The second full European trading session following Thursday’s Referendum vote saw a further intensification of financial market volatility yesterday. Sterling lurched lower still, making new post-vote lows against both the euro – at 83.9p – and the dollar at $1.3120 – the latter representing the lowest levels of GBP/USD seen since late 1985. The pound has drifted higher from these lows in overnight trading in Asia and early trading this morning, resulting in opening levels of around 83p and $1.3340.
To an extent, this price action is not dissimilar to that which emerged on Friday morning after Thursday’s overnight collapse. But just as we did then, we caution against taking much comfort from these relatively minor upticks in sterling’s value. The key point is that the UK economy and related asset markets have been hit by a major negative shock the implications of which will take considerable time to tease out, work through and ultimately resolve. While full and complete detail on the end-game of the fall out of the Referendum is not required for markets to sustainably stabilise and begin to put this shock behind them, some level of additional clarity on the way forward and the associated parameters (e.g. timelines and possible broad outline of any UK-EU deal) likely is. And the difficulty here is that the whole situation is subject to extremely high levels of uncertainty, not just linked to the economics of Brexit but also to politics both within the UK (where, for the first time ever, the leadership of both of the main UK parties is simultaneously in doubt, for example) and in the EU which itself faces important challenges relating to popular support for ‘project Europe’. Indeed, the process governing UK withdrawal has yet to be invoked, with the so-called Article 50 protocol not likely to be triggered until a new PM is in place, possibly by early September. German chancellor Angela Merkel, French President François Hollande and Italy’s PM Matteo Renzi decided against pressing the UK into a rapid start to its negotiations, but insisted that the EU will not hold informal talks with the UK until it triggers Article 50 to leave. The same three leaders pledged to set new policy priorities for the EU by September and implement projects to increase economic growth and security in a bid to prop up flagging popular support for the bloc after the UK voted to leave.
So notwithstanding some tentative signs of stabilisation in sterling’s value, and indeed in markets more generally (European stock markets are opening in positive territory following further heavy losses yesterday – especially in financial stocks), we continue to emphasise that the very large-scale uncertainty which defines the post-Referendum landscape is likely to continue to be associated with high levels of market volatility for some time to come. Indeed, such considerations have informed the decision by two ratings agencies to downgrade their UK sovereign ratings, with S&P stripping the UK of its last remaining top-notch rating, dropping it by two notches from AAA to AA. The agency warned that more downgrades could follow, arguing that “in our opinion this (referendum) outcome is a seminal event, and will lead to a less predictable, stable and effective policy framework in the UK”. In relation to sterling’s outlook on the currency markets in particular, we continue to think that the balance of risks is skewed strongly towards further weakness for the UK unit in the weeks ahead. In our view this could see Eur/GBP head to 85p or higher, and GBP/USD to possibly as low as $1.25-1.30, with this outlook implying downside for Eur/USD which we wouldn’t be surprised to see trading at $1.08 in the weeks ahead, from this morning’s opening level of $1.1070. Sterling’s relatively larger prospective losses vs. the dollar in this scenario would in our view be linked to the US’s relative remove from the economic fallout and also the dollar’s allure in times of global uncertainty and risk aversion.