UK Sterling: Pounded! What’s Next?

11 October 2019

Understandably, perhaps, Brexit fatigue is widespread. However, the issues at stake are far too important to allow the outcome to be decided simply because of weariness. Not only are the economic implications significant, but the result will define the relationship between the UK executive government, the Parliament, the courts, and the electorate for decades to come. Whatever the result, the public is likely to remain divided, and the politcal landscape could be completely redefined, as the fate of the major political parties may be in doubt.

Weariness and complacency, however, are not options for investors! The range of Brexit permutations remains numerous. However, after a pessimistic start to this week (including a reportedly downbeat conversation between UK Prime Minister Boris Johnson and German Chancellor Angela Merkel), the week is ending with Irish Prime Minister Varadkar optimistically suggesting a “pathway” to a deal may have been found. Until details emerge, however, it is hard to assess the likelihood of any compromise being accepted by the UK Parliament (especially if the UK needed to give considerable ground on the Irish customs backstop issue).

During the past three years of uncertainty, the UK sterling exchange rate, unsurprisingly, has been pounded! Equally predictably, the pound has bounced on the news of possible Brexit breakthrough. How durable with this rally be? Alternatively, what would be the consequences of a No-Deal Brexit — the market’s base case scenario until 48 hours ago? The Chart provides important clues about how the exchange rate has reacted to previous large economic shocks . In particular, sterling became significantly undervalued during the Global Financial Crisis. The exchange rate only rebounded after the UK government implemented aggressive monetary and fiscal policies addressing the causes and consequences of the Crisis, and the economy recovered. Eventually, the pound appreciated towards its long-term average rate.

In the period ahead, likewise, sterling will be influenced by several key factors, in addition to the outcome of the Brexit negotiations. In particular, the currency’s value will be driven by the monetary and fiscal policies UK authourities pursue to address current economic weakness. As in the previous currency crises, the medium-term FX outlook will also be influenced by the UK government’s success in remedying the economy’s chronic shortcomings. Ironically, perhaps, while these deficiencies contributed to the UK’s decision to leave the European Union, Brexit will not resolve these problems, but is likely to make them far worse.

Recent travels to the USA and Europe lead me to believe sterling is undervalued. But, by how much? The Chart suggests the exchange rate is now 15% below the long-term average. However, perhaps the GFC has lowered the pound’s equilbrium value, e.g. note the green line reflecting the lower LT average since the GFC. In that case, sterling is not undervalued, and the additional economic shock of a No-Deal Brexit could lead to additional sterling depreciation.

Project Fear?: Just the Facts

In the Brexit debate, expert opinion has been discounted, especially as the pre-referendum dire economic projections did not materialise. Now, however, nearly 4 years have passed since the Brexit process was set in motion. To be sure, the UK economy has not collapsed. However, the Chart illustrates the UK has lagged the EU-27 countries by roughly 2% during this interval.

Indeed, the underperformance has occurred despite UK household spending outpacing Europe, even while UK real disposable incomes declined following the post-referendum sterling devaluation. It seems, the UK consumer has believed the hit to incomes and the Brexit uncertainty would be short-lived. In response, British households dipped into savings to maintain spending. As a result, the Chart below illustrates the savings rate reached a record low in 2017. Fortunately, real incomes are now rising at a healthy 2.5% clip. But, it is now dawning on consumers that Brexit uncertainty will continue, and the savings rate is now rising. After living on borrowed time, UK households will continue to boost savings. Consequently, I expect the UK consumer will be a headwind for the overall economy for the next few years.

What is more worrisome has been the weakness in UK capital spending in recent years. To be sure, business investment also has not collapsed, as the business sector has adopted a wait-and-see approach to the Brexit saga. Nevertheless, capital outlays have expanded only 1.5% during the past 3 years, while European investment has risen over 10% (see earlier Chart). Brexiteers suggest, hopefully, UK investment will rebound after uncertainty diminishes. I suspect, however, Brexit will cause both UK and foreign investors to reconsider their future options.

Likewise, exports have failed to benefit much from sterling’s devaluation. During the past three years UK sales abroad have risen 7%, or about half the pace of EU-27 export volumes. The Chart above illustrates the link between FX movements and UK trade has diminished. One explanation is that the development of pan-European supply chains have reduced the responsiveness of UK maunfacturers to currency flucuations. To be sure, disrupting these supply links will create additional challenges post-Brexit.

Productivity Puzzle: Brexit Not the Solution

To be sure, Brexit had many causes. However, the only modest improvements in living standards and real incomes over many years, especially in post-industrial regions of the country, played a huge role. In addition, the ensuing rise in income inequality highlighted the gains from globalisation and deregulation were not widely shared (and that politicians were not taking the greviances of the disaffected seriously enough). Moreover, the pain caused by fiscal auterity following the GFC added to the sense of grievance.

