Gilts at risk from overseas selling if Sterling slides further

Expectations of a hard Brexit that triggered the marked devaluation of Sterling last year have effectively reversed since a now noticeably weakened Prime Minister in charge of a minority government must lead the exit negotiations with diminished political capital.
Britain looks ready to make more concessions to the EU than previously envisioned. Philip Hammond, the Chancellor of the Exchequer, has already stated that the vote to leave the European Union (EU) was not a vote for Britain to become insecure or poorer, thus prioritising the economy over anything else. We believe the stance taken by the Treasury will help to stabilise Sterling in the short term.
Looking ahead, the EU will prioritise cementing stability within the EU membership itself as two years of negotiations start on Britain leaving the block, and that is before a new trade relationship is discussed between the two parties. Depriving the UK of some—and potentially major—economic benefits it enjoyed as an EU member is therefore on the cards.
Affecting the Pound potentially the most will be the loss of passporting rights that allow banks and insurance companies to sell financial services into the EU freely, without having to set up a local presence. Financial services are the UK’s largest contributor to the trade surplus. Losing these benefits means those trade surpluses are set to weaken, unless offset by improved export conditions in goods as Sterling weakens. As an overwhelmingly service based economy however, the net effect points towards a widening, not a shrinking, of UK’s trade deficits with the EU.
The UK’s overreliance on foreign capital to not just fund the trade deficit but also fund deficit spending and sustain confidence in an already propped up housing market underpins Sterling’s structural weaknesses. It leaves monetary policy of the Bank of England (BoE) largely on hold and in a position of dovishness.
The import-cost induced inflationary pressures following the marked devaluation in Sterling means consumers’ debt-fuelled spending power looks significantly weakened over the remainder of 2017 amidst indications of wage rises remaining absent. Therefore, any tightening by the BoE will likely come in a delayed fashion, as the weakening of energy and food prices should ease inflationary pressures further out. The muted long-term inflation picture will therefore not succumb gilt to significant price pressure, as even when inflation adjusted, UK’s long-dated gilt yields are negative.
However, bigger pressures await gilts if Sterling continues to weaken or succumbs to increased volatility. We see foreign investors’ enthusiasm in gilts, which in the period from 2010 to date amounted to £237 billion of net purchases (even as UK investors redeemed £116 billion in the same period), wane as a primary concern for gilts longer term.
Across UK asset classes, we see UK equities overall the least affected. Large-caps are likely to absorb the two years and probably more of soft Brexit negotiations, along with the rising structural imbalance caused by UK’s twin deficits, better than mid and small-caps. A potentially higher and volatile inflationary backdrop would also favour high dividend yielding equities as favoured income strategies.