Morgan Stanley "Preparing to Buy" the British Pound, but final "Leg lower" Must First Pass

- GBP/USD could rally towards 1.55 by end-2019, gains vs. Euro more constrained

- "GBP valuations would look attractive" on Brexit progress

- Spot references: Pound-to-Euro exchange rate: 1 GBP = 1.1412 EUR. Pound-to-Dollar exchange rate: 1 GBP = 1.3506 USD

Hans Redeker, Morgan Stanley, Image (C) Pound Sterling Live

Foreign exchange strategists at global investment bank Morgan Stanley have told clients in a mid-year foreign exchange forecast update they are preparing to buy Pound Sterling, but only after further devaluation which they see occuring over coming months.

The call suggests a longer-term downtrend in the Pound might just be about to come to an end, with strategists eyeing a Brexit negotiation end-game and a number of interest rate rises at the Bank of England in 2019 as being drivers behind a more sustained pick-up in the currency.

Hans Redeker, a strategist with Morgan Stanley & Co. International PLC in London says his models show GBP to be one of the most undervalued within G10, adding, "if the prospects of a soft Brexit deal potentially increase later in the year as we get closer to the endgame, GBP valuations would look attractive, allowing the currency to rally, particularly as the USD bear re-emerges."

Sterling took a significant hit in the wake of the Brexit referendum in June 2016 but has since recovered ground against the U.S. Dollar and Euro as Brexit negotiations proceed and the economy continues to deliver growth.

However, as we move through mid-May there are signs that the recent recovery in the currency might be over amidst a slowdown in economic growth, leading some analysts to suggest Sterling might have already put in its 2018 highs. Indeed, we are told by Morgan Stanley there are some medium-term headaches that will likely weigh on Sterling over coming weeks and months, something that will drive the currency to yet cheaper levels against the Dollar and Euro.

"GBP is also in the midst of its final leg lower as equity volatility rises, domestic growth stalls and uncertainty rises as we approach the Brexit endgame," says Redeker.

The analyst notes the UK economy to be heavily reliant on foreign investor sentiment and is therefore vulnerable "to a withdrawal of foreign funds as global liquidity conditions tighten and volatility rises. This would hit at a time when Brexit uncertainty could be rising into autumn as we approach the Brexit endgame," says Redeker.

Morgan Stanley economists meanwhile expect a consumption slowdown to bring UK growth to a standstill, "reducing the return on investment on GBP assets".

"In our view, to increase its attractiveness as an investment destination, GBP would need to weaken," says Redeker.

Targets to Aim for

While near-term risks remain, it must be noted that ultimately any further weakness only exacerbates Sterling's undervaluation and presents the speculative community with compelling levels from which to purchase the currency ahead of a rebound.

"After the GBP depreciation we expect this year, GBP/USD at 1.32 would be about 7% below its PPP fair value, and the GBP TWI would be about 10% below pre-Brexit levels. On a REER basis, GBP is also one of the most undervalued within G10. If the prospects of a soft Brexit deal potentially increase later in the year as we get closer to the endgame," says Redeker.

Morgan Stanley believe "a potential soft Brexit deal, rising UK real rates, attractive currency valuations and USD weakness should help GBP/USD rally towards 1.55 by end-2019."

Forecasts show GBP/USD could be as low as 1.32 by the third-quarter 2018, ahead of a recovery to 1.37 by year-end.

The EUR/GBP exchange rate is seen as high as 0.92 by the third-quarter 2018, a target that is maintained through to the first-quarter of 2019. A decline to 0.89 is seen by year-end 2019.

This gives respective Pound-to-Euro exchange rate targets at 1.0870 and 1.13.

This will disappoint those hoping for a more bullish Pound-Euro forecast, but Morgan Stanley do warn they see value in buying any Euro weakness.

"Long-term EUR prospects remain bullish, as we expect growth and reform momentum to pick up later this year," says Redeker.

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