The Bank of England has kept rates on hold at its meeting today, contrary to market expectations. Sterling staged a modest rebound, albeit from multi-decade low levels against the US Dollar, as the central bank held fire on further stimulus activity. The Bank of England noted that ‘most members of the Committee expect monetary policy to be loosened in August’, preferring to wait until its August Inflation Outlook report to gauge the impact of the EU Referendum.
The EU referendum has made the prospect of stagflation – the combination of weak growth and inflation – an increasingly likely situation for the UK economy. Although inflation currently hovers at 0.3%, the weaker Sterling (GBP) is likely to lead, at least in the short–term, to a rise in inflation via import prices.
A historical study[1] shows that the exchange rate pass-through for the UK could see over 10% impact on the CPI from currency movements. The 10% drop in the GBP could therefore result in a 1% move higher in CPI in the UK in the following 6-12 months after the exchange rate movement. The Bank of England calculates in its May 2016 inflation report that the impact from a 10% decline (since end-2015) in GBP could push inflation higher by 1.8-2.5% by end-2018. The GBP has declined 15% since end-2015, meaning the inflationary impact is likely to be greater than previous forecasts. The central bank concludes that ‘Ultimately, monetary policy would be set in order to meet the inflation target, while also ensuring that inflation expectations remained anchored.’
We expect that the impact of the EU referendum on GBP, and in turn domestic UK inflation, could be more persistent (in contrast to the Bank of England), especially in the event that inflationary expectations become unanchored. At the moment, there has been no real evidence of rising inflationary expectations in recent weeks. 5yr-5yr forward rates for the UK remain depressed, a seemingly direct result of the EU referendum. However, with fuel and food prices set to rise in coming weeks, a rebound could occur in expectations quite rapidly.
We anticipate that GBP is likely to be under further pressure in coming months, as the uncertainty surrounding the EU Referendum begins to show up in softer economic data and rising inflationary pressure from import prices.
[1] Campa and Goldberg, Distribution margins, imported inputs, and the sensitivity of the cpi to exchange rates, NBER, 2006.
Martin Arnold, Global FX & Commodity Strategist at ETF Securities
Martin Arnold joined ETF Securities as a research analyst in 2009 and was promoted to Global FX & Commodity Strategist in 2014. Martin has a wealth of experience in strategy and economics with his most recent role formulating an FX strategy at an independent research consultancy. Martin has a strong background in macroeconomics and financial analysis – gained both at the Reserve Bank of Australia and in the private commercial banking sector – and experience covering a range of asset classes including equities and bonds. Martin holds a Bachelor of Economics from the University of New South Wales (Australia), a Master of Commerce from the University of Wollongong (Australia) and attained a Graduate Diploma of Applied Finance and Investment from the Securities Institute of Australia.
Last week saw investors continue to purchase safe haven assets as inflows into precious metals totalled US$111mn.
Long crude oil saw inflows for the first time after nine straight weeks of outflows.
Investors uncertainty fuelling inflows into both long and short GBP ETPs.
Last week saw investors continue to purchase safe haven assets as inflows into precious metals totalled US$111mn. Year to date inflows into precious metals now total US$2.5bn, closing in on the highest six-month period of US$2.8bn witnessed in October 2012 when the gold price hit US$1900, prompted by concerns over quantitative easing and the Greek crisis. This time around, we see investor concerns over the risk of the UK referendum and its potential departure from the EU destabilising the global economy, the US elections and overly dovish US Federal Reserve monetary policy supporting the gold price. We saw inflows across the board in precious metals, gold, silver, platinum and palladium ofUS$73mn, US$17mn, US$15mn and US$1mn respectively, whilst some investors sold out of short silver positions. Safe haven investing also saw outflows from industrial metals ETPs.
Whilst palladium flows were relatively low, the trend now looks to have troughed after year of outflows. This chimes with our research which highlights the palladium has been in supply deficit for the last four years, trades well below marginal cost and is a key beneficiary of the EU6 regulations on car emission controls.
Long crude oil saw inflows for the first time after nine straight weeks of outflows. During those nine weeks, investors were selling long positions and purchasing short positions across the whole energy sector with the exception of heating oil. We see this more as profit-taking and risk aversion rather than a structural bearish view adopted by investors as the short positions have been relatively much smaller. We see the Brent fair value of US$55 per barrel at the year-end, reflecting the 75th percentile of the crude production cost-curve, where supply demand responses occur. Furthermore, we expect Iran production to have achieved a 6 to 9-month production peak due to reluctance from international oil companies to invest.
