Eighteen months of Brexit negotiations have seen both the EU and UK postpone making a final decision. This has forced corporates, amongst others, to hope for the best but prepare for the worst. However, if corporates prepare for a ‘no-deal’ without adequately hedging their exposure so that in the event of a deal they will be sufficiently covered, they could face losses if Sterling does in fact rally.
Last week’s Salzburg Summit provided negotiators with a platform to position a possible deal, but the Summit did little to materially bring a deal closer to reality. Without any alternatives on the table, and neither side softening their stance, it is no surprise that media headlines are viewing a ‘no-deal’ as the single most probable scenario amidst all of this uncertainty.
And it is clear that markets are pricing in the risk of a no-deal. Sterling’s response to Brexit-related developments is evidence of this, especially in August when no-deal signs saw Sterling trade at its lowest level against the Euro for over a year. Should uncertainty surrounding the negotiation process continue, Sterling could see further downside.
Sterling’s fall - and market activity around this - does bear some resemblance to the actions corporates took in the aftermath of the global financial crisis in 2008. Corporates hedged in reaction to the collapse of Sterling, which fell to 1.02 against the Euro. Over the next couple of years, when the pound bounced back to 1.28, corporates that over-hedged their currency exposure went bust.
In 2019, the downside risk of a no-deal Brexit could be a 7-8% fall in the value of Sterling. If a deal is struck, however, the pound is expected to rally by up to 15-18%, especially if investment flows into the UK. Therefore, 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.
In the lead up to Brexit, it is crucial that corporates start to reassess their FX risk exposure. Those who hedge too strongly in anticipation of a ‘no deal’ scenario are likely to face significant losses, putting their operations at risk. Corporates should also be careful not to sell off too much Sterling as it could actually rally strongly if a deal is struck.