Get ready for a sterling revival under Labour

In addition to the Brexit vote in 2016, it has had to absorb headwinds coming from the political paralysis under former Prime Minister Theresa May’s minority government, Covid lockdowns, rising energy prices and the debacle in the UK government bond market during Liz Truss’ short premiership.

After reaching a nadir of $1.07 in September 2022¹, sterling has since risen to $1.27¹ as opinion polls indicate the Labour party will likely form the next UK government following the upcoming general election on 4 July. For the first time in over a decade this could potentially lead to closer UK relations with the European Union (EU) and provide a catalyst for a sterling revival.

Closer ties with the EU under Labour is possible because, unlike the Conservatives, the party is less hindered by Eurosceptic backbenchers. This was made clear by Shadow Chancellor, Rachel Reeves, in her Mais lecture in March, where she argued for “forging a closer relationship with our neighbours in the EU”.

This follows on from comments made by Labour leader, Keir Starmer, at a centre-left leaders conference in Montreal in September 2023, that the UK-EU Trade and Cooperation Agreement (TCA), negotiated by former Prime Minister Boris Johnson to govern the future security and trading relationship after the UK left the EU, is “too thin”.

This doesn’t mean reversing Brexit or rejoining the EU’s single market and customs union: these red lines are unlikely to be broken by Labour in the short term. The party also recognises that renegotiating parts of the TCA with the EU to smooth trade disruption, and which is up for review in May 2026, will be extremely difficult. The EU has made clear that this will be an implementation review. Any changes to the terms of the TCA will require the EU commission to obtain a new negotiating mandate from member states.

At this juncture that looks unlikely, as there’s little need for the EU to re-negotiate the TCA with the UK. After all, the EU retained quota and tariff free access to the UK market for goods, where it reports a trade surplus. The EU also has a limited deal on services, where it reports a trade deficit with the UK, which enables member states to erode the UK’s market share.

Labour may struggle to entice the EU into investing significant time and political capital to open-up the TCA when it has other issues to deal with, like the war in Ukraine. Importantly the EU will want to be convinced that any trade deal changes would not be reversed by a future government, or that the UK would try to  “cherry-pick” parts of the current arrangement (e.g. removing the need for border checks on goods).

However, both sides recognise that, with a change to a Labour government, there is the potential for the UK and EU to review the relationship. Rebuilding trust with the EU sits with the UK. To do that, Labour could take a two-step approach:

First, Labour could focus on rebuilding a political relationship before tackling an economic one. Labour’s Shadow Foreign Secretary, David Lammy, argued in a Foreign Affairs essay in April that the UK should seek a “new geopolitical partnership with the EU” to include a “security pact that drives closer coordination across a wide variety of military, economic, climate, health, cyber, and energy security issues.” This is a stark contrast to the Johnson government, which rejected any foreign and security agreement with the EU and instead focussed on the TCA. In practical terms, this could involve the UK government attending EU foreign policy meetings, as there is currently no formal means of cooperation with the EU.

The EU will probably be more agreeable to a closer political relationship following the Russian invasion of Ukraine and the greater need for security cooperation. After all, EU leaders covet British military equipment and intelligence and vice versa. Furthermore, should former president Donald Trump secure a second presidency it may mean that US military support would come with conditions, such as sticking to NATO’s commitment of 2% of GDP defence spending. UK defence support to the EU would likely be more reliable than US support under Trump’s America First agenda.

Second, Labour could propose to keep the UK aligned to EU single market rules for food and agricultural products to lay the ground for an improved future economic relationship. Technically this should be easy to implement so that border checks on such produce between the UK and the EU would be unnecessary and it would solve the Northern Ireland border issue too. Though it would likely come with greater oversight from the European Court of Justice (ECJ). Ultimately, that would mean the UK becoming a “rule taker”, something that may be politically difficult for Starmer to swallow.

If Labour really wants to enhance its economic ties with the EU, it certainly has an incentive to get the ball rolling now on a dynamic alignment with EU rules. Given that the UK is already outside the single market and customs union, some firms, which do most of their business outside Europe, may diverge from EU regulations to gain competitiveness. The longer this divergence goes on, the more businesses adapt supply chains to prosper in a post-Brexit world. Should Labour delay a renegotiation of the UK trade and economic relationship to a second term it would make it more difficult to realign to the EU in the future.

