Sterling and the Johnson effect

25 July 2019

6 minute read

Whenever a new political leader is elected, or selected, it inevitably impacts the currency. Add to this the complications of Brexit, and the increased probability of a no-deal outcome with Prime Minister (PM) Boris Johnson, and it is no surprise that sterling remains a key topic of conversation.

As we mentioned in Markets Weekly two weeks ago, the pound (GBP) had reached a more than two-year low against the dollar (USD) at 1.2382, off the back of continuing uncertainty on the UK’s future trading relationship with the European Union (EU). While the currency had since improved a touch, Mr Johnson’s selection this week has done little to assuage no-deal fears, with sterling moving back into the 1.2444 territory on the day of his appointment.

Foreign exchange markets justifiably do not like uncertainty. The end result is volatility, with three-month volatility in GBP at its highest levels since April.

GBP volatility largely driven by uncertainty

Brexit uncertainty far from over

From a political standpoint, the game is far from over. Clarity over Brexit and the PM’s strategy remains poor.

On the one hand, there is speculation that the PM plans to spend the summer preparing the country for no Brexit deal, including public campaigns and funding initiatives. However, parliament would likely block that outcome from happening through a no-confidence vote, probably triggering a general election.

On the other hand, the PM is likely to meet key European leaders who, while backing the Brussels mantra of “There can be no changes to the Withdrawal Agreement”, will listen to what Mr Johnson has to say.

It is difficult to envisage large-scale changes to the agreement being made. There could, however, be movement around a time-limit to the Irish “backstop”; a separate deal on citizens’ rights and moves to focus on the future relationship between the UK and EU.

Brexit purgatory

In light of small changes from the initial agreement, the PM could find himself in a similar position to that which his predecessor faced, with a deal that suits Brexit moderates but still fails to get a parliamentary majority. The added penalty of such a strategy could be the isolating of the hard-line Brexiteers that make up the PM’s cabinet and selected Mr Johnson in the first instance.

Both scenarios above appear to highlight one clear message: the complete instability of UK politics makes a general election the most likely outcome in coming months despite there being little appetite for it in neither parliament, nor the country more widely.

Implications for investors

With the politics remaining as ambiguous as ever and the GBP likely to continue to trade on politics, it is our view that volatility in sterling will continue. The volatility will be primarily driven by a period where no clear and tangible solution to Brexit presents itself. As parliament enters its summer recess, the bulk of the move in GBP and volatility will likely occur on politicians return in early-September through to mid-October.

Uncertainty makes investing particularly difficult due to the fact that two-way risks will remain. Investors may look at the recent weakness in GBP and the perceived volatility and ask does GBP look attractive from a long-term valuation standpoint?

Our answer is that while GBP has fallen by around 5% against the dollar since early May, and there will likely be a day when it poses an attractive entry point, political and business instability will continue to cap any potential upside for now. So long as this remains, investors should position themselves to withstand, or bet on, elevated GBP volatility.

GBP not yet compensating for political complexities

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