The case for a sterling squeeze

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Morgan Stanley’s latest note on UK trade describes sterling as a potential “equilibrator” that could see its 5 per cent to 20 per cent premium relative to peers eroded because of Britain’s “sizeable and persistent current account deficit”.

Which really shocked Alphaville because we’d never heard the word “equilibrator” before. Wiktionary says it is:

(rare) A device that maintains equilibrium or balance, especially a part of a heavy gun (e.g. an artillery piece or a tank gun) which balances the barrel and other parts so as to enable the gun to be elevated easily.

The Google results seem really skewed towards mounting guns (sorry, lethal assistance) on the back of vehicles. What this tells us about Morgan Stanley’s Europe Insight team is unknowable.

Anyway, about the potentially looming sterling slump.

In advance of the publication of the Pink Book — which normally lands around Hallowe’en and contains suitably spooky statistics (balance of payments) — Morgan Stanley has taken a deep-dive into recent trade figures to make sense of the pretty wild few years the UK has had.

Trade stats are, even by the standards of some national statistics, really, really janky. In a previous job, Alphaville once had the Office for National Statistics’ methodology for calculating monthly precious metal trade flows explained to us, and subsequently yearned for a trepanning [ed note: wut? Oh].

The upside, of course, is that everyone else is also trying to calculate their trade figures, so everything roughly works out in the end. If one country has a current account surplus, another must have a deficit, and:

— someone must be funding that deficit through investment or buying assets, OR;
— the domestic currency weakens to close the gap (by making imports more expensive, and exports cheaper)

Anyway, Morgan Stanley has looked through the available data very thoroughly, and have their top conclusions run something like this:

— the composition of UK trade is shifting, with goods trade remaining “deeply subdued relative to pre-2020 levels”, which services trade has picked up (despite some looming headwinds)

— the UK’s pivot away from Europe in trade terms isn’t super visible in the figures just yet. The analysts write:

The UK is exporting a higher proportion of its services to the US and away from Europe, although that might be due to cyclical factors (i.e., stronger US growth performance in recent years), rather than any structural trade shifts. Indeed, services trade arrangements vis-à-vis the US have remained largely unchanged post-Brexit, although some parts of the sector have seen rising frictions in trade with the EU. Goods-wise, exports to EU and non-EU countries have been similarly subdued, but we think that this is largely due to the indirect, dampening effects of the UK manufacturing sector’s deep integration in the EU supply chains, where frictions have been emerging since the post-Brexit TCA arrangements came into force.

(on this point they defer partially to analysis by King’s College London’s Jonathan Portes, which you can read here.)

— FDI data, which is really janky even within the broader tent of trade figures being janky, suggests foreign investment is slowing. But the data, to be clear, is really thin (partially due to a methodology change in 2020, a particularly bad time for a methodology change to have occurred).

Morgan Stanley says “more data evidence — the upcoming Pink Book, for example — will be needed”, which is total reasonable but also somewhat beggars the entire premise of the analysis.

Overall, these findings point to a picture of a continued, or even widening current account deficit for the UK — which means something has to give.

And David Adams, one of Morgan Stanley’s foreign exchange strategists, reckons sterling is the weak spot (our emphasis below):

In a scenario where the UK current account deficit approaches disequilibrium, a weaker GBP is one clear channel that could return the economy to balance. Indeed, the rebalancing of the international payments position could come through the currency, the value of domestic assets, or a fall in domestic demand. In a free-floating market, the currency channel might be the least disruptive one. To gauge the range of adjustments that might be sufficient, we have built a so-called ‘fair value’ model of the exchange rate based on some basic fundamentals. Our model points to something like a 5-20% premium on GBP at current prices. In the extreme case of a meaningful FX: A Weaker GBP May Be the Key David Adams and structural current account deficit widening, this premium could be meaningfully eroded in order to attract capital at the margin in an increasingly capital-competitive world.

There are a lot of questions Adams poses around this hypothesis, which we’re going to try to quickly get through here (as a reminder, any time when FTAV poses a bunch of questions in a row, they should be read aloud in this voice):

— Might people just starting buying UK assets anyway?
— Might people not just starting buying UK assets because they expect sterling to drop because people like them are not buying UK assets?
— Might people who might buy UK assets not buy UK assets because assets that aren’t UK assets are more attractive assets?
— Might there be a limit to how much cheaper UK assets can get given UK assets are already really cheap?
— Might there be further problems if the UK government borrowing costs remain substantially elevated?
— Might the global economic picture shift?
— Might the UK’s domestic economic picture change?

The answer to all of these, of course, is absolute nobody has a clue. But in the absence of a divine intervention, sterling bearishness seems pretty reasonable. Adams:

In sum, GBP weakness may be a useful means of generating necessary capital imports and is arguably the least disruptive compared to higher interest rates or cheaper equities. But whether depreciation is necessary and the potential magnitude required are state-dependent and highly uncertain.

While we estimate that GBP has room to depreciate based on PPP and fair value comparisons, those are neither forecasts nor targets. Rather they suggest headwinds for GBP over time. How the structural external position of the UK economy evolves will be an important watchpoint for FX investors given GBP’s potential source as a ‘release valve’ for the economy.