This was first published on Netwealth – 28 September 2023
The pound has weakened recently. The change in market expectations that UK interest rates will peak at a lower level than previously expected has had the predictable impact on sterling that many (including ourselves) thought it would. UK policy rates, currently at 5.25%, are expected by the market to peak at 5.5%; three months ago, this was closer to a 6.25% peak. We think rates have now peaked, but it would not be a surprise if there was another hike.
In turn, sterling has weakened by more than seven percent since mid-July versus the dollar, from around 1.31 to its current 1.21, which is where much of the focus is.
In part, this correction is no surprise as rate expectations have been a key driver of currencies this year, and the markets had previously been aggressive in their view about the direction of UK rates. This fed off previous communication from the Bank of England and also from previous pessimism about UK inflation. It was this, the market felt, that would force UK rates higher.
The markets were not previously reflecting the nuances about monetary policing tightening that were being widely discussed among many economists and in the policy debate. In particular, that the lagged impact of previous tightening has yet to feed through and thus rates were already tight enough and that inflation, while high, looked set to decelerate. But now they are, and hence rates are seen as close to their peak.
The short-term speculative money attracted into the pound because of rising interest rates has left. The question is whether such a change in mood and direction triggers a more general shift? The fact sterling has also softened versus the euro has, in turn, helped feed a bearish mood towards the pound. There has been a hasty downward revision of the market’s currency forecasts, and when sentiment changes in currency markets this can often become self-fulfilling.
Although interest rate expectations have been a significant driver of currencies this year, views about underlying economic fundamentals matter, too. Herein lies the challenge for sterling. While, the pound looks cheap, and UK assets appear undervalued, the economy also looks weak based on likely growth rates and potential vulnerability to shocks.
This, though, is not a UK-specific problem, and is more of a western European phenomenon. Thus, while the pound has weakened against the euro recently, both currencies share similar backdrops with economic conditions poor and policy credibility being questionable.
As just one barometer, using the MSCI index, the 12-month forward P/E ratio (a measure of valuation) for the UK is 12.6 compared with 18.5 for the US. For the euro area it is 11.6 including Germany at 10.5. Such figures capture the pessimism towards the UK (and Germany, too) compared with the US.
Last year we debated sterling extensively, as we felt very early in 2022 that devaluation was likely, and by this time a year ago that it had fallen enough, which it had. That remains our thinking – that sterling is already weak enough – but given recent market moves the downside risks appear to outweigh potential upside pressures, so the pound could weaken further in coming months.
That’s where the risks lie, but the attraction of UK assets should give sterling support. The challenge for sterling will be growth and whether it loses momentum, or just as likely remains weak. This will intensify pressure for some policy easing next year, with perhaps a one-off cut in rates.
Last year, when the pound plummeted, it was clear at that time the UK policy mix was sterling negative, with tighter fiscal and loose monetary policy alongside weak growth and rising inflation. There is not the same case now. While there is little room for policy manoeuvre it is not sterling negative in the same way. The issue, then, is whether a weaker pound in its own right is seen as the necessary shock absorber for a weak economy. With core inflation stubborn it is not clear that it is.
Even when interest rates peak, monetary policy is likely to be tight, because headline inflation will decelerate and we are likely to move to a period of positive real interest rates. Also, unnecessarily, quantitative tightening looks set to increase, and both this and positive real rates point to a tough monetary stance. Fiscal policy will remain tight.
The recent shift in policy over the green agenda has created a perception of regulatory uncertainty, which is never helpful for investment. Although, as we have noted previously, inward investment into the UK is still high. But from a trading perspective as the upside seems limited, that may tempt the market to test sterling’s downside.
At the root of sterling’s challenge is the UK’s large current account deficit. It reflects wider savings and investment imbalances in the economy. In turn, and as the Office for Budget Responsibility (OBR) highlighted in their recent annual assessment of fiscal risks, the UK is increasingly reliant on foreign capital inflows to buy gilts.
Let me quote the OBR as this captures the trend and the challenge: ”The UK Government has historically relied upon a large pool of long-term domestic savers, in particular pension and insurance funds, as end investors in its debt. However, over the course of this century the share of UK government debt in foreign (non-official) hands has almost doubled from 13 to 25 percent, the second highest in the G7 and 2 percentage points below France.”
Even allowing for the European Central Bank’s purchases of German, French and Italian government debt, as the OBR noted, this is still a significant deterioration in the UK’s position.
The 2008 crisis, which heralded in what has now proved to be close to a near halving of the UK’s trend growth rate, has had the most profound impact this century. The 2016 Referendum has also changed perceptions, although it’s often overlooked that at the start of that year the IMF caught the widespread mood of the time when it highlighted that sterling was seen as being 15% overvalued, and then it rallied ahead of the vote, making its subsequent fall inevitable.
The result, of course provided the trigger. By then the ensuing political crisis that lasted over three and a half years and uncertainty about policy didn’t help, as they framed perceptions from which the pound has yet to truly recover. Political uncertainty may also weigh on UK assets soon but this time its currency impact should be limited.
A general election is due by January 2025 and most likely next autumn. There is no direct link between elections and sterling’s performance, although there are occasions when an imminent election grips market attention. Invariably, though, an election creates a degree of uncertainty and leads business to put decisions on hold.
On historical measures the pound is cheap versus the dollar. But then this is always the case when one takes a snapshot of a currency that has been in a long downward decline, trending weaker versus the dollar. Of course, this can change. The huge shift in the dollar-yen rate over the last year is testimony to that, with its current moves reversing a previous 50-year trend. Moreover, the yen looks set to weaken further, and perhaps significantly so, versus the dollar. Such a turnaround could happen to sterling eventually, but not yet.
Indeed, the key story in recent years has been the strength of the dollar. The key to this has been the outperformance of the US economy – so-called US exceptionalism. Rising geopolitical risks have also boosted the dollar’s attraction as a safe haven, alongside the Swiss franc, and displacing the yen. It’s not clear that this is about to change.
It remains hard to say where the fair value for sterling should be, but the scale of the current account deficit and need to attract inflows suggests investors must be rewarded with a sufficient risk premium to buy sterling. Purchasing power parity is sometimes cited, based on trying to gauge what a currency is worth based on what it can buy at home, but here, too, sterling does not seem out of line.