You probably haven’t noticed, but Britain’s economy has become a lot smaller in recent weeks.
It’s not just down to the recession. The falling value of sterling means that, measured in dollars, our economy has gone from being the fifth-largest in the world, to the sixth. We’re now back behind France.
In the second quarter, our GDP came in at £363.8bn. At the time, says Edmund Conway in The Telegraph, this was equivalent to $727bn. But now it’s worth just $559bn, compared with $606bn in France.
If it’s any comfort, sterling isn’t the only currency suffering. In fact, the entire global currency markets are in turmoil. Up until now, your average investor hasn’t really need to pay much attention to currency movements. But they’re going to have to start…
Sterling has taken a hammering in recent weeks, but it’s not the only one. Most currencies are in trouble, from commodity currencies such as the Australian dollar, to the hugely vulnerable economies of Eastern Europe.
In fact, only two of the major currencies are strengthening – the yen and the dollar (the Swiss franc is also in good shape, as it’s always been seen as a ‘safe haven’ currency). But neither the Japanese nor the Americans will be particularly pleased about it.
Why the yen is strengthening
The yen is rising because the carry trade is ending. We’ve written about the carry trade many times before but basically, this is when you borrow money in a low-interest rate currency – the yen – and invest it in a high-interest rate currency – such as Australian or New Zealand dollars.
In recent years, it’s been an easy way to make money. With – for example – Aussie interest rates rising, you could expect the currency to keep strengthening, and at the same time, you’d be getting a rising yield from the higher rates. Trouble is, once it reverses, it reverses fast.
Everyone rushes to get out of their trades, so the high-interest rate currency slumps, while the yen strengthens. Huge gains can rapidly turn into huge losses, as investors all head for the door at once.
Need any evidence? Yesterday both the Aussie and the Kiwi dollars fell by 18% against the yen, “in a matter of hours”, reports Ambrose Evans-Pritchard in The Telegraph. The yen has also risen by 40% against the euro and sterling (also high interest rate currencies compared to the yen) since July.
The situation has become so bad that the G7 countries have basically given Japan’s central bank the green light to go ahead and intervene in the forex (foreign exchange) markets, and sell yen to try to put a lid on the gains. And the Japanese are likely only too keen to oblige – part of the reason that the stock market has taken such a pounding is because of fears of what the strong currency will do to exporters’ earnings. But the warning shot – which would normally make traders more wary of the prospect of betting against a central bank – hasn’t had much impact as yet.
The yen is also up against the US dollar, rising 15% since the end of July. But the yen is about the only currency the dollar has weakened against.
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Hedge fund selling is pushing up demand for dollars
This dollar strength is happening for similar reasons. Hedge funds and other investors are selling risky assets, such as emerging market stocks. The money is then either being returned to investors (as in the case of hedge fund redemptions) or kept in cash, or ‘safe’ investments such as US Treasuries. That pushes up demand for dollars, and pushes down demand for almost everything else.
The ban on short-selling has made the situation with hedge funds worse. Although hedge funds have performed pretty well as a whole during the crisis (you’d still have lost a lot of money this year, but much less than if you’d been invested in any of the major markets) investors have been queuing up to pull their money out (as my colleague David Stevenson pointed out the other day: How the hedge fund squeeze will push stocks even lower) as one of the hedgies’ key strategies has been wiped out by careless government intervention. In fact, hedge fund manager Hugh Hendry of Eclectica Asset Management directly blames the short-selling ban for the recent surge in volatility in markets. His own fund is mainly invested in gilts and is up more than 40% this year, so it’s not like he’s talking his own book.
Falling stock markets are bad news for our pensions
Unfortunately, all this asset-dumping and currency havoc has some serious knock-on effects. Falling stock markets are bad news for our pensions, and threaten to leave insurers short of assets and reliant on government bail-outs (see First the banks – could insurers be next? for more on this).
And there’s no sign of it ending any time soon. As Oliver Kamm points out in The Times, the other major driver behind stock market falls is the simple fact that investors are now “considering the economic outlook and concluding that there are immense risks to their future wealth.” You can’t rely on the traditional valuation measures, such as the price/earnings ratio, or the dividend yield, because the worse the economy gets, the more likely earnings are to disappoint, and dividends to be cut.
“So sharp falls in stock prices, and the volatility of stock markets, are far from irrational. They are a signal – not a cause – of the underlying stresses in the world economy.” We’ll have more on the chaos in the currency markets and what it means for British investors in this week’s issue of MoneyWeek (out on Friday – subscribe to MoneyWeek magazine).
By the way, just before I go, there’s a very good letter in the Financial Times this morning which I’d like to draw your attention to. The writer points out very clearly why the current crisis isn’t the result of capitalism run wild, but is in fact down to previous ill-conceived government interventions in the market. And the bad news is that we’re making all the same mistakes now, only on a much larger scale. Read it here: Only way out is to let long-overdue recession happen.
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