Expert Commentary: Focus on UK economy and British Pound

According to latest reports, a slowdown in the housing market and a weakness in the construction industry only worsened amid higher costs. In your point of view, should we expect a further decrease in the UK economy?  Why?

Our base case scenario is that we are expecting a slowdown in the UK economy in 2017. If we ask what has been propping the UK economy up since Brexit, the answer would be the consumer spending story; we have seen consumption being fairly resilient since Brexit. On the other hand, we have seen investment taper a little bit less, therefore, what has been driving the UK economy is really consumer spending.

Though, at this point, the outlook looks pretty bleak, especially if we take into account the fact that we have got a squeeze in household consumer incomes, coming from higher fuel prices, higher inflation, and a lack of wage inflation. Real incomes are being squeezed, which in theory leads to weaker consumer spending power. Thus, the channel which has been propping up the UK growth is likely to weaken a little bit going into 2017. 

One of the main drivers of the British economy was consumer spending, though consumers are now under pressure from higher inflation with much weaker purchasing power. In your opinion, will they manage to provide sufficient economic growth? Why?

I think we have the same story here. Unless we see wage growth picking up massively, which is not our economists' base case scenario, we are unlikely to see that story manifesto. In fact, we have got little source of growth. Take net exports: at this point we are really not expecting Sterling depreciations to have a massive impact on net exports. In fact, the export story as well as the investment story would take an excuse from what happens during Brexit and what the Brexit deal with the EU will look like.

Most traders said negotiations over Brexit remained the major driver for the Sterling. Are you of the same opinion or not? Why?

I do share this point of view. In the short term, we always look at the Bank of England curve to see what is priced in for policy expectations; whether the curve is too low or too high, it can give you short-term directions for the Sterling. Now that we look at the curve, it seems to be pretty flat and pretty accurately pricing in a stable BoE policy path. The major driver for the Sterling over the twelve-month horizon will be the outcome of the Brexit deal. We are splitting the negotiations into two parts. In the short term, we are probably going to see higher uncertainty, a lack of clarity and any key questions being answered on trade and the financial services sector. All of the above prolongs the risk of getting investment uncertainty spilling over to permanent loss of investment, which is Sterling-negative. Currently, we are expecting the Pound to stay lower for longer in the near term, even if we do not think it has freely done its pre- and post-Brexit adjustments. That could potentially mean that the Sterling might fall to the cyclical base of 1.15-1.20 against the US Dollar. After that, it would be a function of how much the Pound can rebound, which would be purely a function of long-term deal agreed between the UK and the EU. 

What are your forecasts for GBP/USD and EUR/GBP? 

In EUR/GBP, we are expecting the similar story. We think that the pair can probably do one final move higher towards the 0.88-0.90 level, but that will largely depend on hurdles related to the elections in different European countries and market shifts that may potentially occur if the ECB puts an end to its quantitative easing programme.

Viraj Patel

FX Strategist at ING Bank