic pain. Year-over-year growth in the Eurozone accelerated from 2.1% in the first quarter of 2017 to 2.8% in the fourth quarter of 2017. On the other hand, year-over-year UK growth moved in the opposite direction and decelerated from 1.8% in the first quarter to 1.3% in the final quarter of 2017. Recent UK economic growth trends are shown below for reference:
Economic growth: supportive comparables
As can be seen above, year-over-year UK GDP growth decelerated from 3%+ in 2014 down to 1.3% in the second quarter of this year. Meanwhile, forward-looking measures (such as services PMIs –surveys of the UK’s professional services sector) have held up reasonably well. The services PMI shown in the figure above has been smoothed using a 3-month moving average. While PMIs deteriorated sharply following Brexit, the figures are now pointing to continued growth in the UK’s services sector. PMIs above 50 indicate a future expansion, while any figures below 50 suggest a contraction.
More importantly, economic growth data and sentiment data have diverged significantly. Year-over-year real GDP growth has been weighed down by both steep base effects and high inflation in recent history. Going forward, base effects are increasingly supportive while forward-looking indicators point to an ongoing expansion. Following four years of decelerating growth, the UK’s economy may be about to turn a corner.
The US dollar lurks in the background
As inflation falls while the outlook for growth improves, the picture from British economic data is mixed. While rising growth will drive rate hike expectations, the opposite is true for decelerating inflation. Beyond domestic developments, we argue that the pound is likely to remain out of favor thanks to our bullish outlook for the US dollar.
Over the past few months, the US dollar has strengthened thanks to accelerating US growth and inflation. As the US Federal Reserve has raised rates (and signaled more rate hikes), the US dollar has outperformed all of its major peers this year. Going forward, US economic growth looks set to slow, joining the rest of the world. As a safe haven currency, a global downturn is the best possible environment for the US dollar. Recent trends in US growth and inflation are shown below:
US growth and inflation at a (rate-of-change) peak
Similar to our process for assessing UK growth and inflation, we look at comparative base effects when analyzing US economic data. As can be seen above, both US inflation and growth are about to encounter particularly tough comparables (looking at this time last year). As drivers for inflation (mainly commodity prices) and growth (retail sales, sentiment data, etc.) run out of steam, the US economy looks set to enter a downturn.
During a global downturn, safe havens shine while ‘risk on’ currencies weaken. As a result, the pound is more likely to weaken despite a relatively positive outlook for growth. While the pound may outperform its ‘risk on’ peers (such as the Australian dollar, and perhaps the euro in the near future), it’s too early to call a bottom for pairs such as GBP/USD or GBP/JPY.
British pound no longer in firing line, but not a buy yet
The British pound has spent the last two years at the bottom of its class. Following the Brexit vote and significant economic pain, the pound has trailed its ‘risk on’ peers by a large margin. This year, the pound is no longer the worst major ‘risk on’ currency (that award goes to the Australian dollar). This being said, it’s still too early to get excited about the pound as economic conditions point to a global downturn. Given today’s environment, safe haven currencies such as the US dollar are a safer bet.
Once global economic conditions turn a corner at some point in the future, the pound will shine once again.