If one outcome was made clear from
the United Kingdom’s 2019 election it is Brexit will happen. The public gave
Prime Minister Boris Johnson a clear message to deliver what the people voted
for in 2016 as quickly as possible.
At the same time, there is less clarity as to what will happen when Brexit transitions from a mandate to reality on January 31, 2020. Regardless of what transpires, business owners and investors need to take steps to protect their assets, perhaps through buying a currency forward contract.
Experts Were Wrong For Years
The Brexit vote took place on June 23, 2016, and within hours of the results, political commentators and experts predicted doom and gloom. For example, the Centre for Economics and Business Research said in late 2018 that France could take advantage of the Brexit “disruption” and overtake the U.K. economy in size.
Fast forward to the end of 2019 and not only did this not transpire, but the U.K. economy grew at a faster pace in the third quarter than initially expected. Ironically, the U.K. economy expanded by 0.4% in the final reported quarter of the year while France’s economy grew at a slower 0.3% pace.
Other predictions that were proven to be flat out wrong include Goldman Sachs’ 2017 prediction of a recession scare and London would lose its status as the world’s financial capital.
Many Brexit “experts” have been
mostly on the wrong side as the U.K. economy remained resilient. From this one
could conclude that listening to the side which screams the loudest may not be
the right approach to protecting your financial assets.
The British Pound Could Tumble Or Surge Depending On Who You Ask
There are valid arguments to say
the British pound will either tumble or surge in the days, weeks, or months
following Brexit becoming official.
Taking the bullish side of the trade is Nomura FX Strategist Jordan Rochester who argues the removal of uncertainties associated with a potential “hard” Brexit bodes well for the sterling. He says the market isn’t fully pricing in a rebound in the U.K. economy and investors could take advantage of the discounted valuation. Also, the ruling Conservative government’s March budget would offer incremental levels of support for the currency.
On the other hand, experts are
making the case that the pound could fall as a combination of fiscal and
monetary stimulus measures will be needed and this could disrupt the relative
“The likelihood is the UK economy records a contraction in Q4,” Richard Grace, head of FX strategy at Commonwealth Bank of Australia, was quoted as saying. “Given the sluggishness in the economy and the transitional headwinds of the Brexit process, we believe the UK economy requires both monetary and fiscal stimulus. We believe the Bank of England will cut rates by 25bp on 30 January.”
Best Of Both Worlds: Currency Swap
A forward currency contract (also
known as a swap) sounds like a financial tool reserved for the largest London
or New York City banks. But this isn’t the case at all as small and
medium-sized enterprises (SMEs) can take advantage of the financial instrument
designed to protect assets.
A forward contract gives an
enterprise owner the ability to buy or sell a currency pair to be settled on a
future date but with a guaranteed exchange rate. The length of the contract
lasts up to one year, but can extend to as much as five years.
Here is an example of how a
contract works. Suppose you are a U.K.-based enterprise owner that sells $1
million worth of clothes to customers in the United States in U.S. dollars.
Since Brexit is mostly a domestic event, clothing demand for any particular
brand is unlikely to change across the pond.
Since the client pays in U.S.
dollars you need to exchange the money to pounds. Suppose at current exchange
rates, $1 million translates to roughly £770,000 pounds. You now face a large
uncertainty in 2020 and beyond because it is unclear what direction the pound
will head in.
If the pound moves in your favor by
10% then your $1 million in sales is now worth £847,000. You earned an extra
£77,000 without having to do any extra work. Congratulations! But on the other
hand, if the pound moves 10% in the opposite direction you will only have
Instead of sitting back and hoping
for the best and planning for the worst, a currency contract would lock in the
current rate. You are now guaranteed a set foreign exchange rate, regardless of
what happens. By erasing one major piece of uncertainty, an enterprise owner
can better plan and budget out the year ahead.
Other actions enterprise owners can
take to minimize potential disruptions from Brexit includes holding off on
planned activities, such as hiring new workers or expanding production.
The Bottom Line
Entering into a currency contract
implies you will miss out on potential upside from favorable exchange rate
fluctuations. On the other hand, it means you will avoid potential downside as
Business owners who are unwilling
to take any chance will come out a winner by avoiding unnecessary stress
associated with factors completely outside their control.