The pound is unsound. Since August last year, sterling has fallen 14.8 per cent against the currencies of our main trading partners. Lately, the decline has got quicker, with big drops against the dollar and the euro. Alongside falling share and house prices, sterling's descent seems to be just another sign of Britain's economic sickness.
Why sterling's falling
Following the dollar's dramatic dive in 2007, many currency investors predicted that the pound was next in line for a fall. Their logic was that the UK's economic situation looked frighteningly similar to that of America.
The comparison between the US and the UK is striking. Both countries have big current account deficits – we buy far more from the rest of the world than the rest of the world buys from us. Although this situation can persist for a long time before investors get spooked, it almost always catches up with a currency in the end.
Inflation is uncomfortably high on both sides of the Atlantic. This means that the purchasing power of both sterling and the dollar is decreasing. According to the textbooks, the currencies of countries with higher inflation should fall relative to the currencies of countries with lower inflation.
In a bid to stop the US economy falling into a slump, the US authorities slashed interest rates from 5.25 per cent last year to their current level of 1.5 per cent. As a result, investors holding US dollars receive a lower yield on their deposits, reducing the currency's appeal. Although UK rates are still 4.5 per cent, there are growing expectations that the Bank of England will cut them aggressively in 2009.
Does a recession mean more sterling misery?
The chances of an outright recession in the UK are now very high. The economy is widely forecast to shrink between this June and December, which would meet the textbook criteria for a recession. This might sound like an obvious recipe for more sterling pain; history, however, suggests otherwise.
There have been five recessions in the UK since 1960. During four of those, sterling has actually gone up against the euro, or its Deutsche mark-based equivalent. On the one occasion that sterling fell during a recession – in 1973-74 – it declined by a mere 3.3 per cent. It's a similar story for trade-weighted sterling. In the four recessions for which we have data, sterling has gone up three times.
The story is less clear cut for sterling than for other currencies. Sterling fell against the US dollar and Swiss franc during the two 1970s slumps and rose during the slumps in the 1980s and 1990s. But one currency has done well against sterling during recessions four times out of five: the Japanese yen. And on the one occasion the yen fell, it did so by less than 1 per cent.
So a full-blown recession might not be the negative event for sterling that you might assume that it would be. The interesting question is why this should be so. One explanation is that markets are forward-looking and therefore price in recessions before they happen. There’s some evidence that this is the case. In the six months before a recession, sterling has tended to fall against the euro. But once the recession actually arrives, it then usually rises against the euro, perhaps because investors are looking ahead to brighter times.
How do we value sterling?
The received wisdom is that trying to predict currency movements is a mug's game. Although we believe that current-account deficits and interest rates affect exchange rates, the way they do so isn't clear. As we've already said, a country can have a big current-account deficit for many years before its currency suffers any ill effects.
A popular way to find out whether a currency is 'cheap' or 'dear' in relation to others is to use purchasing power parity (PPP.) This theory says that a basket of the same goods should cost the same in any country. The Economist magazine publishes an index that compares the prices of a McDonald’s Big Mac hamburger across the world. The relative prices of a Big Mac are then compared to the actual exchange rate.
Whether based on hamburgers or a broader basket of goods, PPP is a blunt instrument. It gives a rough-and-ready picture of overvaluation or undervaluation. While cheap and dear currencies tend to correct in the long term, the timing is totally uncertain. So a currency that shows up as dear on a PPP basis can keep getting dearer, as can a cheap one get even cheaper.
At the moment, PPP suggests that the exchange rate ought to be around 75.5p per E1. The actual rate is more like 78p, so the euro is 'overvalued' by around 3 per cent. But this tells us almost nothing. During the 1990s, the euro/sterling rate stayed above 'fair value' for several years on the trot, at one point becoming 26 per cent overvalued.
By contrast, the pound is dear relative to the dollar and roughly at the right level against the Japanese yen. The biggest discrepancy is with the Swiss franc, against which sterling looks very undervalued.
