Sterling’s current weakness reflects both a strong dollar and U.K domestic factors. While the dollar is likely to roll over and weaken when a new global economic cycle kicks in, the factors holding sterling down may limit the currency’s long-term potential for recovery.
Friday saw sterling plummet to $1.09, having started lasted week at $1.14. Investors fear that the U.K government’s newly announced ‘focus on growth’ package of fiscal and de-regulation policies will do more harm than good to the underlying economy and ultimately harm the long-term attractiveness of sterling-denominated assets.
The new Prime Minister Liz Truss and her new chancellor, Kwasi Kwarteng, are attempting to boost GDP growth to a long-term average of 2.5% by loosening fiscal policy. It is an odd time to be doing so while the country’s central bank tightens monetary policy to bring down inflation. Some economists fear the government’s efforts to support growth will drive inflation upwards.
The Bank of England expects to be blamed if this is the case, and it has to respond with higher-than-otherwise interest rates. Liz Truss has already demonstrated little love of the Bank of England and talked of ‘reviewing its mandate’ during the recent Tory party leadership contest.
The strong dollar
The strength of the dollar against other currencies reflects the aggressive stance of the Fed in its fight against inflation, echoed last week by another 75bp rate hike and a promise by Fed chair Jerome Powell to continue to tighten monetary policy until the risk of an embedded inflation problem is eliminated.
The dollar is at near-parity with the euro, not seen since the early 2000s, and at a multi-decade high against the yen. But it is at a 37-year high against sterling (at $1.09), despite the Bank of England being the second most aggressive major central bank with rate hikes after the Fed.
Clearly, something else it at work. The domestic causes of a weak pound are a combination of long-term structural issues hampering growth and the consequence of the country’s June 2016 decision to leave the European Union.
The structural issues include labour skills, an overpriced housing market that inhibits labour movement, and low investment. These contribute to weak productivity gains and to near-stagnant real wage growth since the financial crisis.
They also contribute to a large current account deficit, with Britain having to borrow large sums from foreign investors to pay its bills.
The legacy of Brexit
Brexit has aggravated the structural issues. It has inhibited the growth of an immigrant workforce to help boost output and has put up bureaucratic barriers to export to the E.U. that deters small and mid-cap companies from exporting to the bloc, resulting in a weak post-pandemic recovery in exports to the E.U.
Brexit has also led the governing Conservative Party to become more populist and unstable and to attack institutions of government when they have different opinions from its own (such as the judiciary, House of Lords, and the Bank of England). Offering tax cuts while running a record budget deficit echoes this and will come to define what has been dubbed ‘Trussonomics’. Investors are deterred by the lack of consistency and clarity on government policies.
The actual size of last week’s fiscal stimulus, which includes a mix of energy price caps, income tax cuts, and the abolition of pencilled-in tax hikes, is unquantified. Unusually, the Office of Budget Responsibility, a statutory body set up to provide independent costings of government spending, was not shown the policies before their announcement.
But the package appears to be the largest single fiscal boost to the U.K. economy, measured as a percentage of GDP, since the ill-fated ‘Barber boom’ of the early 1970s. At a minimum, it adds £60bn to this 2022-23 budget deficit, which is now forecasted to be around £220bn (from around £40bn before the pandemic).
The government is gambling that the fiscal stimulus and set of economic reforms will soften the blow to living standards arising from inflation without fuelling the inflation.
It is a big gamble. The labour, and goods, are simply currently not available to meet any increase in demand. Imports will rise, extending the balance of payments deficit.
One must ask, to what end is the government doing this? It is tempting to see it, cynically, as a sop to Conservative voters. For this group, tax cuts and policies to help the housing market (such as the announced cut in stamp duty), are red meat.
But the tax measurers favour the wealthy, who may already vote Tory. Meanwhile, the Red Wall of northern voters will be disappointed at an apparent abandoning of ‘levelling up’, and may return to voting for Labour. While this package may benefit the Conservative Party’s supporters and donors, it is hard to see it extending the party’s electoral appeal.
Of course, the package may help deliver strong, non-inflationary growth. We hope so. Until then, however, the markets are sceptical, and the outlook for the sterling is poor.
- No Investment Advice: This financial commentary is for informational purposes only and is not intended to be, and should not be, construed as an offer to sell or a solicitation of an offer to buy any security or financial instrument or invest in any equity or investment strategy. It should not be used to form the basis of any investment decision.
- Investment Risks: There are risks associated with investing in securities and past performance is not indicative of future results. Always seek professional advice before investing.
- Not Legal/Tax Advice: This financial commentary is not intended to be, and should not be construed as, legal, regulatory, tax, or accounting advice. Always seek professional advice and consult with your legal counsel, tax and accounting advisors when contemplating any course of action.