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British Pound to Remain Volatile as the World Adjusts to the Realities of Brexit

British Pound to Remain Volatile as the World Adjusts to the Realities of Brexit

2016-06-24 21:22:00
James Stanley, Strategist
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British Pound to Remain Volatile as the World Adjusts to the Realities of Brexit

Fundamental Forecast for GBP: Bearish

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The world received a lightning bolt of a shock last night as it was announced that British voters have decided to leave the European Union, and the near-term impact thus far has been profound. Global markets put in aggressive risk-off moves as Gold prices drove higher in the midst of the deepest decline in the British Pound in over 30 years. But just because we’ve seen the final vote counted and the Brexit referendum is over, it doesn’t mean that investors can begin to get comfortable yet; this is where the proverbial rubber begins to meet the road.

The process of disintegration between the U.K. and the European Union can take up to two years as specified by Article 50 of the Lisbon Treaty. And even then, that two year window can be delayed if agreed upon by both parties, so we’re likely very far from seeing what a final resolution might look like. This slow-grinding process can produce considerable volatility across markets as the world receives more clarity on what a post-EU U.K. just might look like.

Next Legal Steps

The next legal step in this process is to formally trigger Article 50 of the Lisbon Treaty in order to begin negotiations with EU leadership on the topic of disintegration. Prime Minister David Cameron announced his resignation this morning, saying ‘fresh leadership’ was going to be needed to guide the U.K. in this new direction, with the expectation of leaving office by October of this year. Prime Minister Cameron also said that negotiations with the EU will not begin until new leadership takes over, so there is a large amount of uncertainty here because we don’t even know who might be running the U.K. as these discussions begin, much less ‘when’ this process might start.

There is an EU Summit on Tuesday and Wednesday of next week, and this is where we’ll likely see European leadership beginning to plan their response to Brexit. It’s widely expected that many EU leaders will spend much of the weekend scrambling ahead of this upcoming summit to address a number of issues, including the rising sentiment of nationalism being seen in many other European countries now looking to host their own in/out referendums. The remaining 27 nations within the EU will draw up a list of issues that each consider to be non-negotiable, or ‘red lines’ that need to be taken into account in this new relationship between Europe and the U.K.

Political Juxtaposition

While the referendum garnered considerable media attention and market interest, technically it isn’t legally binding. Prime Minister Cameron doesn’t have to respond to it, nor does he need to formally trigger Article 50 of the Lisbon Treaty to begin succession dialogs. But the entire topic of the referendum came in response to a rising political challenge in the United Kingdom. Facing the increasing popularity of UKIP (United Kingdom Independence Party) in 2013, Mr. Cameron pledged that, should his Conservative party take a majority in Parliament the U.K. government would negotiate a more favorable agreement with the EU before holding an in/out referendum. This led to the European Union Referendum Act 2015, which defined the process by which this would take place; mandating that the referendum would be held no later than 31 December, 2017.

The negotiations for more favorable terms with the European Union ended on the evening of February 19th, and there were numerous areas of focus during those discussions; key of which was the topic of immigration. Upon the conclusion of these discussions, a date of June 23rd was announced for the referendum and Prime Minster Cameron allowed Members of Parliament to freely campaign for whichever side of the referendum they desired; and for the following four months a vigorous debate ensued.

Many public voices weighed-in against the prospect of the ‘leave’ side of the campaign. BOE Governor Mark Carney provided numerous warnings, going so far as to say that a decision to Brexit would bring on higher inflation, higher unemployment, slower growth and a sharp re-pricing in the value of the British Pound. This would put the Bank of England in the very difficult position of having to choose whether to mold rate policy towards either moderating inflation (at the risk of even deeper unemployment) or boosting growth and employment (which could increase inflation even more). This stern admonishment towards the leave camp even received an element of reprimand from members of British Parliament for the Central Bank taking a concerted stance in the widely-followed political debate.

This vigorous debate created factions within the British population that will likely continue to exist as the U.K. awaits the appointment of their next Prime Minister. The divisive debate over Brexit is not likely to recede anytime soon as a wide swath of the British citizenship laments the decision to divorce from the EU.

Risk Bearing

This brings us to the crux of the issue: Nobody quite knows how the next two years, or even two months or two weeks are going to pan-out from here. The U.K. has been a part of Europe since 1973 and the past four decades have produced a litany of legislative efforts and trade deals that now need to be unwound. How will they be unwound, what will they be replaced with, and how will each the U.K. and the EU respond? Even the questions here have their own questions, and that is brutal uncertainty that capital markets generally abhor. There simply aren’t any comparable historical models with which markets can compare this to. We’re in uncharted territory here.

The big worry for the global economy is the impact to an already fragile European economy as the EU loses their second largest national economy and second largest military. In the aftermath of Brexit, the FTSE100 out of the U.K. posted a -3.2% loss on the day. But the IBEX in Spain was down by -12.4%, the MIB Borsa Italiana in Italy was down by -12.5%, and ASE out of Greece was down by -13.4%; so despite the fact that the U.K. was very much the focus around the Brexit referendum, it could be reasonably stated that economies in mainland Europe may have more to lose.

But none of this is certain yet; and very little else is. The one thing we know is that a majority of British voters want to leave Europe, and now the world needs to wait for the political machinations to make that happen. In the meantime, we’re likely going to be facing considerable uncertainty: Around the future of the U.K., the future and sustainability of Europe without the U.K., and how an already fragile global economy might forge ahead in the face of these newfound risks.

For that reason we’re shifting to a bearish forecast on the British Pound for the week ahead as markets wrestle with the prospect of what a post-EU U.K. might actually look like. Uncertainty is expected to reign supreme, and this is something that investors will generally respond to by simply avoiding risk.

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