Ignore the Pound's Pain This Might Just Be the Floor

(Bloomberg Gadfly) -- Sterling can survive Britain's divorce from the European Union.

But you wouldn't know it from its reaction to The Sunday Times'report that Prime Minister Theresa May’s speech on Tuesday will signal plans for a hard split from its biggest trading partner. Monday saw the pound dip to its weakest versus the euro since November and fall briefly below $1.20, the lowest level since the Oct. 7 flash crash. 

If this constitutes the bulk of the hard Brexit news, we just might be close to the floor for sterling versus the euro. May's position looks more like a tough starting point for negotiations, and one that should lead to a more balanced compromise from the European Union over the course of the next two years. By refusing to allow any cherry-picking on the shape of the exit, the bloc's intransigence has forced the government into this position.

Over time, what drives a currency is the demand for its nation's assets and services, and the outlook for Britain is good. 

It's not just that U.K growth has been surprisingly robust. Britain was the fastest-growing Group of Seven nation in the third quarter, posting an annual rate of real GDP growth of 2.2 percent versus 1.7 percent for both the EU and Germany. This is at odds with a weakening currency. 

Prospects for future expansion don't have to be doom and gloom. Chancellor of the Exchequer Philip Hammond has warned the EU that the U.K. can radically alter its competitive model to prevent long-term economic damage. Creating an offshore tax haven on the doorstep of Europe, particularly as the City now arranges the lion’s share of the continent's financing needs, certainly sets out the sharp edges of the negotiations. 

While the increase in the value of foreign earnings from the pound’s weakness has been one of the major factors behind recent strength in the FTSE 100, the stronger economy has also lifted the index, and has also bought the more domestically inclined FTSE 250 along with it. A healthy domestic stock market is a good barometer on an improving outlook for real investors putting money to work.

The stability of the gilt market after Sunday's report also suggests that U.K. bond investors are sanguine on the outlook for the currency. To them, Monday's mayhem looks like a short-term blip, and the broader picture is more supportive. Bonds can be looked at as a forward pound -- you're lending pounds today in exchange for pounds tomorrow. The fact that foreign investors have mostly been net buyers of gilts since the referendum can be seen as a vote of confidence in the currency.

What's been surprising since the vote is how few M&A deals there have been to take advantage of the weaker pound, as my colleague Chris Hughes has argued. Any further weakness in the currency could shift this picture and spark a trend for more opportunistic acquisitions, which would benefit sterling. 

At some point the euro is going to have to factor in the economic downside effect of the U.K. leaving, and that should create a drag on the single currency.

The picture isn't quite so straightforward with the dollar. The prospects for a stimulus-led growth pickup support continued strength in the greenback, though perhaps three rate increases from the Federal Reserve are already priced in. Still, President-elect Donald Trump’s indication that he'll arrange an early trade deal with Britain could pave the way for the pound to escape a permanent downward spiral versus the dollar. And any move by the Bank of England to back away from easing will substantially benefit the pound. 

It always looks darkest just before dawn, but sterling's sunlit uplands may be beckoning just over the horizon. 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Marcus Ashworth is a Bloomberg Gadfly columnist covering European markets. He spent three decades in the banking industry, most recently as chief markets strategist at Haitong Securities in London.

To contact the author of this story: Marcus Ashworth in London at mashworth4@bloomberg.net.

To contact the editor responsible for this story: Jennifer Ryan at jryan13@bloomberg.net.