Will sterling take a tumble?

Thought of the day

Sterling initially rallied by as much as 0.9% against the dollar on 4 December as hopes built that a deal had been reached with the EU on the Brexit “divorce bill.” These gains evaporated late in the day and sterling has fallen by a further 0.4% on 5 December after the Northern Ireland DUP party, the UK government’s minority partner, raised objections to proposals for the Irish border question.

Currency fluctuations have a big impact on UK stocks, as around three-quarters of FTSE 100 revenues come from overseas. But despite this renewed weakness on political uncertainty, we don’t believe sterling will depreciate further and hence don't expect a boost to stocks.

  • Sterling’s valuation is cheap. Compared with current values of GBPUSD around 1.34, we estimate a Purchasing Power Parity valuation of 1.59, while two-year swap interest rate differentials suggest a rate of 1.49.
  • Undervaluation can be justified by political risks, but we believe a compromise is the likely outcome with the DUP, which is unlikely to risk another election and the loss of its political power. This should allow a deal to be reached and for talks to progress to the next stage.
  • With unemployment low (4.3%) and inflation rising (3%) the Bank of England (BoE) recently raised rates for the first time in a decade. If politics don't escalate, we would expect the economy and the BoE to support a slightly stronger GBP.

So our three-month to 12-month forecast for GBPUSD is 1.36 and we expect UK equities to continue to underperform. Within Europe we prefer Eurozone equities to UK stocks.

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