Valuation: not much downside left

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Medium- to long-term valuation measures do not suggest material downside to GBP.

Sterling’s place in the FX space 4 of 5 UK economy: Rising from the ashes 2 of 5

Residents of the United States, please read this important information before proceeding

Please read this important information before proceeding.

Our medium-term BEER model suggests GBP/USD fair value at 1.54 (Figure 1), broadly in line with current levels. The collapse in GBP/USD fair value from its peak in 2008 has been mainly driven by stubbornly high UK inflation and falling terms of trade, though both declining measured productivity (output per worker remains below pre-recession levels) and interest-rate differentials also further eroded GBP/USD fair value (Figure 2).

However, these factors now appear to be fully reflected in the price of GBP.

Figure 1: GBP/USD in line with its BEER fair value...

Source: Barclays

Figure 2: …inflation and terms of trade drove down its collapse

Source: Barclays

Figure 3: GBP is cheap against most G10 currencies…
G10 FX valuation against GBP, positive number signifies overvaluation against GBP and vice versa

Source: Barclays, OECD

Figure 4: …Even in real terms

Source: Barclays, BIS

OECD purchasing-power parity (a very long-term valuation measure) suggests a slightly lower fair value GBP/USD level at about 1.51. In the context of typical modelling error, such misvaluation is unremarkable and does not warrant a material adjustment in GBP.

Sterling’s valuation is undemanding

However, as Figure 3 shows, USD is the only currency where a PPP valuation suggests modest GBP overvaluation. Sterling looks slightly cheap against EUR and JPY (PPP fair values at around EUR/GBP 0.84 and GBP/JPY 160), while the likes of AUD and CHF look materially more expensive against GBP. As per below, and going beyond pure valuation measures, both currencies remain our favourite shorts against GBP.

The above is also reflected in GBP’s real trade-weighted exchange rate, which remains firmly inexpensive (Figure 4). Overall, sterling’s undemanding valuation (which looks positively attractive on certain crosses) is likely to limit downside to the currency. If anything, it provides scope for a wider rebound by sterling, once the right catalysts are in place.