To paraphrase Paul Krugman, productivity may not be everything, but in the long-run it pretty much is! Real incomes can sustainably rise only in line with labour productivity gains. The Chart above illustrates the UK’s productivity puzzle. That is, UK efficiency lags far behind that of key trading partners. Indeed, this may explain the recent weak export performance.

The Chart above illustrates the situation has become even more complicated recently, as efficiency gains have slowed considerably following the GFC (a pattern seen in most advanced economies). Indeed, productivity has been actually declining during the past two years.

Of course, membership in the European Union is not the source of this problem. Leaving the EU, however, will almost certainly make it worse. Inevitably, weak business investment and greater trade protectionism will harm competitiveness. The combination of weak capex and poor productivity may lower the UK’s long-term potential growth rate by up to 0.5% anually. The problem — and solution — lies elsewhere. As I will discuss in the next section, educational reform will be a key crucial to boosting productivity, lifting incomes, and reducing inequality (investment in upgraded infrastructure certainly would not hurt either!).

Immigration: The Brexit Bogeyman

The emotive immigration issue, however, was perhaps the most important factor in Brexit referendum outcome. To be sure, public frustration grew as UK policymakers did not take seriously enough warnings that increased migration was putting pressure on vital public services.

Economists are simple people, and we calculate a country’s long-term GDP growth potential as the sum of productivity growth, capex, and labour supply. I have already discussed, the shadow Brexit casts on the investment and efficiency outlook. The Chart above illustrates the vital role immigration has played in boosting labour supply and offsetting negative demographic trends in most western economies. Likewise, the UK has benefited significatly from migration. Moreover, fortunately, UK demographics are more favourable than many European countries where the population has been declining during the past 5 years, e.g. Germany, Italy, Iberia, and central Europe.

Of course, immigration could be considered problematic if local workers were being displaced. Fortunately, the Chart above debunks this myth. During the past two decades, the employment rate within the native-born population has been rising, not falling. The alternative notion that migrants arrive to take advantage of generous unemployment benefits is also unsupported, as the foreign-born employment rate has risen and is similar to the native workforce (indeed, female Muslim immigrants depress the foreign-born employment rate). There is also scant evidence that immigration depresses local wages.

The Chart above illustrates the vital link between the immigration debate and educational reform. First of all, it is worth noting that the level of educational achievement of UK immigrants is superior to that of other countries. Indeed, over half of UK immigrants have a university education compared to 40% in the USA, 25% in France, and 10% in Italy. At the other extreme, the share of poorly educative native-born workers is higher in the UK than in the USA, Germany, and France. This segment of the UK population — not university educated or vocationally trained — confronts the most intense competition from an immigrant community, which is usually better educated.

As a result, the employment rate amongst the poorly-educated UK population is lower compared to the foreign-born workers (see Chart above). One possible explanation, of course, is that immigrants are willing to fill low-paying jobs local workers will not take. However, the Chart also shows the UK employment rate is similar for well-educated workers, regardless of their place of birth. The lesson is that education matters: local UK workers can compete if they possess the required skills and training. The Chart illustrates a similar pattern in all other advanced economies.

The policy implications are clear. Immigration is a benefit, as it offsets demographic pressures by boosting labour supply. However, migration imposes special pressure on poorly-trained, native-born workers. Therefore, educational reform, especially focused on low-income groups, is a vital ingredient in lifting productivity and incomes, as well as reducing inequality. However, the Chart illustrates EU immigration (and overall inflows) have declined since the referendum with negative consequences for labour supply and long-term GDP growth potential.

Strategic Implications

  • The UK economy will slip into recession in 2020.
  • As has occurred during the past 3 years, the corrosive impact of Brexit on investment, immigration, and productivity will lower the UK’s long-term GDP growth potential 0.5% annually. The UK will underperform the EU-27 nations. I worry more about this than I do about the short-term shock of a No-Deal Brexit. As is now the case, the consequences may not be apparent immediately, but over a generation the economy may be 10% smaller than it otherwise would have been.
  • The Bank of England is ready to cut interest rates. I expect base rates will decline 25 to 75bp during the next year, depending on the outcome of Brexit negotiations during the next 3 months.
  • Fiscal policy become expansive. I am encouraged by the focus on education and infrastructure spending.
  • Sterling is undervalued. In the case of a No-Deal outcome, sterling would decline to USD 1.11 and Euro 1.05. On the other hand, I estimate the pound’s underlying value at roughly USD 1.45 and Euro 1.20. If a negotiated deal to leave the EU is reached, and subsequent talks about the future UK-EU trading relationship proceeded more smoothly (a big if, as these negotiations will be even trickier), sterling could approach these levels over the next 2 to 3 years. Probably worth careful consideration at this stage.