In currencies the biggest moves have been in Sterling ETPs, with short GBP rising from US$58mn at the beginning of the year to its peak today of US$117mn. Following a very similar pattern witnessed during the Scottish Referendum where flows peaked at US$124mn. Interestingly, due to the recent sell-off in GBP against a broad set of currencies, some investors have begun purchasing long positions in GBP, with the inflows into long GBP ETPs almost equalling the inflows into of short GBP ETPs over the last week.
Key events to watch this week. Investors will be closely following the UK’s EU referendum on Wednesday. The vote is dictating short-term sentiment, and in turn market movements. The polls are indicating a slight edge for the ‘Remain’ campaign, but investor optimism that is currently boosting cyclical asset prices will quickly unravel on any sign of the ‘Leave’ result becoming more likely.
For more information contact
ETF Securities Research team
ETF Securities (UK) Limited
T +44 (0) 207 448 4336
E info@etfsecurities.com
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Market Insight – Foreign Exchange – Impact of the EU Referendum
Brexit possibility rekindled
After the “Remain” camp took a seemingly unassailable lead in voting polls towards the end of May, a bout of Sterling strength reflected market relief as a degree of uncertainty was removed from the upcoming vote. However, this reprieve turned out to be short lived, as six out of eight of the latest polls have shown the “Leave” camp ahead with an average lead of three percentage points (Source: FT Brexit poll tracker), rekindling investor concerns and stressing the considerable stakes at risk on June 23rd. Interestingly, average gambling odds (sample of 24 bookmakers analysed) have put the likelihood of a “Brexit” at around 30%, but this is unlikely to provide much comfort to market participants with assets to protect (see Figure 1). With a US interest rate hike looking increasingly unlikely this month, the EU referendum is the biggest event in the calendar and preparing portfolios adequately will be top of the agenda for investors. Below, we look at the primary assets that are likely to be impacted by the either outcome of the vote.
Sterling – Direct exposure
In the event of a “Brexit” the most immediate impact is likely to play out on currency markets, with the Sterling likely to see significant moves in either direction. Recently, the Sterling has been the clearest barometer of the market’s concerns over a “Brexit” scenario, having already fallen 9.1% since mid-November (on a trade weighted basis). The largest consideration over the decision to leave is the uncertain impact that it will have on the UK’s trading relationship with the EU, the largest consumer of its exports (EU accounts for 47% of UK exports, Source: ONS). Various scenarios outlined in academic studies by PWC, Oxford Economics and the Centre for Economic Progress (CEP) all predict UK trade to be adversely impacted by a decision to leave the EU, explaining why the Sterling is likely to be the primary victim should a “Brexit” materialise. As a vote to leave would be the first decision of its kind, market forecasts over the extent of a Sterling fall are disparate, ranging from 12% by the Treasury to over 20% by some sell-side analysts, such as Credit Suisse.
A “Remain” outcome would see postponed investment projects recommence and consumer/business confidence surge, offering potential support for the Sterling from current depressed levels. The UK’s strong reliance on its financial sector and large current account deficit makes the Sterling vulnerable to market volatility, but also means that the currency rallies when uncertain events pass or bouts of market instability abate (see Figure 2, EU referendum unveils Sterling opportunity).
UK equities – Financials and Real Estate vulnerable
For UK equities the outcome of the vote is likely to affect performance along multiple avenues. For the large firms that comprise the FTSE 100 index, a much smaller portion of revenues are generated in the UK compared to the broader FTSE 250 index. A “Brexit” scenario could provide a competitive boost for larger, more internationally focused firms through a weaker Sterling, but may hurt smaller enterprises that generate revenues domestically. In addition, for equity sectors that are vulnerable to the vote’s impact on the regulation of foreign activities and consumer confidence, like those in Financials and Real Estate, the outcome could spur significant moves.
Gold – Traditional hedge
Gold has traditionally been viewed as a safe haven investment, offering protection during periods of elevated uncertainty and market turbulence (see Figure 3). A vote to “Leave” is the result associated with the most uncertainty, and therefore is likely to see the market’s appetite for safe haven assets increase, which could be a supportive factor for the yellow metal. However, the gold price is less likely to experience a sharp reaction should the status quo in the UK be maintained, with investors instead turning their attention back to the US for any indications from the US Federal Reserve of further monetary tightening.
*All figures quoted are sourced from Bloomberg unless stated otherwise.
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The information contained in this communication is for your general information only and is neither an offer for sale nor a solicitation of an offer to buy securities. This communication should not be used as the basis for any investment decision. Historical performance is not an indication of future performance and any investments may go down in value.
