The British pound recently fell almost to its lowest level to the euro in eight years, fast approaching parity with the euro. But this does not mean investors should jump in. The U.K. currency, which has lost 15.4% of its value versus the euro since the Brexit vote of June 23, 2016, has reason to weaken further.
One euro bought 0.9156 sterling pounds on Monday, Aug. 21, on international markets. The pound has not seen such weakness since October 2009, according to FactSet data. At the time, the U.K. was reeling from the fallout of the collapse of Lehman Brothers, whereas it still looked like Europe would be spared the brunt of the global financial crisis.
The pound has been on an accelerated downhill trajectory since April this year, when Prime Minister Theresa May announced the ill-fated snap elections that saw her Conservative party's majority in parliament diminished, weakening the government's hand in Brexit negotiations:
The U.K. economy is holding up well, considering the political upheaval. To be sure, data released on Tuesday, Aug. 22, that showed U.K. public finances posting their first July surplus since 2002 is great news, but it is only one month of data. The surplus is likely to be temporary. Public sector net borrowing still increased in the current financial year to date (April-July) from the same period a year ago.
Those who hope to bag themselves a bargain in sterling this time could be disappointed. The U.K. government on Monday released a couple position papers to advance its negotiations with the European Union for its future position, but these have not contributed to a boost in confidence.
The EU has said from the beginning that it wants the withdrawal conditions agreed upon before discussions on future trading conditions take place. The main issues that need to be agreed upon are the rights of EU citizens in Britain and British citizens in the EU after Brexit, the Irish border, and the U.K.'s financial obligations to the EU -- the "divorce settlement," as the press calls it.
There has been little progress on any of these issues, and fears are mounting of a so-called "cliff-edge" Brexit, with no exit agreement in place on March 29, 2019. Still, this is politics, and any U-turn, downturn or upturn is possible.
However, besides the Brexit politics, there are economic reasons why the pound will remain weak. A recent paper on the impact of debt published by the Bank for International Settlements (BIS) argues that credit booms, while producing a significantly positive effect on output in the short run, have significant negative effects on output over the medium term -- consider to be a horizon of five to seven years.
This is because the bill for the credit boom -- the servicing of debt -- must be paid after the money has been spent. The U.K. economy, after enjoying the fastest rate of expansion in consumer credit since 2005, could be about to face the need to start paying the bill.
European rating agency Scope Ratings initiated the U.K.'s credit rating at AA, with a negative outlook.
"Debt remains at elevated levels, and the economic and fiscal policy outlook has weakened owing to uncertainty around and consequences of the exit from the EU," Scope Ratings lead analyst Dennis Shen wrote in a report released last week.
"While the U.K. maintains significant credit strengths -- including London's role as one of the world's premier financial centers -- we consider the current constellation of risks to signal an overall adverse trajectory. The negative outlook reflects this assessment."
Public debt is around 88% of GDP in the U.K., and the International Monetary Fund (IMF) expects it to decline to 83% by 2022. The rating agency said Britain's high public debt, at the upper end of its AA peer group, "remains a material credit weakness."
Economic growth fell to 1.8% last year from 2.2% in 2015, Scope Ratings noted. This was partly because of a drop of investment, although household consumption kept growing, supported by unsecured credit and a decline in the savings ratio. In the first quarter of this year, the savings ratio fell to 1.7%, the lowest level on record.
On the plus side, unemployment is now at 4.4%, the lowest rate since 1975, even with labor force participation at a high 78.7%. But with wage growth subdued and inflation above the Bank of England's level of 2%, consumption is likely to be depressed.
Credibility, both for the Bank of England and for the government, has become more important since the Brexit vote. Both are lacking. The Bank of England still keeps interest rates at a record-low 0.25% despite inflation's overshoot, while the government dances around the Brexit negotiations, with EU critics saying Britain still is trying to have its cake and eat it.
As long as the Brexit negotiations remain in the realm of vagueness rather than concrete progress, the euro will have the upper hand. The pound may look cheap now, but it could get even cheaper.
This article originally appeared at 08:00 ET on Real Money, our premium site for active traders. Click here to get great columns like this from Jim Cramer and other writers even earlier in the trading day.
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