3 Reasons To Buy The Pound As Brexit Comes To A Head

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Includes: DEUR, DGBP, DRR, ERO, EUFX, EUO, FXB, FXE, GBB, UEUR, UGBP, ULE, URR
by: Mayer Winkler
Summary

Britain does not have to do deal with pesky sovereign debt loads in the Eurozone.

The Bank of England has a war chest of foreign exchange reserves rivaling the EU and US combined.

Brexit could still be cancelled, pending a likely general election in Britain in mid-October.

The Brexit story just keeps getting wilder and wilder by the day. Ever wilder political developments keep crossing the wire seemingly every few minutes now, with every piece of news rocking the British pound sterling. This month has finally seen the currency break down below the post 2016 Brexit referendum lows at $1.21 to new all-time lows at $1.19. Just to give a bit of perspective on the amplitude of this move, sterling was as high as $2.11 just prior to the last financial crisis. That constitutes a massive 44% move between two of the world's most liquid currencies, even considering a relatively long span of 12 years. How much lower can sterling really go?

Chart Data by YCharts

Obviously, the reason to sell the pound at this point is the consequences of a hard no-deal Brexit. Tariff walls between the European Union and the UK could go up, restricting trade and damaging the currency on forex markets. That much is certainly understandable. But there is a contrarian argument to be made here for going long the pound, one ETF option being FXB, despite the obvious risks, based on the following three points.

#1 - Sovereign Debt Loads

True, a hard Brexit that leads to tariffs between the UK and the EU would certainly hurt the pound in real terms all else being equal, but it would also hurt the euro as well in real terms. Reduction of trade between countries tends to raise prices across borders, weakening both currencies. The question for the pound specifically is which currency will be hurt more? Since the balance is 27 EU countries versus only a single UK, claiming that the UK would be hurt more makes sense on the surface at least, and therefore the argument that the pound would suffer more seems to hold water.

However, consider sovereign debt loads. The UK has a debt to GDP level of 84.7% currently. That of the euro area is slightly higher at 85.1%, so at first glance, this seems equally weighted, giving the advantage to euro. However, take Italy for example. That country is the second most indebted nation in the Eurozone behind Greece. This is old news certainly, but what's new is that Italy now has a new government that, according to Bloomberg, is on a collision course with the European Commission on its 2020 budget set for this month, just prior to Brexit. Here's Bloomberg:

To avoid disciplinary action by the Commission, Rome agreed to keep this year's budget shortfall at 2%, but the confrontation with Brussels is expected to be reignited when talks about the 2020 budget start in earnest in September.

The main issue is Italy's threat to issue a parallel domestic currency in the event that its 2020 budget is rejected by Brussels. The Financial Times reported on this just last month. If executed, Italy could be ejected from the Euro and the remaining Eurozone countries and their banks would have to foot the Italian bill. The stress on the Euro in that case could be heavy, pushing the pound higher despite, or perhaps even thanks to, Brexit. The UK would not have to deal with any of this directly if it's out of the EU at that time. It could also make the EU desperate for a trade deal with the UK post Brexit in order to alleviate some of the pressure. If a deal is eventually reached, sterling would rally.

Let's not forget Greece as well, which, despite consistent and commendable budget surpluses since 2016 (its first surpluses since joining the Eurozone), has seen its debt to GDP ratio nonetheless rise to record levels last year to over 181%. In other words, it looks like it's too little too late for Greece. See below. The first chart shows its budget deficits/surpluses since 2009. The second, its debt to GDP ratios over the same time frame. The surpluses aren't helping apparently.

Greece Government Budget

Greece Government Debt to GDP

#2 - Forex Reserves

This next point has to do with currencies directly. One of the main tools with which central banks manage the values of their currencies relative to others is foreign exchange reserves. According to the latest data from Trading Economics, the Bank of England has 137% more foreign exchange reserves than the European Central Bank. It's $174 billion versus $73.3 billion. The UK even has more forex reserves than the United States, which is currently at $129 billion. This is all firepower for defending currencies against devaluation, and Britain has almost as much as the United States and the European Union combined. At the very least, this forex war chest should help stabilize the pound post Brexit.

#3 - Brexit Could Still Be Cancelled

The first two points should help give reassurance that at least the pound has some adequate protection against negative effects of Brexit, real or perceived. The third point is that Brexit itself could still be cancelled, which would catapult the pound significantly. Prime Minister Boris Johnson has already suffered a critical defeat in Parliament, which has just voted in favor of legislation requiring him to request yet another Brexit extension to January 31, 2020. Johnson has said that he will not request an extension no matter what, and that he will instead put all his cards on the table and call elections for October 15, allowing the British people to decide. Then Brexit, once again, will be entirely up to them.

Conclusion

Points #1 and #2 would protect the pound in the event of Brexit, and in my view, they are enough to even push it higher despite the obvious drawdowns from a hard break from the EU. Point #3 would be bonus rocket fuel for the pound and would not negate the first two points anyway. Considering record lows on the pound at this point, I'd say going long the pound is low-risk high-return, at least as far as currency trades go.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in FXB over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.