This document is not, and under no circumstances is to be construed as, an advertisement or any other step in furtherance of a public offering of shares or securities in the United States or any province or territory thereof. Neither this document nor any copy hereof should be taken, transmitted or distributed (directly or indirectly) into the United States.
This communication may contain independent market commentary prepared by ETFS UK based on publicly available information. Although ETFS UK endeavours to ensure the accuracy of the content in this communication, ETFS UK does not warrant or guarantee its accuracy or correctness. Any third party data providers used to source the information in this communication make no warranties or representation of any kind relating to such data. Where ETFS UK has expressed its own opinions related to product or market activity, these views may change. Neither ETFS UK, nor any affiliate, nor any of their respective officers, directors, partners, or employees accepts any liability whatsoever for any direct or consequential loss arising from any use of this publication or its contents.
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Hedging risk ahead of the referendum Market Insight – Foreign Exchange
Hedging risk ahead of the referendum
Vote imminent
Three months after the date was announced, the EU referendum is finally around the corner. Political campaigning and media coverage of the event is reaching a highpoint as both “Leave” and “Remain” camps make a final attempt to sway the voting public in their favour. Like the 2015 general election and Scottish referendum before that, the uncertainty linked to the outcome of the June 23rd vote is being played out on the global currency market. The Sterling has tumbled 8%* (on a trade weighted basis) in the past six months as an increasing number of economic reports have highlighted the potential downside risks to the UK economy from a “Brexit” scenario. For foreign investors, managing Sterling exposure from UK holdings will be an increasingly important consideration in the build up to the vote, as growing tensions and uncertainties continue to ripple through the currency market.
Referendum poses tail risks
When investing in foreign assets, investors, often unwittingly, acquire currency risk. An asset denominated in a currency other than that of the investor, always involves taking a currency position where exchange rate movements form a part of investment returns. Historically, this factor has often been overlooked, but in the current environment of record central bank activism and political uncertainty, it has never been more crucial. Globally, FX market volatility has risen to multi year highs and the trend appears unlikely to relent.
For non-Sterling investors with UK holdings, the referendum poses a currency risk. According to the latest analysis by the UK Treasury, the Sterling could be subject to as much as a 12%* drop should the vote result in a “Brexit”. While polls are showing a growing likelihood of a “Remain” outcome, option prices reveal that uneasy investors have purchased record levels of downside protection against the Sterling.
The chart above compares EUR and GBP returns of a FTSE 100 position over the past 18 months. It highlights that a European investor with currency unhedged FTSE 100 exposure would have experienced daily returns that were 26% more volatile than that of an equivalent UK investor, all as a result of oscillations in the EUR/GBP exchange rate. As the referendum approaches, investors with UK holdings will need to assess their currency exposure and make a decision of whether to hedge this risk. In the current financial environment, currency movements are becoming more pronounced and events like the EU referendum have potential to prompt considerable volatility in investor portfolios.
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ETF Securities FX Research: EU referendum unveils Sterling opportunity
Summary
Gambling odds turn favourable for the ‘remain’ camp as political polls show tight referendum result.
Adverse economic impact is expected to outweigh regulatory and fiscal benefits of the UK leaving the EU.
Pessimistic sentiment is at the highest level on record in the FX options market for EUR/GBP. GBP should rebound.
Sentiment turning
According to the latest polls, the gap has narrowed over the past few months in favour of Britain leaving the EU.
The current polling suggests that around 44% of voters will support staying in the EU, with 42% in the ‘leave’ camp, leaving a significant undecided proportion. According to the website oddschecker, the referendum result is likely to be more stark than current polling indicates. Current betting odds across a number of online gambling sites suggest 78% of gamblers are expecting Britain to stay in the EU.
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However, phone and online polling have seen diverging trends in recent weeks. Evidence indicates that when voting intentions are measured and there isn’t a ‘don’t know’ option, most undecided voters will choose the status quo, in this instance, for Britain to remain in the EU. Most internet polls have as a standard option, a ‘don’t know category and that is partially to blame for the divergence in views between internet and phone polls. While phone polls show a generally larger divide between the two camps (in favour of ‘remain’), recent evidence has been showing that the gap is narrowing between the ‘remain’ and ‘leave’ alternatives.
Will history repeat itself?
In 1975, UK voters were given the choice to stay or leave the European Economic Community. Voters were faced with the question, ”Do you think the UK should stay in the European Community (Common Market)?”. The 2016 question is very similar: “Should the United Kingdom remain a member of the European Union or leave the European Union?”
In 1975, the final result showed that there was 67% support from voters for staying in the EC, in line with current estimates ‘remain’ campaign.
