Pound Replaces Oil As Leading Indicator

While Crude Oil price movements have been a sensitive leading indicator to economic conditions and financial markets since late 2014, the British Pound collapse has now become a leading indication for many commodities since the June 23rd UK referendum and THE metric to watch until this currency stabilizes. With the Pound depreciating rapidly we present several stages of political development to examine post Brexit.

Stage 1 Ends

Stage one was shock and awe. When asked what economic effect the UK leaving the European Union (Brexit) would have, we opined that there would be an initial shock in the financial markets with more modest longer term ramifications for the UK and the Global economy. Stage one of our expected Brexit shock occurred as the Pound and  stocks panicked 5 to 10% in less than a day. Initial negative reactions were extreme, immediately followed by new highs a week later in UK stock indices while the Pound continues to languish 15% lower. As the surprise Brexit pounded the British Sterling on June 24th we gave a downside objective of 127 to 131. Today that target (See chart) has been reached as investors search for a floor. 

Stage 2 Begins

 Stage 2 of our short term shock expectation is the Lame Duck phase where fear of  US and EU investor selling due to what “might”occur in a few years creates economic harm with net capital investment outflows. “Foreign investors purchasing commercial property have made up 45% of all commercial property bought and sold since 2009.” With the actual policy and trade agreement outcomes still several years away, our concern is for the pre-election vacuum of leadership needed to calm investors and stem the tide of commercial property divestment. The blue rectangle (see chart) was our original Stage 1 forecast. Now we worry about underestimating the potential further devaluation of the British Pound during this Stage 2 window that will continue until the UK elects a new Prime Minister no sooner than September 9th. While the Bank of England (BOE) may print money and buy assets to lower interest rates and credible Brexit cancellation rumors may arise to  support the Pound, a vocal quarterback is needed to strongly articulate an emergency action plan that encourages foreign companies to stop selling assets and start buying. Such leadership appears to be impossible prior to September/October and our 127-128 support zone looks vulnerable to be overtaken by significantly lower currency valuations. Premier Investment Banks, Goldman Sachs and Deutsche bank, have price forecasts for the Pound all the way down to 115 to 120. Such a move in 2016 would depress most commodities (Oil/Grains/Copper/Stocks) while boosting Bond prices as yields fall even further into new record low territory.

Pound 7-16

Targets under 125 all the way to 115 have merit in 2016 until fiscal governance is restored. While price forecasts are highly speculative, the time window for chaos appears more certain, anchored to the election process culminating in September or October. Should the Pound appreciate back up to its breakdown zone of 139-140, we would then assume the systemic currency crisis has been averted. Currently the trend of Pound depreciation is ongoing and each break of support increases the financial risk of panic over the short term.

Stage 3: Negotiations

This stage is the potential Brexit recovery phase that entails multi-year UK negotiations with the EU where leadership has the potential to remove the fear discount priced into markets. With  a passive policy response and stalled resolution with the EU, there will be risk of a net investment outflow from the UK due to growing uncertainty over trade and policy outcomes. With aggressive fiscal policy and tax incentives coordinated with the BOE the potential mild recession could be avoided and transformed into an above tend up cycle in 2017  with good export growth and tourism resulting from currency depreciation. We’ll reexamine the economic forecasts in the 4th quarter when England’s currency should have reached an important support level and a new political road-map will have been articulated.

Systemic Risk 

The potential for a widespread financial contraction and recession in the UK resulting from Brexit is a concern we have downplayed in recent reports and interviews, while acknowledging the preexisting weakness of the global economy. The potential for a British Pound induced panic from now until at least early September is our caveat emptor warning, even though the economic impact is “potentially” short lived. Should the Pound fall below 120, leading economically sensitive commodities such as Oil and Copper would also be falling sharply, indicating that UK and global GDP’s will be slowing further. Some feel the US and UK were already headed for a recession toward the end of 2016. Now we can add more negative headwinds blowing out of the UK thanks to Brexit anxiety. The forecast for the degree of economic slowing in the UK is unclear to us, but investments should assume capital outflows will continue throughout the 3rd quarter with resulting new record low Bond yields around the globe as economic anxiety grows during this directionless pre-election period. A depreciating UK currency boosts the Dollar and depresses key commodities such as fossil fuels and base metals as well as interest rates. Once the pound finds a floor stock markets will surge higher.

UK GDP

Oil has been a great economic and financial barometer over the past 18 months. Now we would add the pound sterling to the sensitive leading indicator list.

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