Investors told to avoid knee-jerk reaction to pound's plunge

Sterling nosedived 6% in just two minutes in an overnight 'flash crash' late last week. On Friday morning, at its nadir, the pound was being traded at $1.1841, which is its lowest since 1985. Tom Elliott, international investment strategist at deVere Group, explains that currency markets are reacting to three things.

First, the realisation that British prime minister, Theresa May, has opted for a risky "hard" Brexit strategy.

Consumer confidence may weaken, with purchases of big-ticket items put off Speeches at the Conservative Party conference last week suggested that the UK government will be willing to sacrifice membership of the single market, and possibly the EU's free trade area, in order to "take back control" of immigration and end "meddling from Brussels" on a range of issues.

A hard Brexit carries a much greater risk of economic dislocation as investment plans are put on hold by UK businesses, and by foreign ones considering investment in the UK, as they wait to see what tariffs and conditions will apply to UK/EU trade once the Brexit negotiations are completed.

Consumer confidence may weaken, with purchases of big-ticket items put off if consumers fear a slowing economy and a rise in unemployment. A weaker economy usually is bad news for a currency.

Second, the UK runs the largest current account deficit in the developed world.

With slower growth and Brexit uncertainty increased, current account inflows could shrinkThe UK current account deficit (which is the total of these) is -5.4% of GDP (£162 billion). It is -2.6% for the US, and +3.2% for the eurozone. This means the UK relies on foreigners to buy their debt, equity, buildings, factories and so on to the tune of £162 billion each year in order for the books to balance.

There is a real risk that with slower growth and Brexit uncertainty increased, these inflows shrink. Then sterling must fall in order to bring the current account deficit and matching inflows into balance.

And third, there is the possibility of higher US interest rates and possibly lower ones in Britain.

Interest rate trends currently favour the dollar over other currencies, as the Federal Reserve is clearly itching to raise rates. Slower growth in the UK as a result of a hard Brexit may lead to the Bank of England cutting interest rates again, down to zero.

Doom and gloom forecasters may continue to be proved wrong as a hard Brexit is negotiatedA widening interest rate differential against the dollar will lead to a weaker pound, everything else being equal.

What should investors do? For the moment, sit still and avoid knee-jerk responses. Recent economic data from the UK has been stronger than had been expected in the wake of the 23 June referendum.

Doom and gloom forecasters may continue to be proved wrong as a hard Brexit is negotiated.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.