Fundamentally weak economy to punish pound

LAST year was great for the sterling bulls. The currency appreciated against the dollar and yen, and edged the euro. But sterling’s gains were driven by weakness in other economies – not by any strength in Britain’s own economic fundamentals.

As global headwinds begin to calm, attention has been focusing on the vulnerable pound. In 2013, the UK’s lacklustre economy is likely to drag the pound lower, and as HSBC’s David Bloom eloquently puts it, sterling is set to “lose the ugly contest”.

The political debate raging in the UK is focused on whether the government should ease fiscal policy to try and boost growth. The coalition looks likely to maintain its current course.

Clearly, fiscal adjustment via austerity is necessary to improve the UK’s economy. According to Kevin Daly of Goldman Sachs “to have left the deficit unchecked, or to have eased fiscal policy further, would risk a sovereign crisis,” as seen in Europe.

But despite this, it will be four years before the UK’s budget deficit falls to 3 per cent of GDP. And according to Ross Walker of RBS, Britain’s current account deficit is expected to average a “potentially unsustainable” 3.5 per cent of GDP in 2012 – the largest in two decades.

The consensus is that 2012 fourth-quarter GDP will disappoint. This view is reinforced by recent purchasing managers’ data showing that the UK services sector – accounting for around 75 per cent of the UK’s output – contracted for the first time in two years.

The UK economy is expected to grow in 2013, at around 1 per cent, this is mediocre at best. It is worth bearing in mind that GDP now stands 14 per cent below what it would have been had the pre-crisis trend been maintained, according to Goldman Sachs.

There is now a compelling case that the UK should be stripped of its prized triple-A credit rating – and this may happen as early as this quarter, when rating agencies reassess the UK. While gilts may shrug off a downgrade, HSBC argues that the kneejerk reaction of traders could be a sharp sell-off in sterling.

It is unlikely that the Bank of England will extend its programme of quantitative easing (QE) beyond £375bn when it concludes its meeting tomorrow. But while rates are expected to stay on hold at 0.5 per cent for the foreseeable future, expectations are that a further £50bn in easing will be added in the first quarter of 2013, which will put downwards pressure on the pound.

Fortunately, the Bank will wait until the economy begins to deteriorate, or inflation – which recently spiked up to 2.7 per cent – eases. This will ensure that QE will not aggravate inflation, which the Bank has a disastrous record in controlling.

The Bank’s reticence to add to the programme should be welcomed. Last year, governor Sir Mervyn King hinted that the Bank might be more inclined to use monetary policy to help weaken the pound, since its rise from 2011 has hindered UK exporters. But Walker cautions that this “would risk bringing an unwelcome surge in import price inflation.”

Some do not want to see additional easing. While initial rounds of QE were necessary, “the happy co-habitation of tight fiscal and loose monetary policy will be challenged [this year] – and sterling with it,” says Bloom, adding “we are in fact not looking for any further QE in 2013”.

Additionally, the Bank has staked a lot on the Funding for Lending Scheme, which has initially shown modest signs of success. It is holding off on more QE until the impact of the scheme begins to filter further through the economy.

Improving sentiment within the Eurozone will mean that the euro is likely to appreciate against the pound. Adrian Schmidt of Lloyds Bank has been long on euro-sterling since mid-December. Going forward, he says that “the continued reduction in risk premiums in Eurozone should support euro-sterling”.

John Kicklighter of Daily FX agrees, saying that reducing Eurozone risk “will afford a modest recovery for euro-sterling, and it will perhaps recover some of the lost ground from its peak in June 2011”.

Even if the Eurozone crisis did come back to the fore, it is debatable whether sterling will materially gain. Kicklighter sees “sterling suffering against third party currencies – especially safe havens like the US dollar – should the euro-area crisis return”.

Regardless of the government’s rhetoric about the UK being a safe haven, 2013 could demonstrate that this is far from the case. Indeed, it appears that the UK’s economy, and consequently sterling, will be exposed. One positive is that market pressure may put a firm onus on policymakers to take the right steps to address the UK’s economic plight.