As the European debt crisis and spending cuts in the UK have played out this summer, the euro and the pound have continued to defy negative headlines, largely because of the support they have received from a reallocation of reserves by central banks out of US dollars. The pound has also been seen as a safe haven because of its stable political and rating outlook, bringing large capital inflows.
“We expect GBP support to be increasingly undermined by negative fundamentals,” says Ian Stannard, head of European FX strategy at Morgan Stanley in the report. “While central bank reserve diversification is keeping the EURUSD elevated against bearish fundamentals, we would suggest the GBP looks even further out of line.”
The UK government gained plaudits from the markets for being the first developed economy to address its debt issues with rigorous fiscal consolidation and its attempt to rebalance the economy with an export-led growth strategy. Both strategies have now hit headwinds, the report says. Domestic demand is constrained by fiscal consolidation and the economy is weakened by an over reliance on Europe for its export earnings. The UK government may struggle to make up for slack domestic demand as global growth slows – it has little exposure to the high-growth markets of Asia.
Resilience in Asia may be of little comfort to the UK as the majority of its trade links are with Europe. Services make up about 70% of the UK economy, so the PMI services number will be a key figure to monitor for the UK’s growth outlook.
And while the UK’s detachment from the eurozone sovereign debt crisis and the political and economic uncertainty in the Middle East and northern Africa has allowed GBP to remain strong as a semi-safe haven, that support appears to be waning as political stability slowly returns, according to Morgan Stanley. That makes the pound vulnerable again to negative economic news at home and abroad.
“The most recent data from the Bank of England shows that foreign investor flows to the gilt market have collapsed and could turn negative once again if the safe-haven flows are reversed,” says Stannard.
The pound has lost 2.25% since its mid-August highs of 1.6572, trading around 1.6200 on Friday, September 2.