The pound looks undervalued across a number of measures.
Before the EU referendum, we estimated that a vote to leave would lower sterling’s trade-weighted (or ‘effective’) exchange rate by 7.5—12.5% after the immediate volatility had subsided. At the time of writing in mid-October, it is 15% below the average level recorded in the four days before Friday 24 June.
We usually avoid making short-term exchange rate forecasts. Their accuracy is highly compromised by the observation
that exchange rate volatility is often far higher than the volatility of the factors that drive them. In addition, short-,
medium- and long-term factors often act on exchange rates in different directions at the same time.But these are extraordinary times. Our estimate was based on a range of assumptions about how the vote to leave
might alter UK interest rate expectations relative to those for other countries, as well as sterling’s sensitivity to Brexit
news and financial risk aversion in the 12 months preceding the referendum.
We pored over Bank of England research papers and speeches, and were confident about our assessment. Such confidence is rare without a disruptive event, such as the referendum. Fortunately, we are not a hedge fund chasing short-term returns. As long-term investors, when considering the strategic allocation of client capital, we are more
concerned with where a currency is heading on a sustained basis and the consequences for expected returns. We
say fortunately because although the academic research on modelling shortterm movements in exchange rates is
thin and inconclusive, there is plenty relating to ‘equilibrium’ rates over the long term.
Finding the equilibrium
Equilibrium exchange rates can be thought of as a lodestone from which actual exchange rates may deviate, but to which they will gradually return over time. In our approach, we describe the equilibrium exchange rate as a function of three factors:
First, the terms of trade, which is the price of a country’s tradable output relative to its trading partners. Higher terms of trade should appreciate the real exchange rate through relative changes in real wealth or income. For example, an increase in the oil price improves the international competitiveness of a country that is relatively less dependent on oil.
Second, productivity, where larger increases in the traded goods sector are associated with a real appreciation of
the currency of the domestic country.
Third, the old-age dependency ratio, where a higher share of the economically inactive dependent population reduces national saving and decreases the current account balance.
Measured against all major developed market exchange rates, our analysis of these long-term economic factors reveals
sterling is substantially undervalued. As a result, while we understand why many global investors are negative on sterling
in the short term, we believe it is likely to head back up towards its longer-term equilibrium rate over the next few years
Exchange rates are also affected by the business cycle and temporary technical factors. In the rare instance when all of these factors point in the same direction, investors should take note. Today, our long-term analysis discussed above, business cycle indicators and technical positioning indicators, such as the number of speculative investors selling sterling, all suggest that sterling is cheap, particularly against the US dollar, but also against the euro and yen.
Brexit negotiations are set to begin formally next year and currency markets are likely to be more volatile as a result. If the UK is excluded from the EU single market and new trade deals are slow to come by, the productivity of the tradable sectors of the economy (particularly financial services) are highly likely to stagnate. In this instance, the longer-term equilibrium exchange rate would shift lower. However, sterling is so substantially undervalued relative to the equilibrium level that the actual exchange rate is still likely to strengthen back towards the equilibrium level over three-to-10 years.
Figure 1: Back to equilibrium
Sterling should appreciate over the next few years as it returns to its long-term equilibrium
This article first appeared in Investment Insights Q4 2016