Sterling work…

Thinking Aloud

With sterling having just plunged to a 31-year low against the US dollar, it’s interesting to note some of the similarities between the UK now and back in 1985. We had a female prime minister at the helm (Margaret Thatcher), while rival political factions vied to take control of the UK’s Labour Party (Neil Kinnock versus militant tendency). Meanwhile, Scotland had just qualified for the following year’s World Cup (OK so perhaps it wasn’t all the same).

So what has brought us to this particular point? Well, of course “Brexit” has had an impact. UK Prime Minister Theresa May’s speech this week started to put some flesh on the bones of her somewhat opaque opening stance of “Brexit means Brexit”. Investors are interpreting her words as signalling a “harder” rather than “softer” EU exit – perhaps trading off restrictions in free movement of labour with access to the European single market. We’ll see – there is much water still to flow under this particular bridge.

Despite some relatively upbeat economic news since the vote on 23 June, there may have been some desire by politicians to get sterling to a point that reflects a little more of the potential bad news – the view perhaps being that if the UK economy remains robust, then perhaps the currency is close to a point from which it could strengthen.

However, the UK’s current account deficit is potentially unhelpful to the currency. A measure that in essence tells us whether a country is a net lender to, or borrower from, the rest of the world, the UK balance has been in deficit for 30 years. The decision to leave the European Union raises the question: does the UK will have the ability to fund this external imbalance? Thus far, the UK has been able to do so. But Brexit does add a layer of uncertainty to the mix.

The great hope is always that weakness in sterling will lead to a rejuvenated export sector.

The great hope is always that weakness in sterling will lead to a rejuvenated export sector. However we have seen sterling weakness before in recent years, and this was accompanied by a notable absence of export-driven juvenation.

In this regard, it is also worth noting that two of the most successful post-war exporting economies have been Germany and Japan, who managed to achieve this feat despite decades of currency strength. It’s what you make, as well as the price of your currency, it would seem.

The Bank of England has been doing its best to do what it takes to support the UK economy – cutting interest rates, expanding its version of quantitative easing and suggesting that the commercial banks lend to the real economy at these low rates. This has been a strategy welcomed by investors, but it is not a recipe normally supportive of currency strength.

Of course, currency rates are the measure of two currencies – a fact that is sometimes forgotten in the analysis of sterling. The cross most focused upon is versus the US dollar. In the US, the debate is when, not if, the Federal Reserve will lift US interest rates – quite a contrast to the Bank of England. This scenario is not conducive to sterling strength versus the greenback.

Turning to the euro, the situation is far less clear-cut. Sterling is at a mere five-year low against the euro, but there has been relatively robust economic data out of the Eurozone of late. This has led some to speculate that Mario Draghi may already “have done what it takes”, with consequent implications for expectations of perennial loose monetary policy. Against that, though, the continued travails of Deutsche Bank cast a giant shadow. Add to this the potential negative implications of Brexit on the Eurozone, and it doesn’t takes huge leaps of imagination to imagine news flow that might tips the euro into weakness.

Longer-term currency models point to sterling offering some value at these sorts of levels. However, in the shorter term, currency analysts are more often minded to assume that trends (in this case a downward one) continue. With Brexit, we are in uncharted territory, and this may cast some doubt on the contents and output of any shorter or longer-term model. We will be beholden to Brexit news flow for the foreseeable future – a news flow that may not always reflect what one might like to call “fundamentals”.

In the meantime, sterling’s long-term lows continue to offer a convenient excuse, in these trying times, to re-live the hairdos, shoulder pads and music of 1985 once again. Added to which, Tears for Fears seems an apposite soundtrack to our current travails.

By Richard Dunbar Senior Investment Strategist, Aberdeen Solutions.  This article originally appeared on the Aberdeen Assest Management ‘Thinking Aloud’ blog on 7th October 2016