This article was written by Idan Levitov, head analyst for anyoption.com.
Much to the chagrin of ‘remain’ campaigners within the UK, the ‘exit’ camp just scored another major victory following last weeks release of the advance GDP figures for the period after the referendum vote.
After unleashing a protracted fear campaign to keep the UK within the European Union, the latest results show that the imminent economic demise predicted by the ‘Bremain’ camp has failed to materialize. Between growth and inflation data, the Bank of England is likely more confident in the outlook now than at any point since the referendum vote.
While risks to the outlook remain significant, especially amid the heightened chatter of a hard Brexit, the steep devaluation of the pound has opened a new chapter for the UK economy as it adapts to changing realities.
In spite of the heavy criticism of the leave camp and its ideals, the UK economy has performed admirably even with the forthcoming headwinds. The major undiscussed benefit of the decision has been the rapid decline of the pound, with GBP/USD down nearly -18.50% from pre-Brexit highs near 1.5000.
In a global economic environment where there is an ongoing race to devalue currencies to make them more competitive in international trade, the pound’s losses have delivered a huge benefit to UK businesses. For instance, during the third quarter, the services sector grew at a blistering 3.00% annualized pace versus 2.70% in the second quarter. This gain was the single largest component of UK GDP growth, which managed to climb to the fastest annualized pace of expansion since the second quarter of 2015.
Besides the uptick in growth, the other major benefactor of the plunging pound has been inflation. After briefly flirting with deflation, consumer prices are bouncing back towards the central bank’s 2.00% inflation target.
A combination of lower interest rates, asset purchases, and the softer pound have all conspired to drive headline annualized inflation to 1.00% in September, marking the highest level since November of 2014. Adding to the upside pressure is the waning impact of weaker energy prices, which are almost matching levels recorded a year earlier, eliminating the drag.
While the substantial rebound might prevent the Bank of England from reducing interest rates further from current levels, when considering conditions and the improving outlook for UK economic activity, further rate reductions may be unnecessary.
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Pressure on the Government Grows
Although the UK remains a member of the European Union temporarily, Prime Minister Theresa May’s plans to trigger Article 50 by the end of the first quarter of 2017 is the looming risk factor that could derail recent economic gains.
One of the benefits of membership is access to the single market, which eliminates many of the tariffs and barriers to trade with other European countries. However, with the Conservative Party pushing to retake control of the UK’s borders and sovereignty, the European Union is unlikely to grant the UK continued access to the economic advantages of the region.
The impact of any such development is extremely difficult to quantify as local firms are forced to determine if they must set up operations in mainland Europe to benefit from a 500 million person trade bloc.
At present, European nations are savoring the possibility that UK firms will be forced to move operations onto the mainland.
France in particular has been particularly aggressive in courting UK businesses, opting to make it easier for businesses to register in English in order to attract companies that are set to lose out on single market access. However, companies may opt to remain in the UK, especially if the outlook for monetary policy remains accommodative and dovish.
Should more rate cuts transpire, especially as FX-driven gains in inflation ebb over time, the downside in the pound could make transactions in sterling more attractive considering the competitive advantage.
At the same time, by exiting the EU, the UK will be able to reduce cumbersome regulations on businesses that end up costing the economy billions every year.
Much hangs in the balance ahead of the upcoming November interest rate decision from the Bank of England. It is still too early for the central bank to determine the exact impact of the referendum outcome despite positive data points including inflation and growth.
However, with growth projected to fall in 2017, additional rate cuts are not off the table. The recent spate of positive data has helped stem the decline in the pound, but over time, if the central bank retains its dovish stance, the downward trend might quickly resume.
Furthermore, if loss of single market access unfolds, the pound might have substantial room to fall from current levels.
While the immediate future looks rosy for the UK amid one of the steepest devaluations in the country’s history, exit considerations could continue to weigh on the currency, especially if the UK’s relationship with the EU becomes increasingly strained.