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Sterling silver linings

Sterling recently hit a two-year low and much has been made of its ‘emerging market characteristics’. But it’s not all bad news
Sterling silver linings
  • The pound has lost 12 per cent against the dollar in the past 12 months, with high import prices adding to inflationary pressures
  • But depreciation means that UK firms with overseas revenues stand to gain

In May, a Bank of America analyst made headlines when he relayed discussions about the pound taking on ‘emerging market characteristics’ in a client note. Fears of sterling’s fall from grace were heightened again this week when the pound hit a two-year low, slumping 1.5 per cent after data showed the UK economy had contracted in April. So far, so ominous.

But first, a note of reassurance. True, emerging market currencies tend to be defined by their country of issue rather than the currency’s behaviour. In reality, the pound is excluded from the club. Behaviour-wise, sterling also lacks the more extreme features of many emerging markets currencies: think dollar pegs in Saudi Arabia and capital controls in China.

But there is no denying the fact that the pound has had a bumpy five years, as the chart shows. 2016’s flash crash saw the pound lose 9 per cent against the dollar overnight. The spectre of pandemic-induced disruption precipitated further dips in March 2020 and December 2021. More recently, news that the UK economy had contracted for the second consecutive month saw the pound lose 1.5 per cent against the dollar. 

One drawback of a weaker pound is that it increases the cost of imports. And this is particularly unhelpful at the moment. Minutes from June's Monetary Policy Committee meeting highlighted the UK’s status as a net importer of tradable goods and energy, both of which are running at ‘very elevated’ prices. This has left many companies feeling the squeeze. But for organisations relying heavily on imports, further depreciation will intensify cost pressures. Companies like supermarkets and clothing retailers are reliant on long global supply chains and now risk seeing raw material costs edge even higher.

It is also worth reflecting on the reasons for sterling’s slide. The dip has taken place at a time of rising interest rates, which, in theory, is surprising. In simple terms, higher interest rates trigger hot money inflows – injections of cash from investors looking to lock in the highest possible short-term interest rates. These inflows see demand for the currency increase, meaning that rate hikes are often associated with currency appreciations. We saw this to a limited degree last week when the pound gained 1.4 per cent against the dollar following the Bank of England’s decision to raise rates. 

Even more surprisingly, the Bank of England implemented its first post-pandemic rate hike in December 2021. The Fed didn’t follow suit until March 2022, and the ECB is only planning to increase rates this July. Game theory tells us that there was potential for a first-mover advantage here: the UK was offering investors a relatively higher short-term interest rate when levels elsewhere were still low. But if there was any theoretical advantage to moving first, it didn’t materialise: the pound has lost 12 per cent against the dollar over the past 12 months. 

Could part of the explanation lie with the Bank of England? The Bank surprised markets when it held back from a widely-anticipated rate hike in November, and governor Andrew Bailey was more recently rebuked by senior Tories for the Bank’s handling of inflation. Public satisfaction with the Bank’s approach also fell to the lowest levels on record this month, with over a third of the UK population expecting longer-term inflation to remain above 4 per cent. And this matters: there is a risk of investors looking to repatriate UK investments if overall confidence in the UK economy declines. 

But while the majority of FTSE 100 firms are headquartered in London, many of them operate elsewhere. David Brett of Schroders reminded us that the UK stock market was particularly reliant on foreign revenues: in 2017, over 71 per cent of revenues generated by FTSE 100 companies came from outside the UK. This is a surprising fact rendered less surprising when you consider how active the FTSE’s banks, mining companies and oil and gas giants are in overseas markets. 

Rio Tinto (RIO), for example, sees the majority of its sales denominated in US dollars; HSBC (HSBA) generates almost 60 per cent of its revenue from outside of Europe. For these firms, as sterling depreciates, the sterling value of these earnings rises. It’s not all bad news.