For buyers of British equities, Brexit didn't seem to matter.
Since late June, shortly after Britons voted to leave the European Union, the FTSE-100 has marched ever upward and now trades near record highs. The FTSE-250, whose members companies are focused on the British economy, has reached an all-time high. The British economy was strong, the Bank of England was working its magic and many economists and business commentators agreed that what the Leavers dubbed "Project Fear," the forecasts of economic doom spun by the Brexit-fearing mob, proved to be false alarms.
The global currency markets told an entirely different story. The currency markets are oceans bigger than the FTSE-100 or the FTSE-250 and their message was that Brexit, or more specifically the uncertainties surrounding Brexit, matters a lot.
In overnight trading on Friday, a frantic, two-minute flash crash sent the pound down more than 6 per cent against the dollar, taking it to $1.18 (U.S.). The pound later recovered somewhat, reaching $1.25, but was still down 1.2 per cent by time the European markets closed for the weekend. Some analysts blamed French President François Hollande for triggering the crash. His Thursday night speech demanded that Britain pay a heavy price for Brexit. Others blamed a possibly rogue trading algorithm.
While algorithm trading may have exaggerated the fall, there is no doubt its decline was based on genuine fears that Britain is stepping into economic unknown. As the votes were tallied and the result of the June 23 referendum became clear, the pound plummeted as much as 10 per cent overnight. It tumbled another 4.2 per cent this week and now trades at its lowest level since 1985.
What do the currency traders know that equity investors do not know? And where is sterling's floor? Is it $1.20, $1.10 or even par? The answer depends on your views on trade flows and investment flows – the latter are more important – in post-Brexit Britain.
The currency traders have responded to comments by British Prime Minister Theresa May that suggest the country is marching toward a "hard" Brexit. That apparently means her Conservative government will yank Britain out of the EU and all its associated rules and ties and damn the economic consequences if doing so allows the country to gain control of its borders.
Britain, of course, will try to negotiate free access to the EU, but doing so could take years, and other European leaders have stated they have no intention of giving Britain any breaks on that front. Before a new trade deal is reached, it would have to rely on the World Trade Organization rules to trade with the EU, which means British exporters would have to pay a 10-per-cent tariff to sell goods, such as cars, on the sunny side of the English Channel.
The good news is that the pound's plunge will help compensate for the tariffs; the bad news is that uncertainties around Britain's post-Brexit trading arrangements should ensure the sterling markets will remain volatile. Perversely, traders probably would be happier if a rock-hard Brexit were announced today. The guillotine at dawn is always better than years of torture that ends with the guillotine anyway.
Investment flows are the more pressing issue. There is little doubt that the currency market was rattled by the blunt comments made by Carlos Ghosn, chief executive officer of Renault-Nissan, at the Paris Motor Show on Sept. 29. "Important investment decisions will not be made in the dark," he said, referring to his decision to defer all new spending on Nissan's massive Sunderland car factory in England's northeast, which sends 55 per cent of its output to the continent, until the terms of Brexit are known.
If Britain were to compensate Nissan for the 10-per-cent tariffs on exports to the EU, Nissan might change its mind, he implied. He's dreaming. If Ms. May's government were to provide export guarantees for Nissan, it would have to do the same for Toyota, BMW and every other car maker in Britain, perhaps every other exporter. It's not going to happen and that means all of Nissan's competitors will adopt Mr. Ghosn's strategy. Not one of them will ramp up production in Britain until they know what the post-Brexit world looks like. If they don't like the new terms, investment could dry up, with factory expansions happening outside Britain.
In the meantime, investment from the companies which use Britain as an export base will be frozen along with the job creation that goes with it. The currency traders know this. They may also be spooked by the possibility that foreigners, rich and poor, skilled and unskilled, will hit the road after deciding that Britain no longer wants them, their talents or their money.
Taxing the rich is fine and good and will win votes for the Conservatives, but apparent xenophobia is an entirely different matter. Amber Rudd, Home Secretary in Ms. May's government, stoked the those fears when, early this week, she announced a proposal to force companies to disclose how many foreign workers they employ. Business leaders were horrified. Comparisons to Mein Kampf were made. Later in the week, the British Foreign Office told foreign academics who act as expert advisers to the government on Brexit that their services would not longer be required.
It is the investment flows, or lack thereof, that will keep the pound under pressure. How low the pound will go is an open question. Currency traders operate in a vast market, tend to move in packs and can send currencies soaring or plunging in seconds, as Friday morning's selloff proved. Given Brexit's uncertainties, it seems unlikely the pound will return to its pre-referendum level any time soon. The currency markets are pricing in a economically damaging Brexit. At some point, so might the equity markets.