Willem Sels, UK head of Investment Strategy at HSBC Private Bank, says there are a number of reasons to expect sterling's weakness to continue.
Willem Sels, UK head of Investment Strategy at HSBC Private Bank, says there are a number of reasons to expect sterling’s weakness to continue.
We have held a negative view on sterling since mid-January and continue to look for further weakness. UK investors’ portfolio performance should benefit from
active global diversification. Foreign investors are likely to suffer from translation losses on UK bond portfolios, but in the stock market, translation effects should help lift earnings prospects.
Recent months have brought a great deal of excitement to currency markets. It started in September, with major weakness of the Japanese yen, followed by sterling weakness since early 2013. Many commentators have labelled some of these moves as ‘currency wars’, but we think that sterling weakness reflects weak fundamentals as well as monetary policy choices which have been well flagged.
Drivers of currency weakness
The UK economy remains in the doldrums. Even in Europe, there are few countries (possibly with the exception of Italy) that have shown little or no growth for so long and have been unable to bounce much since the trough of the 2008 recession. Even in nominal terms, UK GDP remains 3% below its March 2008 peak. Recent data remains lacklustre and has continued to disappoint in spite of already weak expectations. As a result, fears of a triple-dip recession may continue to worry currency markets.
Fiscal / Monetary policy mix
Policy makers could respond in several ways to this economic weakness, and the choices they make can have a profound impact on whether it is the currency or the bond market that take the biggest hit. In the case of the UK, it seems that the government has chosen to continue on its path of fiscal austerity, and that the recent rating downgrade has only strengthened their resolve. Press reports and markets are expecting more monetary easing, and are waiting for the Chancellor to use his Budget on March 20 to reinforce his message of ‘fiscal conservatism and monetary activism’. The former should support the gilt market, while the latter should weigh on sterling, in our view.
Monetary policy uncertainty
What exactly the Bank of England is up to is unclear, and we think that foreign investors are bound to limit GBP asset exposure until they can form a clearer picture. Three Bank of England members voted for more quantitative easing in the latest meeting, but markets are also wondering about a change to the inflation target (or the introduction of a growth target), an interest rate cut or an expansion of the funding for lending scheme. Clearly, this uncertainty is exacerbated by the imminent handover of the governorship from King to Carney in July. Uncertainty does not inspire confidence and we see this as a negative for Sterling.
Diverging central bank policies
It is no surprise that the yen and sterling are among the weakest currencies in the world, as their central banks are among the most dovish. While the Bank of England may further ease monetary policy in some shape or form, markets are worried (even if a bit prematurely in our view) that the Federal Reserve will start to exit its quantitative easing programme. Since currencies are very much a relative global game, the policy difference between the US Fed and the Bank of England is likely to weigh on sterling performance.
Improving global risk appetite
We think risk appetite will continue to improve, as global tail risks (e.g., those of a US recession, a eurozone breakup or a Chinese hard landing) have decreased and economic growth is slowly improving in all major economic blocs (in the case of Europe, less negative is a positive). In our view, this is leading investors to shift out of safe haven assets. When risk appetite was at its weakest, investors looked for safe havens, and AAA-rated gilts were seen as a good complement to US Treasury holdings, especially for investors who did not want the euro-currency risk attached to German Bunds. We think that improving risk appetite is likely to lead foreign investors do gradually exit the gilt market, causing them to sell GBP and weighing on sterling’s performance.
Sterling plunged in 2008 but since then has been trading in a broad sideways range. The recent weakness has brought the trade-weighted value of sterling towards the lower end of its five-year range, but valuations still seem to be close to fair value (on PPP and other measures). We think the recent momentum and current sentiment will allow valuations to fall into the ‘cheap’ territory.