Investors Grow Cautious as Sterling Falls to New Lows

EghtesadOnline: Sterling fell on Thursday, as risk appetite in global markets waned and investors grew cautious before the first reading of Britain's third-quarter growth data, capturing the impact on the economy of June's Brexit vote.

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29 October 2016

Analysts are expecting a 0.3% rise in gross domestic product last quarter, which would keep the annual growth rate steady at 2.1%. The data, due out soon, will not include details of consumer spending or capital investments but give the markets an insight into whether Brexit-inspired uncertainty is affecting the economy or not, Reuters reported.

"A better-than-expected quarter is likely to see a sharp rebound in the pound," said Kathleen Brooks, research director at City Index. "A weaker-than-expected reading could see another plunge in the pound, although we think a positive surprise would have a larger impact, since so much Brexit gloom is already baked into sterling."

Sterling was trading 0.3% lower at $1.221, while it was also lower against the euro at 89.40 pence . The pound also tends to perform in sync with stock markets, which were nursing losses on Thursday.

Traders and analysts said the evidence so far suggested that the economy had held up well and Britain was likely to dodge a recession.

Nevertheless, the currency has shed nearly 18% against the dollar since the June vote, with losses accelerating in October after Prime Minister Theresa May raised the prospect of a "hard" Brexit.

This would mean the government favoring tighter immigration controls over free trade in exit negotiations, potentially curbing the foreign investment needed to fund Britain's huge current account deficit.

In early September, the Bank of England said it was likely to cut rates again this year if the economy slowed as it expected.

But sterling's weakness and a rise in inflation expectations have prompted most to rule out a Nov. 3 rate cut—around three quarters of the 60 economists polled by Reuters in the past few days expect rates to stay at 0.25% for the rest of the year.

"Even though the threat of a 'hard Brexit' instils a long-term bearish outlook for the pound, sterling/dollar may face a larger correction over the days ahead, especially as the BoE appears to be in no rush to implement lower borrowing costs," said David Song, currency analyst at DailyFX.

Consumers to Lose

In the short run, one of the main effects of a weaker pound will be inflation. Imported goods will become increasingly expensive and higher costs for businesses are likely to be passed on to consumers. Clearly, UK consumers are concerned about what this will mean for the affordability of their goods and services. Inflation has already crept up to 1% since the referendum and is very likely to move higher.

However, the amount by which prices will rise could prove to be lower than anticipated. In other words, inflation may not move to an excessively high level. That’s due mainly to a continued deflationary cycle across the world economy, according to Financial Tribune.

In the US, inflation is still relatively low and China’s GDP growth rate is set to slow in the coming years. Therefore, central banks are somewhat nervous about raising interest rates across the developed world for fear of encouraging deflation to take hold rather than being worried about inflation.

As such, UK interest rates may be kept low or moved even lower in the coming months. This has the potential to stimulate the UK economy since exporters will become increasingly competitive on price versus their foreign peers. Therefore, investing in UK companies that have operations abroad (which a large number of listed companies do) could prove to be a sound move over the medium term.

Such companies sometimes have very little exposure to the UK economy. This could help to protect investors from potential weakness in the UK economic performance in the short run.