What’s been behind sterling’s significant devaluation and what are the implications? Holly Cassell, Assistant Manager of the Neptune UK Mid Cap Fund, looks at the Great British Pound Crash and the implications for investors in an article that originally appeared in GQ.
On the 7th of October the world watched as the pound fell more than 6% against the US dollar in the space of just a couple of minutes. The ‘flash crash’ was a dramatic response to Theresa May’s rhetoric suggesting a likely ‘Hard Brexit’ from the European Union – but add the 11% drop in sterling in response to the Brexit vote itself – and the pound hasn’t been this cheap against the dollar since Careless Whisper was topping the US Singles Chart (in February 1985, in case you were wondering). What does this say about the prospects for the UK economy, and what does it mean for you and I?
A pressure valve for the UK economy
To really understand what’s happening in currency markets, it’s important to think of an exchange rate as simply the price of one currency in terms of another. The exchange rate reflects the supply and demand for pounds in the market: what we’ve seen of late is a fall in demand for British currency, driving down the ‘price’ of sterling.
The UK’s growing current account deficit could provide us with one explanation for this declining demand for pounds, particularly in the context of Brexit. In the UK, we borrow more from other countries than we lend to them, leaving us with a current account deficit that has reached its highest level since the Second World War.* While this in itself isn’t necessarily a problem, financing a deficit of this magnitude does leave us reliant on the “kindness of strangers” in the words of Mark Carney, Governor of the Bank of England.
It’s not all bad news though: weaker sterling will also act to flatter our trade and investment balances
The decision to leave the EU undoubtedly brings into question some of that kindness, with the likely effect of slowing foreign investment into the UK while negotiations are ongoing. It’s not all bad news though: weaker sterling will also act to flatter our trade and investment balances. UK-produced goods suddenly look cheaper overseas, encouraging exports, while investment returns on foreign-owned assets here in the UK will be depressed.
The most recent bout of pressure on sterling stems from fears that the government’s focus on immigration over economics will force a ‘Hard Brexit’ in which the UK not only leaves the EU but also exits the Single Market. In this instance, the ability of the pound to float against other currencies provides what is effectively a pressure valve for the economy. The loss of tariff-free trade with our largest single trading partner would undoubtedly represent a significant shock to the UK’s outlook. The fall in sterling that we would see in response then acts to offset some of the impact by improving the UK’s competitiveness overseas and therefore stimulating growth in exports.
Inflation: remind me what that is again?
The most obvious impact of sterling depreciation will be inflation, as the cost of imports increases. If inflation were driven by rising demand this would be no bad thing, but inflation driven by a shock to the economy is not accompanied by growth. It therefore has the potential to be far more damaging, possibly forcing a rise in interest rates for which our economy is ill-prepared.
Let’s take a look at the impact on various different groups:
- Shoppers will see the price of imported goods increase, as evidenced by Tesco’s recent run-in with Unilever over the price of Marmite. The impact isn’t limited to food and other high street purchases: energy bills (and indeed petrol prices) will likely also rise given the UK is a net importer of fuel.
- Workers have finally started to benefit from rising real wages, but this could all be about to change. Nominal wage growth has been positive but fairly weak, so growth in spending power has been exaggerated by the ultra-low inflation we have become used to.
- Homeowners will suffer if the Bank of England acts to increase interest rates. The vast majority of UK mortgages are variable or short-term fixed rate, so any rate rise will impact homeowners very quickly, making monthly payments less affordable.
- Holidaymakers have already started to find their cash doesn’t stretch anywhere near as far when overseas; meanwhile, overseas visitors to the UK will get much more bang for their buck, with a recent study for the Wall Street Journal suggesting London is now the cheapest city in the world to buy a Louis Vuitton handbag. Good to know!
- Business may be booming for exporters, but companies importing raw materials will see profits squeezed. Uncertainty relating to the UK’s future trading arrangements will likely cause delays in investment and hiring decisions, while some firms could find themselves acquired by overseas rivals looking to gain access to the UK market for a bargain price.
So is it time to stockpile my favourite yeast extract while I still can?
Probably an extreme response, but it’s true that as long as Brexit negotiations rumble on, the UK’s trading position and economic stability will remain uncertain – so at the very least it might cost you a bit more. While a steady flow of tourists in search of bargain designer leather goods looks likely to continue, our status as a safe haven for investors is under question. It seems we may just have to get used to a ‘new normal’ of weak sterling. Staycation anyone?