If the UK and EU are willing to enter a closer political relationship and dynamic alignment on trade, it could lead to an opening up of the TCA down the road. Under that scenario, foreign exchange traders could anticipate a reversal of some of the disruption to supply chains post-Brexit. This could support growth and be positive for sterling.

Of course, there are additional factors that drive sterling apart from sentiment surrounding the UK’s relationship with the EU, such as the UK’s current account deficit (CAD), which is a broader measure of trade with the rest of the world.

While a Labour government may lament the perilous state of the country’s public finances and the poor productivity growth outlook, there is better news on external trade. The UK’s CAD has narrowed to 3.1% of GDP in the fourth quarter of 2023 from 6.8% in the third quarter of quarter of 2016, just after the EU referendum. Excluding volatile net imported energy, the CAD falls to 1.6% of GDP.^[1] This indicates that, bar another surge in oil and gas prices, there is less downward pressure on sterling.

The CAD improvement has been partly led by rising net service receipts. Surprisingly, this has not come from the financial service and insurance sectors, which have delivered a consistent combined surplus of 3% of GDP per annum since the referendum. Instead, it’s come from a rising share of net receipts from computer and other services, including management consultancy and trade between affiliated enterprises in the UK. This has become the biggest driver of overall net service receipts at 3.4% of GDP per annum up from 2% in the third quarter of 2016.

Breaking the data down by geography, the UK is increasing sales of these services to non-EU countries, like the US, which is now a larger customer for services than Europe. Arguably, much of the increase is coming from UK service-sector wages charged to US customers. Even considering the bounce in sterling against the dollar last year and the catch up in wages, the UK remains a cheap destination in real terms for US companies to outsource work to their UK-based affiliates. According to the Adam Smith Institute, the sterling equivalent median average full-time salary in the US last year was £45k, higher than £35k in the UK.² Arguably, the rising UK service sector surplus with the US could continue for some time.

If a lower CAD supports sterling stability, the UK is well positioned to attract foreign capital. London has been mooted as a listing venue for Chinese clothing manufacturer Shein, which was valued at $66bn (£52bn) at its last funding round. Shein had planned to list in New York but concerns over ties to China and labour practices have proved to be a hurdle. Although much smaller, single-board computer manufacturer Raspberry Pi recently listed in London in a boost to the UK IT sector, which has proved fertile hunting ground for acquisition targets by foreign companies. Opportunities also exist away from the stock exchange: Canadian asset manager AIMCo is planning to increase its headcount in London in order to invest 'billions' in the UK, including on projects linked to the 'green industrial revolution' policy. If Labour’s economic agenda (see our Labour wants Bidenomics for Britain) is conducive for business-friendly conditions, then more foreign capital could flow into the UK and drive-up sterling.

On the other side of the sterling foreign exchange rate anchor is the US dollar. We argued back in June 2023 that there is room for the greenback to fall. This was predicated on a stronger global recovery than expected. So far this year, the US economy continues to defy expectations. At the start of this year, the Bloomberg consensus of economists had forecast that the US real GDP would expand by 1.3% in 2024, but that has now been upgraded to 2.4%.³ For a counter-cyclical currency, faster economic growth is generally bad news for the ‘safe haven’ dollar.

Another reason to expect the dollar to weaken is that it is expensive when compared to other major currencies. Looking at Purchasing Power Parity, which measures the price of goods in various countries to compare the currency’s relative value, sterling should be trading around $1.40, or around 9% higher from its current exchange rate of $1.27. ³

When factoring in the impact of interest rates, there is even more upside potential. From our analysis of the statistical relationship between the foreign exchange rate and the UK-US interest rate differential of 2-year government bonds, we find that sterling should be trading at around $1.50, or 18% up from current levels ($1.28) today’s exchange rate.⁴

In conclusion, a new Labour government could use defence and security to rebuild trust with the EU and provide a catalyst for sterling appreciation. In addition, a narrowing of the UK current account deficit and a weak outlook for the greenback are also tailwinds for the pound to appreciate.

[1] LSEG Datastream / Evelyn Partners

[2] https://www.adamsmith.org/blog/american-wages-are-higher-than-british-by-more-than-you-think

[3] LSEG Datastream / Evelyn Partners

[4] LSEG Datastream / Evelyn Partners