What a weak pound means for UK investors
While a weak pound reflects anxiety about the outlook for the country's economy, it shouldn't worry equity investors. In fact, we should positively welcome it. A weak pound is good for British shares.
Not including the present bout of weakness, there have been eight periods since 1970 where the trade-weighted sterling index has suffered an annualised decline of 10 per cent or more. In seven out of these eight periods, the UK stock market went up. The average annualised gain was an impressive 10.5 per cent.
Why should a weakening pound be good for our stock market? The standard City answer would be that it's good for corporate earnings. British companies – especially the biggest ones – are very international. So, when other currencies strengthen against the pound, UK firms' overseas earnings are worth more in sterling terms.
Another angle is that a falling pound denotes nervousness about the UK economy. And, as finance theory reminds us, high risks merit high returns. Therefore, investors who buy risky assets during times of sterling weakness are duly rewarded.
Drilling down into the stock market's individual sectors, we also find that value stocks have tended to outperform growth stocks during periods of sterling weakness. However, since value stocks have tended to beat growth stocks more often than not over the past three decades, this doesn't necessarily tell us anything useful.
Among the individual stock market sectors, general industrials, personal goods, tobacco and pharmaceuticals have outperformed the wider UK market two-thirds of the time during sterling bear markets. With the exception of general industrials, all these are defensive sectors. By contrast, cyclical sectors such as IT hardware, property and general retail have underperformed two-thirds of the time.
Gilts haven't been a safe haven during sterling bear markets, either. In the eight previous episodes of sterling weakness, the price of 10-year UK government bonds has fallen five times.
How low will sterling go?
Before its recent rally, the US dollar was at an all-time traded low for the modern era of freely floating currencies. Sterling has also fallen heavily, from 101 in February 2007 to 89 in August. But that’s still a long way off its record nadir of just 62, which it reached back in the crisis-ridden days of 1976.
On average, sterling has fallen around 15 per cent during its previous eight bear markets. It's already sold off by roughly that amount this time around. The biggest ever plunge was just over 20 per cent back in the early 1970s. In terms of time, the current sell-off is already quite long in the tooth; 14 months compared with an average of around 12. The longest bear market was 18 months.
How to get currency exposure
You may feel strongly that the dollar's recent rally against sterling is set to continue. Or perhaps you think that the euro has peaked against the pound. But what is the best way to turn your insight into profits?
Multi-currency bank accounts may seem like an obvious way to play the currency markets. As their name suggests, these are accounts that let you switch money between several currencies, all from a single account. So, you can tactically move from dollars to yen to Swiss francs as the mood takes you.
In practice, though, the big banks are not known for offering great exchange rates to retail customers. This often means that you need quite big moves in the exchange rate just to cover the cost of buying and eventually selling the foreign currency.
"It is also hard to obtain competitive rates of interest on foreign currency holdings with UK banks," says Chris Saint, currency strategist at Hargreaves Lansdown, a wealth management firm. "It's therefore important that people shop around. We're planning to let clients hold currencies with us at better rates than are on offer elsewhere."
Another disadvantage of physically switching currencies through a bank account is that any profits would potentially attract capital gains tax. This also goes for gains on most currency derivatives, such as contracts for difference, futures, options and covered warrants.
To avoid paying tax on your foreign-exchange profits, you could always take out a spread bet. As well as being tax-free, spread betting allows you to buy and sell at very keen exchange rates – far better than any bank is ever going to offer you.
What's more, the range of currency pairs available through spread-betting companies vastly outnumbers the narrow selection you'd get on a multi-currency account. IG Index, for example, offers more than 60 pairs. Because the currency markets trade 24 hours a day, you can open and close spread bets at almost any time, whereas banks' hours are much more restricted.
Although most people use spread bets to take positions over days or weeks, there's no reason why you can't use them to speculate over a currency's direction over several months. All you'd have to do is buy one of the longer-dated 'futures' bets expiring in three months' time. To keep the bet running after three months, you'd simply roll it over into another bet.
