Expensive Stocks and Bonds Could Hamper Pound Sterling's Recovery in 2018

Trader exchange rate

The British Pound will struggle in 2018 as global investors start to shun U.K. stocks and government bonds seeing them as being too expensive.

Analysts at Deutsche Bank are maintaing a negative stance towards the British Pound over the coming 12 months even though they now concede the traditional villian for Pound Sterling - Brexit - will not be the concern it once was.

Deutsche Bank join other institutional analysts in adopting the view that Brexit is becoming less of a concern for Sterling, but differ in opinion on whether or not this represents a greenlight to a stronger Pound.

“We think Brexit will be less of a driver of GBP in 2018 and the focus will turn back to fundamentals. Lacklustre growth and unattractive asset valuations should outweigh the risks of a hawkish tilt from the Bank of England in H1, and see GBP TWI drift lower again,” says Oliver Harvey, a strategist at Deutsche Bank.

Driving weakness in Sterling over coming months is an expected imbalance between the amount of money that leaves the U.K. each month and the amount that comes into the U.K. now that asset valuations now appearing expensive.

Analysts at the investment bank are wary that global investors will rotate out of U.K. assets owing to expensive valuations, which will in turn restrict the inflow of foreign capital which is required to keep Sterling afloat.

"Flows are the dominant driver of exchange rates currently and have deteriorated for the Pound," says Harvey.

Importance of capital flows for the Pound

Above: Deutsche Bank note the flow picture for the U.K. is deteriorating

In short, the flow picture could deteriorate further if global investors believe U.K. assets are becoming overpriced.

The FTSE 100 - a gauge of the valuation of the U.K.'s main listed companies - surged to a new record this week as the global economic upturn continued to drive corporate valuations higher which has in turn attracted inflows of foreign investor capital. But Deutsche Bank observe stock markets are no longer cheap on a price-to-earnings basis which raises concerns over the longevity of the rally in stocks.

Harvey also says U.K. government bonds are expensive on a valuation basis given current inflation dynamics in the U.K. while economic growth also continues to lag behind that of the rest of the world.

UK assets are now looking expensive

Above: UK bonds are expensive, stock prices are mixed.

Relative economic performance is also highlighted as being a source of potential downside, particularly for the Pound-to-Euro exchange rate.

The Eurozone's economy is outperforming the U.K. economy on a relative basis which is expected to place pressures on GBP/EUR. “If divergence continues, the Pound should lose out on an asset allocation basis, with EUR/GBP neatly tracking relative consumer confidence over time,” says Harvey.

Growth divergence between Europe and the UK

Above: The Eurozone economic outperformance is tipped to boost the Euro at the expense of the Pound

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Risks to the View

One significant risk to Deutsche Bank's call for a weaker Pound is the Bank of England which is of the belief the U.K. economy is in fact performing at a rate consistent with the need for higher interest rates.

The Bank indicated in 2017 that a continued positive performance by the U.K. economy and an abatement of Brexit risks could beget further interest rate rises in the future.

A currency tends to rise when interest rates at its central bank are rising as global investors seek out the higher yield on offer. The Bank already raised rates once back in November, by 25 basis points to 0.5%; a move that coincided with the Pound's general appreciation in the second half of the year.

Rising wage growth could increase price pressures which could prompt a hawkish response from policy makers at the Bank.

There are signs that pay growth is actually picking up well and this is part of the reason behind why some other strategists are turning bullish on the Pound.

Data from IHS Markit released this month shows permanent starting salaries continued to rise markedly in December amid reports of candidate shortages and robust demand for staff.

Markets are currently sceptical over how soon the Bank of England would be prepared to raise interest rates again however, but any hawkish turn would be good for the Pound.

The Bank’s comments around the “growth and inflation trade off should be listened closely to as they could bely an increasing willingness to sacrifice the little economic growth the UK currently has by raising interest rates further in order to contain price pressures," says Harvey.

On balance, however, Deutsche Bank expect the Bank of England to remain cautious in the first half of the year allowing them to hold a sceptical stance towards the Pound.

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