Square Mile: Sterling is at the bottom of the pile

Broomer, Jason_700x450

Currency valuations are driven by a wide range of factors extending from relative real interest rates and politics to global capital flows and money supply. These factors can be difficult to quantify and are sometimes interdependent, which is why forecasting rates is so very difficult.

It is usually possible to identify currencies with positive traits but since the credit crisis the main currency blocks have all suffered from problems ranging from the merely ugly to the really hideous.

Currency selection has become a bit like the Monday morning routine of rifling through the laundry basket to find the most presentable shirt to wear. All may have blemishes but sterling is currently firmly at the bottom of the pile.

In the first two months of the year, the pound quietly fell by 6 per cent versus both the dollar and euro. Much of the narrative justifying this move has focused on June’s Brexit vote and while we agree that this does make sterling a bit whiffy, it overlooks some deeper-seated curry and beer stains that will require scrubbing to shift.

The crux of the issue is the UK’s longstanding current account deficit with the rest of the world. This is made up of the trade balance and net investment income flows. As the chart below suggests, while the trade balance has improved, the deficit in investment income has remained in negative territory since the financial crisis.

Despite this improvement, the UK needs to attract around £70bn annually in foreign capital to help keep the pound stable, or some £200m each day. According to a recent report by Reuters, foreigners have been plugging the gap, last year buying a net £60.5bn of UK government bonds. This sort of “kindness of strangers” may become harder to find.

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Foreigners currently hold 25.9 per cent of all outstanding gilts. Using Debt Management Office data which goes back to 1996, this is comfortably below the 35.9 per cent peak reached in 2008. However, these numbers do not reflect the impact of the Bank of England’s holdings held as part of the asset purchase facility (quantitative easing to you and me). If the £400bn value of these assets are stripped out of the equation, it pushes the current proportion of gilts held by foreigners alarmingly near to the 2008 peak.

Central bank reserve management is an arcane world and it is frankly not one that I inhabit. (Is the Chinese central bank a buyer of sterling as it diversifies its FX reserves or a seller as it defends the yuan rate?)

What is more certain is that the flows from sovereign wealth funds, which are usually based in oil-rich nations, are not only going to cease but likely to reverse as budgets rage out of control. Even Saudi Arabia’s huge $650bn of foreign reserves will rapidly deplete if government expenditures and the oil price remain where they are.

Relative interest rate differentials are also no longer as attractive as they once were. During the run-up to last year’s general election, it appeared touch and go whether the Bank of England would lift interest rates ahead of the US Federal Reserve. Today, the Fed has already begun to ratchet up rates and forecasts for a UK rate rise have been continually pushed back. Rates may have turned negative in Europe and Japan, but so too have inflation rates, thereby moderating their relative attractiveness.

It can scarcely have escaped notice that foreigners have been avid buyers of UK property, with tens of billions pouring into the London property market in rec-ent years. Residential real estate has also been popular, with the super-rich picking up property.

Brexit has caused consternation with investors and the uncertainty will continue to dim sterling’s allure in the near term. However, a recent Goldman’s note estimates that it could take a revaluation in the order of 20 per cent to correct the current account imbalance. A vote to  remain within the EU on 23 June may well cause the pound to rally, but just don’t bet your shirt on it staying strong thereafter.

Jason Broomer is head of investment at Square Mile Investment Research and Consulting