The currency markets have already priced in much of the risk of a ‘no deal’ with GBP trading at its lowest levels for over a year. However, if a deal was to go through, it could actually present a much greater risk to some than a no deal. Contentious? We ask an expert to explain.
It has been 18 months since Britain began its withdrawal from the EU and there is still no deal struck between the two sides. With only six months left on the clock, Britain’s negotiating strategy still lacks a clear and decisive path. This has forced corporates to hope for the best but prepare for the worst.
However, if corporates fail to adequately hedge their exposures so that in the event of a deal they will be sufficiently covered, “they could face losses if sterling does rally”, warns Clive Shelton, Director at multi-currency platform, EasyFX.
Negotiations have given corporates little reason to believe a deal can be reached. The likelihood of Britain not agreeing a deal with the EU before March 2019 has been magnified by key figures – including International Trade Secretary, Liam Fox, and Bank of England Governor, Mark Carney – publicly warning of the possibility of a no-deal.
“The recent Michel Barnier statement that a deal could be reached within six to eight weeks provided a momentary scintilla of hope for the negotiation process,” notes Shelton. “However, ‘no-deal’ warnings have once again resurfaced, following Prime Minister Theresa May’s statement that the only alternative to her Chequer’s Plan is to crash out of the EU without a deal.”
Markets pricing for no-deal
Corporates and markets have duly reacted to such ‘no-deal’ warnings. One constant throughout the volatile negotiation process has been the sterling’s response to Brexit-related developments, notes Shelton. “August’s no-deal signals saw sterling trade at its lowest level against the euro for over a year. Prolonged uncertainty surrounding negotiations is likely to see sterling take a further beating,” he states. “It is clear that markets are pricing in the risk of a no-deal.”
It is also no surprise that corporates (amongst others) are preparing for an unfavourable outcome. To minimise their exposure to adverse sterling movements, it is apparent that many corporates are hedging against the falling value of the pound.
Have they jumped the gun? Shelton thinks not. What is happening with the markets now is somewhat reminiscent of the actions corporates took in the aftermath of the 2008 global financial crisis, he notes.
The collapse of sterling then saw corporates hedge their currency at the wrong point – the GBP/EUR fell to 1.02, and when it bounced back to 1.28 over the next couple of years, a number of those companies that over-hedged their currency exposures went bust.
This outcome, says Shelton, should serve as a stark reminder to corporates to hedge their exposure to a sensible level, rather than overdoing it in response to the doomsday Brexit predictions. “The downside risk of a no-deal could be a 7-8% fall in the value of the sterling, however if a deal is struck the pound could rally up to 15-18%, especially if investment flows into the UK.”
Despite the failure of Theresa May and her European counterparts to come to an agreement at the recent Salzburg Summit, Shelton believes there remain “multiple opportunities” to agree upon a deal before the year-end: corporates need to be prepared for this possibility.
“In the event of a deal being reached, corporates that have hedged strongly in anticipation of a no deal are likely to face significant losses, putting their operations at risk,” he warns. “Corporates should be careful not to sell off too much sterling as it could actually rally strongly if a deal is struck.”
Clearly at this critical juncture, it is crucial that treasurers start to think about how to reduce their exposure to currency fluctuation risk regardless of the outcome.