UK investors concerned about a repeat of the post-referendum slump in sterling in the event of a ‘no deal’ Brexit may be worrying for no reason, according to Rathbones’ Ed Smith, who said it would take extreme action for the currency to devalue further.
Since the referendum result returned a win for the ‘Leave’ campaign, sterling has fallen against most of its peers as uncertainty over the nature of the post-Brexit relationship with the EU has spooked investors.
As the below chart shows, traditional safe-haven currencies such as the Swiss franc, euro, US dollar and Japanese yen have recorded double-digit rises compared with sterling value since June 2016.
Performance of euro, Swiss franc, US dollar and Japanese yen since 23 June 2016
Source: FE Analytics
However, Smith (pictured) – head of asset allocation research at Rathbones – said that sterling is undervalued and a ‘no deal’ Brexit has already been priced in. 
“Our analysis suggests that even in a 'no deal' Brexit scenario, the economic fundamentals of the UK economy which drive the exchange rate over the long term still suggest that the path of least resistance for sterling is one of appreciation,” he explained.
Rathbones' long-term view of currencies is driven by three key drivers: productivity, export/import prices and expected savings.
“And [even] if we make some really extreme assumptions about what might happen to those factors after a ‘no deal’ Brexit, we still can’t get the equilibrium exchange rate that those factors imply below today’s actual exchange rate when we look at most currency pairs,” said Smith.
The head of research added that only in extreme circumstances would sterling devalue further.
For example, if all the productivity gains that the UK has made since 1992 – which was the year the single market programme as we know it kicked off – were erased.
“That’s clearly, somewhat preposterous because those gains have been about things other than just UK trade with the EU,” he said.
“[Another extreme example would be] if the UK’s trading gains with emerging markets were all to be wiped out and the UK can’t find a trade deal with anyone.”
Another key driver of currencies is inflation, but here too there is not much sign of a threat to sterling.
Although some economists and analysts have highlighted the potential inflationary impact of renewed quantitative easing coupled with unprecedented levels of fiscal stimulus, Smith said the outlook remains more subdued.
“Our base case is for inflation to remain low for the foreseeable future,” he said. “The history of epidemics and pandemics suggests that there are more shocks to demand than there are shocks to supply.”
As such, periods of pandemics or epidemics tend to be deflationary, as has been seen in places such as China, which was the first major economy to feel the impact of the coronavirus.
There are also longstanding reasons why the outlook for inflation looks challenged, with Smith highlighting the deflationary impact of new technologies and quantitative easing.
“Look at the last 10 years, for example. Lots of people suggested that the printing of money when quantitative easing first came on the scene was going to lead to sky-high inflation,” he said. “In fact, if you look at inflation in most developed markets over the past 10 years, it’s dropped close to the 2 per cent target.
“And that’s because of all sorts of factors that have cancelled out the impact of an increase in central bank money or what we refer to as ‘the velocity of money’ – the rate at which money is spent and spent again in the economy.”
And the so-called ‘velocity of money’ is likely to come under pressure over the next year or so, said Smith, as companies are forced to repay emergency loans that were designed to plug holes in revenue streams and businesses and households hoard cash to stave off any concerns over the recession.
In addition, there will be some long-term disinflationary impacts of the coronavirus such as the increased digitalisation of the economy as new norms established during the lockdown period continue, and declining demand for commercial real estate as working from home becomes more mainstream.
A recent report by the Bank of America suggested that sterling had become more like a liquid emerging market currency than one of a G10 – the group of the 10 largest economies – country, given the high levels of volatility, largely fuelled by Brexit uncertainty.
However, other investors have pointed out that while sterling may behave like an emerging market currency, the UK is not an emerging market and sterling still has reserve currency status.
And even if sterling were to lose its reserve currency status with the International Monetary Fund (IMF), it would not likely see a great devaluation, said Smith.
“The UK isn’t really much of a reserve currency in the IMF basket, it accounts for 5 per cent of global reserves,” he explained. “Whereas the US dollar accounts for 60 per cent of reserve assets and the euro is somewhere between 20 to 25 per cent of assets. So, it’s not a major safe haven.”
If a ‘no deal’ Brexit is unlikely to impact sterling, what of UK equities that have also been hamstrung by the uncertainty and lagged their international peers?
Smith said UK equities haven’t looked as cheap relative to global equities since the 1970s when the UK was “the Greece of the world, going cap in hand to the IMF for a bailout”.
“A huge valuation gap started to open up in 2016, which led a lot of people to think that maybe this is an unfair reaction to Brexit,” he said. “Global investors were just shunning UK assets even though most companies made their money abroad and had little to do with the UK government’s trading relationship with Europe.
“They haven’t wanted to add that headache to the portfolio in an already uncertain world.”
Performance of indices since 23 June 2016
Source: FE Analytics
Not all of the change in sentiment can be attributed to Brexit, however, with Smith highlighting the sectoral composition of the UK equity market, which has higher weightings in areas such as banks and energy which have seen profitability constrained by regulation and decarbonisation trends over the past 10 years.
As such, the asset allocation specialist said he wasn’t convinced that the 40-year valuation gap is starting to close.
“There are still lots of question marks over Brexit,” he said. “Even if we do manage to sign a bare-bones free trade agreement in goods, there are all sorts of agreements to be made on the services sector which will drag on into 2021.
“I still think from an international investor's point of view there are plenty of headaches there they might not want to deal with.”