Financial success for international professionals

Brexit (Part 2) - How it hit the pound in your pocket, and why that affects the UK economy

· by Roy Walker · Read in about 6 min · (1263 Words)
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(Read this article and follow me on LinkedIn Pulse.)

First a recap - as we saw in Part 1 of this article, the impact of the Brexit decision on global stockmarkets can be summarised as a rise in volatility but not a disaster scenario. In fact, overnight last night the FTSE100 closed almost 3.6% up as investors realised ‘it’s not the end of the world’. (The dotted line in the chart below is the 2015 close.)

The volatility will be here to stay for a while as the UK-EU political posturing plays out. In the bigger picture, the trend for major markets is downwards (with USA being the most resilient) in line with increasingly pessimistic global economic forecasts.

You don’t need to be an economic boffin or an expert at interpreting abstract art to see this in Europe for example - a clear series of lower highs and lower lows broadcasts the market direction that has been established for over a year.

The GBP Pound Sterling was knocked off it’s feet by the Brexit vote result

The currency markets were where the Brexit decision had the most significant impact. The Pound fell of a cliff on Friday, and plunged at one point to almost 1.32 against the USD, underscoring near-term concerns on the UK economy.

After a minor pick-up last night, the pound sits at 1.34 against the USD, the lowest in over three decades.

Why did the Pound fall?

The Brexit vote threw a boulder of uncertainty into the currency pond. The UK leaving the EU single market has the potential for a significant impact on trade at least in the medium term (depending on what kind of deal the newly-appointed UK political leadership can negotiate). Worries on the economy mean that investors are more reluctant to hold GBP denominated assets, and sterling has consequently spiralled downwards.

Concerns over a deterioration of the UK’s economic performance mean that Standard & Poors credit agency has downgraded the UK’s sovereign creditworthiness from ‘AAA’ to ‘AA’ (two notches). Fitch has also reduced the UK rating to ‘AA’ from ‘AA+’. Moodys has said it’s outlook on UK is negative, with a risk of downgrade from it’s ‘Aa1’ rating. (Both Fitch and Moodys had both already downgraded the UK from AAA during the 2013 austerity.)

So let’s take a quick fact-check on the UK place in the world rankings. First, where exactly is the UK in the GDP global rankings?

GDP (Gross Domestic Product) of leading economies, 2015.

The UK is the 5th largest economy in the world. The table shows GDP figures for 2015, from the International Monetary Fund ‘World Economic Outlook Database’.

Annual Growth Rate (%) of GDP to Q1 2016.

To first quarter 2016, the UK’s GDP grew year-on-year by 2.00%. Compared with United States: 2.10%, Euro Area: 1.70%, and Germany: 1.30%. (Source: Trading Economics.)

The UK’s Share of Global Trade

A contraction of the UK economy and a devalued sterling will affect the world economy via a reduction in UK imports. According to World Trade Organisation’s International Trade Statistics 2015:

IMPORTS - the UK accounts for 3.6% of world merchandise trade imports, and 4.1% of commercial services imports.

EXPORTS - the UK exports 2.7% of world merchandise trade (ranked 10th in the world), and 6.8% of commercial services (ranked 2nd after USA at 13.9%).

On the import side, if the UK economy contracts, we would expect a reduction in imports. However, the UK accounts for less than 4% of global imports, so the impact on the global economy should not be excessive.

On the export side, the UK punches well above it’s weight in services exports - ranked 2nd after USA, reflecting the importance of the UK (and London in particular) as a financial services hub. This explains why UK financial sector equities were especially punished on Friday. Example - Barclays price chart:

But before we start wailing and hand-wringing, let’s see how important exports are to the UK’s GDP.

Exports as Percentage of GDP, 2014

UK exports (goods and services) account for about 28% of it’s GDP (latest data, 2014). You can see that figure in comparison to other leading economies in this chart.

Countries with a higher proportion of GDP from exports will be more affected by global economic events. Countries where exports are less of a GDP driver will be somewhat more detatched.

When we see that the USA, the largest economy in the world, has only 13.5% of GDP as exports, this helps understand why the US economy (and stockmarket) has performed relatively better than the rest of the world during the declines of the last year.

Get to the point Roy, what about the ‘pound in my pocket’?

You already know… A devalued pound means that imports are more expensive. If you live in the UK, the imported groceries in your shopping bag become more expensive. Imported electronic goods are pricier. Fuel prices are likely to rise. The cost of a holiday abroad becomes higher.

If you are retired abroad but your pension income is in pounds sterling, your purchasing power in local terms will have taken a big hit.

In USD terms, your purchasing power today is about 9% less than a month ago. The table below also shows the GBP fall against the EUR, AUD and SGD.

Post-referendum GBP fall against selected currencies

But now to put on our economic hat

A lower pound has upsides for the UK. The obvious one being that the UK’s exports become cheaper for international customers. As we’ve seen above, about 28% of the UK’s GDP is exports, so with those exports suddenly more cost-competitive then trade has the potential to expand significantly.

The chart below shows the growing importance of exports to the UK’s GDP since the 1960’s. (source:World Bank).

UK exports (goods and services) as percentage of GDP, 1960-2014

Now, let’s discuss the negative impact on exports of the UK being thrown out of the single market. The UK will still have ‘access’ to EU markets, but (post-Brexit) with the tariffs of a non-EU supplier. So, alright then, what are those tariffs?

The World Trade Organisation kindly gives us the boiled-down averages:

Simple and trade-weighted average EU import duties, 2013

In the chart above, ‘MFN’ means Most Favoured Nation status. This refers to the requirement of WTO members to extend the lowest available tariffs to each other; i.e. as would be applied to the UK once outside EU, but with no other special terms negotiated - relying on the WTO baseline only.

Comparing the tariff averages with the pound devaluation, we could make a (semi-) flippant remark that if the UK was outside of the EU right now, a sizeable proportion of UK exports sold into the EU would be more price-competitive today than they were last month!

However, London is an international financial centre…

.. and the comment above does little to calm the nerves over what happens to the UK’s financial services sector.

But, being a global financial centre, a large number of multinational corporations choose to list their shares on the London Stock Exchange, and make the UK the home of their headquarters. This is reflected in the constituents of the FTSE100. Research from Capital Group in 2013 showed that 77% of revenues generated by FTSE100 companies come from outside the U.K. This serves to emphasise the postive side-effect of the referendum fall-out - a de facto ‘competitive devaluation’ of the UK currency.

Tune in later for Part 3 of this article, where I’ll discuss the importance of a currency strategy for your international portfolio.