Unfortunately, no. We expect further weakness in the British pound as uncertainty over the economic impact of “Brexit” drives the currency toward GBP/USD 1.15, and an even larger decline cannot be ruled out. However, at such levels the near-term uncertainty should be priced in, and the pound will become range-bound and driven by the negotiations over trade and financial market access to the European Union, a process that has yet to begin in earnest.
We published a brief on the outlook for the pound in July, arguing the post-Brexit bounce would prove temporary as economic uncertainty over Brexit would re-emerge and drive the pound lower. This occurred in early October as UK prime minister Theresa May announced she would seek to invoke Article 50—the formal process by which an EU exit can begin—by the end of March 2017, and exit the EU by 2019. While the pound weakened on the news, the selling intensified on October 7 as comments from French President François Hollande that the EU should take a tough stance on the United Kingdom’s desire for a “hard Brexit” triggered a mini-panic.
The pound has tumbled to a 30-year low of $1.22 and is down 29% from its recent peak of $1.72 in 2014. While such a decline is large, it is in line with the median decline since 1971. Thus, the currency is not yet at an extreme level on either a momentum or valuation basis.
A move decisively below $1.20 should begin to tilt the risk-reward balance back toward pound upside, at least in the near term. But between now and March 2017 (let alone 2019), anything can happen. The Tories could be forced to back down, or go for a “soft Brexit,” if it becomes clear the economic costs are too high. Or the EU could cave, allowing the United Kingdom a quick and easy divorce. Or not, as the French and Germans could decide to make an example of the United Kingdom to keep other restless EU members in line. How Scotland reacts to the Brexit process is another political factor to consider.
Having conviction in any view is difficult, which is precisely why Brexit will hang over the pound throughout 2017. The more markets move in the near term to price in a negative outcome, the more pressure will be put on politicians to minimize such an outcome. All that can be said now is to expect a volatile pound.
More broadly, recent currency volatility has raised the issue of currency hedging. The fall in the pound highlights the importance of having some unhedged foreign currency exposure in portfolios, especially for a pro-cyclical currency like the pound. For GBP-based investors that are fully hedged, lowering currency hedges on any pound rally would seem prudent, although the more the pound falls in the near term, the more risk-reward moves back in favor of maintaining hedges.
In general, we think it is best for investors to develop a strategic currency policy before trying to make tactical calls on currencies, in light of the sharp reversals seen in many currency pairs this year. A strategic hedging policy (including the decision not to hedge) provides a framework to deal with rising currency volatility, instead of being whipsawed by it. For instance, while we expect continued USD strength amid rising political risk in Europe, it is late in the USD cycle, making renewed dollar weakness likely over the intermediate term given elevated valuations.
Timing the switch from USD strength to USD weakness, or GBP weakness to GBP strength, will not be easy. Finding the right balance of acceptable currency risk in portfolios is critical, particularly considering the prospect of rising political and economic uncertainty.
For more on developing a strategic hedging policy, see our report from earlier this year, Strategic Currency Hedging Policy: A New Framework.
Aaron Costello is a Managing Director on the Cambridge Associates Global Investment Research team.