Eran Peleg, CIO
The British Pound has dropped significantly in recent months, since the Brexit vote at the end of June. But is it actually cheap?
Economic models can guide us in establishing whether currencies are cheap or expensive. According to Purchasing-Power-Parity (PPP) models (https://en.wikipedia.org/wiki/Purchasing_power_parity), the answer is YES.
Source: Bloomberg, OECD, Clarity Research
Unfortunately, using such economic models to time investment is often tricky business. These models cannot be used to predict the short or medium term direction of a currency. If they do work, it is usually over extended periods of time – i.e. over the very long-term. And, as with any model, particularly those with long-term horizons, one has to ask whether the long-term relationships that define or underpin the model are still relevant, or has a structural break occurred that makes the assumptions problematic.
In the current case of the UK, one can definitely argue that we are most likely facing a possible change in the long-term relationships. It is true that the country was never a member of the Eurozone (EMU), but as a member of the European Union (EU), it has enjoyed preferable terms of trade with Europe. So, it is possible that the model's signal is not as robust as it would have been otherwise. But given the extent of current PPP undervaluation, it is interesting to note nonetheless.
The Economist's Big Mac Index is a famous version of the PPP model. It tracks the price of one standard, basic, product (Big Mac burger) across different countries, and based on the simplistic assumption that the price of such a good should be the same anywhere, it derives the implied undervaluation/overvaluation (relative to USD) of each country's currency. With a Big Mac price of GBP 2.99 in the UK versus $5 in the US, the implied GBP undervaluation is currently above 25%. Although it would not be prudent to expect an exchange-rate correction in the near-term, at least we can bet on a cheap burger on the next trip to London.
Disclaimer: Nothing contained herein is investment advice and one should consult with a professional about their investment situation before they make any investment decisions.