A Contrarian View On GBP

by: Prodipta Ghosh

Originally published on April 7, 2016

During 2009, as the first signs of stability set in following the market crash the year before, there were two major macro themes doing the rounds. One was in rates. The idea was an unexpected comeback of inflation following the QE by Federal Reserve. Although hyperinflation and debasement of dollar were fringe ideas, a lot many asset managers and hedge funds were buying CMS caps. The other one was in FX, touted as the GBP/EUR parity trade. It was equally popular, following the QE unleashed by the Bank of England, as Europe apparently remained much less affected by the financial meltdown.

Of course, both of them failed spectacularly. Almost a decade after, it is deflation and disinflation that investors are worrying about instead. And propelled by the European Sovereign Debt Crisis, among other drivers, the British pound had its best run against euro since the beginning of the currency union. The original QE by Bank of England now stands dwarfed by the European version.

And somehow, now the parity trade is gaining favor again. The market is quite concerned about the British pound. There is a chance of a Brexit on the horizon, of course. And even disregarding that, some predict a serious downside to the GBP in any case, pointing at the recent current account data released by the Office of National Statistics last week. This was the high deficit in record, as noted by ONS.

But the devil is in the details, as always. Here is a detailed break-up of what is driving this record current account deficit and how this is getting financed.

It is clear that while trade deficit is a large negative number indeed, it is not the main culprit. In fact, the trade deficit has stabilized, and the long-term trend is in fact marginally upward. It is the massive collapse in the net income component of the current account that has been instrumental in pushing the current account deficit to this record number. The net income component in the current account consists of net earnings from foreign investments (like profits from overseas companies, and dividend and interests from loans and marketable securities). This collapse of investment income is highly correlated to the UK's outstanding direct investment position, as shown below. The story here is: the trade deficit is being funded mostly by direct inward investments. As a result, more foreigners are pouring money in than residents are investing abroad. This has resulted in shrinking investment income, putting further pressure on the headline current account figure. Interestingly, almost all the trade deficit of UK is from its trading relationship with the European Union. The trade balance with the rest of the world is, in fact, positive (goods and services together).

The question is: is this something investors should worry about? In general, a deficit in the current account is negative for the risk perception of the currency (if floating) or the economy (if it is a pegged regime). However, funding the current account with direct investment (which tends to be stable) and not with portfolio investment (aka "hot money") is much better than other options. Unfortunately, this has become a double whammy for a country that depends on investment income to a large extent to balance its current account. As explained above, this very nature of funding the current account with inward investment has led to increasing current account deficit itself. Given the stable nature of the funding, this is no immediate risk. Bank of England seems to have similar view (also see the latest report). It further notes the resilience of the UK's external balance sheet.

Looking closely at the net income highlights two more points. Firstly, looking at the spikes in the net income, we can also conjecture that the net asset position for the UK is long risk assets (potentially, UK residents hold more risky assets abroad than foreigners hold in the UK). Secondly, to the extend that net income has exposure to fixed income, we should naturally expect this to shrink. UK nominal yields are much higher compared to those of much of the developed world, and more so across the channel.

This sets the stage for the guesswork on what to expect out of the currency in this context. Most fundamental estimates for the GBP value it (against the USD) at around the fair mark after the recent sell-off. But most fundamental valuation methodologies are rather lines in sand. And more so for the GBP. These valuations are usually based on trade balance, through some form of purchase power parity. As we have seen from above, UK current account balance, and hence the fundamental valuation of the currency itself, in the foreseeable future will be dominated by net interest income. This means it will be vulnerable to further deterioration in the eurozone economy and a general sell-off in risk assets. On the other hand, any pick-up in the hawkishness of the Bank of England will be a natural booster. In a complete risk-off scenario, with major trouble in Chinese economy or a real estate crash in the UK or something similar that can stymie the inward investment flows, we may have large downside risk for the GBP. Otherwise, the risks are pretty balanced as off now.

And given this, it appears a large sell-off expectation in Brexit is somewhat misplaced. We do not have finer details about the inward direct investment flows, like country of origin, etc. But if it is not from Europe, it is not likely to to be impacted to a great extent. Also, a marginal devaluation of the GBP is positive for UK equities, hence we probably will not see a large portfolio outflow either. On the trade balance side, a breakaway from the EU may actually work to balance the trade deficit with the EU partners. And as noted above, UK's external balance sheet is quite resilient. Overall, barring investor sentiments or panics, there is no super-strong justification for a large sell-off in the GBP.

But the market pricing in USD/GBP volatility and skew is quite different from this conjecture. As explained here, perhaps the investors are overestimating the probabilities of a leave vote. And even if it is not the case, it appears the sell-off that is priced in is not fundamentally well supported. Market positioning-wise, speculators are most short since start of 2015 (as from the CFTC Commitments of Traders reports). Maybe it makes sense to go contrarian here and position for a GBP rally after the Brexit.

All data in the figures are from the Office of National Statistics and Bloomberg.