Why We Still Worry About Sterling…


The British pound has been the strongest performer of all major currencies over the past six months, appreciating by almost 5% on a trade-weighted basis, and has been the second best performing currency in the world against the USD (gazumped only by the indomitable Somali Shilling) over the same period. Sterling’s run coincides with the UK’s recent robust economic performance (at least on a headline basis) relative to its peers. In fact, last quarter’s 0.8% rise in UK GDP represented the fastest growth rate amongst the G-7 nations. 

 

These two events are not unrelated, of course. As the UK economy improves, the pound has strengthened in anticipation of rising UK interest rates, as global investors, starved of yield in virtually every developed market economy (and with some central banks, such as the ECB, toying with the idea of negative interest rates), begin to salivate at the possibility that Mark Carney may finally give them what they are looking for – positive carry.  (Funding pension plan deficits with sub 2% returns isn’t easy after all).   

 

However, now that both the value of the pound, and investors’ expectations for UK interest rates, have been raised, the question becomes: what next? Will UK PLC’s momentum continue to drive sterling higher against its peers, or has the good news now been ‘priced in’, making the pound vulnerable to a correction? 

 

As you may have guessed from the title of this piece, we feel that the second scenario is the more likely (and not just because GBPUSD has now exceeded our target of 1.63). Whilst we concede that attempting to call turning points in the currency markets is a notoriously tricky business, and it is certainly possible that sterling’s current momentum has not yet been extinguished, we remain unconvinced by its recent resurgence. There are three main reasons for this view:

 

  1. The UK’s recovery is too fragile to support higher interest rates;
 
  1. The economic ‘re-balancing’ (away from debt-fuelled consumption, towards investment and exports) has not happened, leaving sterling vulnerable to a widening (or at least a persistently large) current account deficit; and
 
  1. The risks associated with the unwinding of the Bank of England’s quantitative easing programme are not adequately priced in (nor is the possibility of the Bank of England actually expanding its quantitative easing programme at a later date).
 

Without rising interest rates, the case for a stronger pound is very difficult to make. After all, the pound remains fundamentally overvalued, the UK offers one of the highest inflation rates in the developed world, and has a central bank which has monetised about a third of all outstanding government debt. Frankly, without the prospect of a higher yield, the pound would be a basket case. 

 

But, the UK economy remains unable to support higher rates. The UK recovery has been driven by two related phenomena: 1) A resurgent housing market; and 2) rising consumer spending. UK household debt and UK house prices are now at or near record highs. As such, rising interest rates represent a double threat to the UK economy. Firstly, they would hit household wealth hard, by lowering house prices (thus damaging consumer spending). Secondly, they would significantly increase the debt service requirements for UK households. In this regard, the UK remains much more vulnerable than other economies, such as the US or Europe, due to:

 

 
 
 
Chart I: UK House Prices 2004 to 2013

Source: Bloomberg (2013)

 

 

 

Chart II: Household Wealth by Source (2012)

Source: McKinsey (2013)

 

 

 

Chart III: Total Household Debt Payments (2012)

Source: McKinsey (2013)

 

A second reason why we feel that sterling is vulnerable is that, because the recovery has been driven by domestic consumption and the housing market, rather than business investment (note: it is estimated that UK business investment remains 25% below its 2007 peak!) and export development, the risk of a UK balance of payments crisis cannot be dismissed. The UK has not enjoyed a current account surplus since 1983, the deficit is near a record high (only twice has the deficit been significantly wider than it is now, and both previous occurrences were during war time). This is both unusual (normally in times of economic weakness, exports slow down and the current account deficit would shrink) and persistent (last quarter saw exports again fall by 2.4%, the largest drop in over two years). Current account deficits need to be funded somehow, and for the moment the UK is managing to attract enough foreign investment to ensure that the currency remains stable. However, if investors begin to lose their enthusiasm for UK assets, the currency will become extremely susceptible to devaluation, as it lacks sufficient ‘real economy’ (i.e. trade-related) demand.   

 

The final reason for our continued bearish stance on the pound will come as no surprise to regular readers; the risks associated with the Bank of England’s massive quantitative easing programme. So far, the Bank of England has printed more cash (on a relative basis) than any other major central bank (see chart IV), and we feel that the uncertainties associated with unwinding this programme have not been adequately priced in to sterling’s value.  The counterargument to this view is that other central banks, notable the US Federal Reserve, are continuing to print, whilst the Bank of England has already suspended its asset purchases. This argument does have merit (against the USD anyway; less so against the EUR) but we feel that there is a non-negligible chance that the Bank of England will resume its quantitative easing once the Fed begins to reduce its programme (yes, this is very much a non-consensus view, but it is based upon the facts stated above which underline the UK economy disproportionate susceptibility to interest rate rises and the general unbalanced nature of the economic recovery to date).

 

Chart IV: Central Bank Balance Sheet

 

Source: Validus Risk Management, Bloomberg (2013)

 

In an interview with Bloomberg last week, former Bank of England MPC member Adam Posen was asked whether current Bank of England policy could provoke a fully blown sterling crisis. “I definitely see the potential” he replied. “Sterling’s going to be up, but I fear it’s going to be as temporary as the housing price boost from Help to Buy.” We would to tend to agree with Mr. Posen. The precise timing of any correction in sterling, and whether it comes in the form of a currency crisis, as suggested by Posen, or rather a gradual decline back towards 1.50, is not clear. However, the fragility of the pound, and of the UK economic recovery, should not be dismissed. 



 

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