British Pound Year Ahead – Brexit To Dominate 2016

2015 in Review

This has been something of a turnaround year for the UK in which unemployment has fallen back to pre-financial crisis levels, wage growth has accelerated and falling energy and food prices have supported a strong consumer driven recovery.

Growth has cooled a little in 2015 after peaking at 3.2% in the middle of 2014 but this was to be expected against the backdrop of slowing global growth, a sluggish recovery in the euro area – the UK’s largest export market – and a strong pound which created big challenges for UK manufacturers.

Still, the economic recovery has never looked under threat and the country has continued to grow at a rate that many of its neighbours can only dream of.

Despite this, the Bank of England is in no rush to raise interest rates and in the November inflation report indicated that the tightening cycle may not begin for another 12 months, despite suggesting only in July that it would be considered at the turn of the year.

When you consider the headwinds facing the UK economy in 2016, it is understandable that the central bank may want to be prudent before hiking interest rates for the first time since July 2007, eight and a half years ago.

Expectations for 2016

As already highlighted, the UK economy faces a number of headwinds in 2016, some of which have the potential to derail what has so far been a robust recovery. That said, rather than threaten the recovery, I expect these events will instead keep it in check while enabling it to tick along nicely.

Brexit

In an attempt to stave off the growing popularity of the right wing anti-EU UK Independence Party, Conservative leader David Cameron vowed to hold a referendum on EU membership by the end of 2017 if he was re-elected. Since the Conservatives won an overall majority at the election in May this year, Cameron has been in negotiations with his EU counterparts in a bid to secure a deal that will satisfy the UK electorate and protect the country’s interests.

It is believed that a deal may be reached by February 2016 which will enable Cameron to hold the referendum that summer, well before the deadline he set in the lead up to the election. The benefit of this is that it removes a significant amount of uncertainty surrounding the UK economy far sooner than was expected. The possible ramifications that a “Brexit” could have are substantial given that almost half of UK exports go to the euro area. There are also a number of huge companies that consider EU membership a key advantage of doing business in the UK. Should “Brexit” become a reality these companies could consider relocation and take thousands of jobs with them.

Fiscal Tightening

UK Chancellor George Osborne may have been given some welcome flexibility in the latest Autumn statement which enabled him to reign in some of the fiscal tightening that will be necessary to eliminate the deficit by the end of this parliament, but austerity is still inevitable in 2016.

While I believe the economy is in a good position to withstand a tightening of the public purse strings, it will almost certainly weigh a little on economic growth in the short term and give the BoE another reason to hold off on raising interest rates to avoid inflicting additional unnecessary pain.

BoE Rate Hike

At the latest BoE inflation report in November, Governor Mark Carney struck a far more dovish tone than he had previously, suggesting that a rate hike may not come for another 12 months. Given that his previous “guidance” in July indicated that a hike would be considered around the turn of the year, it is clear that the BoE is far less confident in the ability of the economy to weather any storms and inflation to return to 2% in the medium term.

That said, I am not convinced that the BoE will in fact wait until the end of next year to raise interest rates. Unemployment in the UK is very low, slack in the labour market is deteriorating rapidly and wages are growing. Combined with last year’s decline in commodity prices falling out of the annual comparison of inflation and an easing in the strength of the pound, I think inflation could rise faster than the BoE is currently anticipating.

If the Federal Reserve raising interest rates in December without any detrimental impact to the US economy, it may give the BoE confidence to move in the middle of next year in a bid to avoid inflation rising too rapidly and possibly overshooting its 2% target.

Global Slowdown

The global slowdown, particularly in emerging markets, is one of the factors highlighted by Carney in the latest inflation report as being a risk to the UK economy. The sluggish recovery in the eurozone could continue to hamper UK manufacturers in 2016, particularly if the euro weakens further on the back of more stimulus from the ECB.

Energy Prices

One possible tailwind for the UK economy in 2016 is likely to be the ongoing weakness in energy prices which have supported the strong consumer driven recovery this year. Disposable income has been on the rise this year as wage growth has far exceeded inflation. With inflation seen rising this year, albeit while remaining well below the BoE’s 2% target, the gap may not grow as fast as it did this year and could even shrink a little. That said, consumers should continue to feel better off, particularly if wage growth continues to accelerate as it has for much of this year.

Conclusion

All things considered, I think the UK economy will continue to grow at around 2-3% next year which will be sufficient to continue to support steady job and wage growth. Meanwhile, inflation should pick up considerably as last year’s decline in energy prices falls out of the annual comparison. This could be assisted by an easing in the strength of the pound which has added to the deflationary pressures this year.

Against this backdrop and assuming the rate hike from the US Federal Reserve in December doesn’t derail the recovery in the US, I think the BoE may feel more comfortable with raising interest rates in the third quarter of next year, pending the outcome of the EU referendum.

Technical Analysis

Cable has been grinding lower throughout the second half of 2015 and at the moment is showing little sign of easing. It managed its first close below 1.50 – a psychologically important level – for the first time since April, last week, and the weekly candle was a very bearish looking marabuzo. The pair may find additional support around 1.48 with it having been key in 2013 and at the start of 2010. Below here, this year’s lows of 1.4550 will be an important level of support and a break of this will be very bearish, potentially opening up a move back towards May 2010 lows of 1.4230. A move above the descending channel that it currently finds itself in would suggest the pair has taken a more bullish turn and prompt a move back towards 1.60, the level it has traded around since 2009.

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