Today is an historic day for the nation of my birth. Nine months after the surprise referendum vote to leave the European Union (EU), the U.K. Prime Minister Theresa May signed Article 50 of the E.U Charter, formally beginning the withdrawal from Europe, or Brexit as it has become known. As significant as the day is in historical terms, though, investors should be careful not to read too much into the news from a market perspective. The process may now be irreversible, but the actual terms of the withdrawal and of any trade agreements that follow are not yet known and they will determine the impact on stocks, both in the U.K. and elsewhere. There is, however, one market that could benefit as negotiations get underway and that is gold.
Gold is technically a commodity, but unlike most commodities it has very little practical use. It is therefore more accurate to think of the yellow metal, not as a commodity but as a currency, and it is in that role that gold stands to benefit from Brexit. The interbank currency markets, where I got my start in a dealing room and worked for nearly two decades, are huge. The average daily turnover is just north of $5 Trillion, making it easily the world’s largest market. In effect, foreign exchange is a massive pool of money looking for a home and if just a fraction of that cash finds its way into gold the precious metal is in for a strong bullish run.
There are a couple of reasons that that outcome looks likely, but they are more to do with the unattractive nature of the alternatives than any particular attraction of gold per se. The British pound (GBP) is one of the world’s major currencies, alongside the U.S. Dollar, the Euro and the Japanese Yen. To some degree that status as a major comes from the fact that London has remained the financial center of Europe, even though the E.U. economy now dwarfs that of the U.K. Post-Brexit, however, many of the big banks whose European operations are based in London are expected to move elsewhere so as to stay within the E.U.
If London does lose its status in the financial world, then that will put pressure on GBP, no matter what the exit package and trade agreements look like. The problem for the forex market, though, is where that money goes. The U.K. is not currently the largest European economy, that honor goes to Germany, but it is a significant part of it. Removing the British market from Europe can, therefore, hardly be expected to benefit the Euro. Right now, though, neither the Dollar nor the Yen look like places to be either.
The Yen has admittedly strengthened around 7% so far this year against the Dollar, but the Bank of Japan is still pursuing inflationary policies, including negative short term interest rates, so further strengthening from this point looks to be limited at best. So, if the Pound, the Euro and the Yen all have reasons to discourage holding them that leaves the Dollar. The market, however, has recently shown that there is little enthusiasm for that currency either.
After a strong post election run the Dollar changed direction at year’s end and is still in a downward channel. That can be expected to continue, as following the failure of the healthcare act last week the President and Congress are now focused on policies that will presumably be more popular, but run the risk of being inflationary. Introducing a package of tax cuts and stimulative infrastructure spending simultaneously, as the White House is now suggesting they will, could easily create a serious inflation problem, and inflation by definition debases a currency.
Given the lack of choices, therefore, it looks likely that traders will turn to gold in its traditional role as a store of value and an inflation hedge. In fact the chart above would suggest that that process has begun already, as gold has risen as the dollar has retraced since December. That upward trend is likely to be confirmed over the next few months as Brexit moves from a concept to a reality and money looks for a safe home in anticipation of disruption, so introducing gold to your portfolio or increasing current holdings looks like a smart move for investors.