How Low Can We Go?

Confidence is down, the Bank Rate has been cut and sterling continues to slide. Simon Lewis, CEO at Partridge Muir & Warren Ltd, looks for something to cheer about.

Team GB were certainly in the ascendancy at the Rio 2016 Olympics and this has no doubt improved the nation’s currency, both within sporting circles and outside. The same cannot be said for sterling, which is currently plumbing new depths.

At the time of writing, a little over 8 weeks after the EU referendum result, the pound is around 11% cheaper relative to the euro, 13% cheaper relative to the US dollar and a whopping 18% cheaper relative to the yen. It looks like a trip to cheer on our Olympic heroes at Tokyo 2020 might be out of reach. Sentiment is a powerful force in financial markets and the sentiment is currently that the UK will be poorer, at least in the short term, as a result of its decision to leave the EU.

There are certainly indications that foreign direct investment (FDI), which is the amount of new money invested in the UK by overseas investors, has fallen sharply this year. The UK had previously been a magnet for FDI, consistently securing over 20% of all inward investment into the EU. There is a risk that FDI will not recover until there is more certainty regarding the broad terms of the UK’s future relationship with both the EU and the rest of the world and an inevitable macro-economic effect of this is currency weakness.

At present, the consensus in the foreign exchange market is that sterling has further to fall and the Bank of England’s recent monetary policy stimulus has made this more likely. It seems odd that the Bank of England should be an enthusiastic cheerleader for currency weakness because there is no clear evidence that past devaluations have had a favourable long term outcome for the UK.

The Bank’s Inflation Report for August followed a pessimistic narrative. “Uncertainty may impact on investment, household spending and housing activity”, warned the Governor, “A fall in sterling will push prices higher.” He then proceeded to cut the rate of interest earned by investors in sterling by half, making a further fall in the value of sterling inevitable.

To add to the gloom, reference was made to the bleak outlook of the PMI Markit Composite series (which predicts business activity), but this data has always been speculative in nature and has signalled seven recessions during a period over which there only turned out to be one. It is interesting that the Bank has chosen to emphasise the negative.

Finally, to seal sterling’s fate, it was hinted that a further cut in the Bank Rate was likely by the year end. With interest rates already so low I am not convinced about the benefit of further interest rate reductions. One of the principal objectives is to improve capacity for discretionary spending by mortgage holding consumers, but only around a half of the UK mortgage stock is at a variable rate and even if passed on in full to those on a variable rate, the latest cut is worth little more than £20 per month for each £100,000 owed.

It is already known that retail banks struggle to maintain their profit margin when interest rates are very low, with the consequence that benefits passed to the consumer become less efficient. The Bank of England has recognised this by introducing the Term Funding Scheme, an innovative arrangement to help retail banks to give consumers the benefit of the rate cut. However, I suspect that the same objective could have been achieved in a different way, without the need to cut the Base Rate.

It is doubtful that a low pound is going to provide a lasting benefit to the UK. Traditionally, it has helped exporters but the fact is that we do not manufacture a great deal in the UK any longer and what we do export is often dependant upon the import of raw materials that become more expensive when our currency weakens. Furthermore, overseas firms account for around 40% of the top 100 UK exporters and such firms will not appreciate the depreciation in their earnings that would result.

The decision to extend Quantitative Easing; the purchase of UK government bonds, by £60 billion to £435 billion was a little more controversial and was passed by only a slender majority of the Bank’s Monetary Policy Committee (MPC). Once again, there are doubts about whether the benefit of this will be efficiently transferred to the wider economy. I suspect, looking at these measures in the round, that the Bank of England has prepared the ground for the Treasury to announce a substantial infrastructure investment programme as part of the Autumn Statement. This would be financed by the issue of further government debt that will be cheaper because of lower interest rates and more attractive to foreign investors because of a weaker sterling.

It is quite evident that those whose financial and other assets are largely sterling denominated have become materially less wealthy in global economic terms. Following the effects of ‘globalisation’ Harold Wilson’s famous protestation that a fall in sterling would not affect “the pound in your pocket” is even less true now than it was then.

However, I started by saying I would find something to cheer about and, notwithstanding the considerable haul of gold and other precious medals that Team GB has added to the nation’s wealth, the UK will benefit from the fact that it has more overseas investment than overseas debt. The weaker pound serves to enhance the value of this differential, a good example being the recent surge in the FTSE 100 share index that has been amplified by the considerable overseas earnings of the UK’s largest companies.

As Clients of PMW’s Wealth Management and Investment Review Services have also been given a relatively high allocation to overseas assets in recent years; I am pleased to report that this has resulted in excellent investment returns over recent months, giving them something extra to cheer about.