Economic impact
The Bank of England have also weighed in on the June 23 vote, noting that growth could be impacted in the near-term. The central bank notes that ‘uncertainty relating to the EU referendum has begun to weigh on certain areas of activity’ with ‘capital expenditure and commercial property transactions…being postponed pending the outcome of the vote.’ The IMF has also indicated that a ‘leave’ vote would be damaging, with its chief economist stating that ‘a Brexit could do severe regional and global damage by disrupting established trading relationships.’
According to a poll by Greenberg Quinlan Rosner, the three most important issues for voters are the economy, immigration and the control of our (UK) laws. While the ‘leave’ camp appears mostly concerned with either burgeoning regulatory framework or immigration, financial markets are focussed on the adverse impact on growth via the external account. The European Union accounts for 45% of UK exports and 53% of its imports. Although the UK has a two year window to re-negotiate trade deals, bureaucrats generally move at snail’s pace. Such a timeframe seems a very tight window for a major project, with government efficiency growth very close to zero. US President Obama has indicated that a trade deal with the US could take as long as 5-10 years to reach agreement and that the UK would ‘move to the back of the [negotiating] queue’. Such comments highlight strong global concerns over the potentially adverse impact on financial stability.
There are modest fiscal benefits expected from not contributing to the EU budget if the UK leaves the EU. Depending on the final relationship of Britain and the EU, the Centre for Economic Policy Research calculates a best case scenario of a 0.31% saving in per capita income, not enough to offset the negative trade effects contributing to a decline of almost 3% in incomes.
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However, any fiscal benefit could be offset by the need to create new administration regarding implementation of new domestic regulation and trade agreements.
HRM Treasury’s own calculations indicate that the UK would be between 3.4% and 9.5% of GDP better off remaining inside the EU within 15 years. The wide dispersion of the GDP range depends on the eventual structure of trade that Britain would adopt with the EU if it left the economic union.
Several economic consultancies have calculated the potential impact should voters decide to leave the European Union. On average a result of a leave vote is expected to make Britain worse off by between 0.1% and 5.5%.i
What’s the FX market saying?
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Against the USD, GBP recently has experienced a modest bounce from multi-year lows. Against the Euro, GBP is hovering at the weakest level in the past 12 months. Negative sentiment is priced in as volatility has weighed on GBP.
Options market pricing is indicating that bearishness is at the highest levels in over a decade for GBP against the Euro.
Volatility is the status quo
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The risk of Britain exiting the EU has seen the cost to insure against a British sovereign default rise by over 100% since the beginning of 2016, another reason for GBP weakness.
Where to next for GBP?
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With so many voters as yet to decide which way to vote, volatility will remain elevated for GBP crosses and will likely keep the pound under some pressure against major currencies. However, such depressed levels of GBP opens up buying opportunities in the medium term as uncertainty fades.
Historically, steep falls in the Pound have presaged strong rebounds. The subsidence of volatility following the financial crisis and the Scottish referendum, led to strong gains for GBP against the Euro. In the four months after the financial crisis, GBP rallied 4.3% against the Euro. Indeed, we expect that the EUR/GBP is the more favourable cross to implement views of Britain remaining within the EU, with the US expected to tighten rates further in 2016 and the ECB keeping the Euro weak with aggressive policy stimulus.
Important Information General This communication has been issued and approved for the purpose of section 21 of the Financial Services and Markets Act 2000 by ETF Securities (UK) Limited (“ETFS UK”) which is authorised and regulated by the United Kingdom Financial Conduct Authority (the “FCA”).
The information contained in this communication is for your general information only and is neither an offer for sale nor a solicitation of an offer to buy securities. This communication should not be used as the basis for any investment decision. Historical performance is not an indication of future performance and any investments may go down in value.
This document is not, and under no circumstances is to be construed as, an advertisement or any other step in furtherance of a public offering of shares or securities in the United States or any province or territory thereof. Neither this document nor any copy hereof should be taken, transmitted or distributed (directly or indirectly) into the United States.
This communication may contain independent market commentary prepared by ETFS UK based on publicly available information. Although ETFS UK endeavours to ensure the accuracy of the content in this communication, ETFS UK does not warrant or guarantee its accuracy or correctness. Any third party data providers used to source the information in this communication make no warranties or representation of any kind relating to such data. Where ETFS UK has expressed its own opinions related to product or market activity, these views may change. Neither ETFS UK, nor any affiliate, nor any of their respective officers, directors, partners, or employees accepts any liability whatsoever for any direct or consequential loss arising from any use of this publication or its contents.
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