What’s the world’s most overvalued currency? You might think it would be something like the Argentinian peso – and with good reason. Argentina has a bit of a reputation for defaulting on its debt and those farm strikes seem to be driving the economy close to meltdown again. Or if not that, you may think it would be the currency of some despotic economy in Africa – somewhere such as Zambia, where the currency is almost completely propped up by the price of copper.
But one currency most of us wouldn’t immediately think of as the world’s worst is the pound. Instead, when the world looks at sterling it sees a currency with only one real blot on its copybook: 1992, when George Soros almost broke the Bank of England, forcing an embarrassing exit from the European Exchange Rate Mechanism. Since then, sterling has been one of the world’s favourite reserve currencies and has been treated a bit like an anti-dollar – a currency that offers foreign investors both solid interest rates and steady growth.
The world should look again. The truth, say analysts at BNP Paribas, is that the pound is horribly overrated and overvalued – just as it was 16 years ago when Soros made his big bet against it. The UK’s currency is at what you might call a ‘Wile E. Coyote’ moment, says Ian Campbell on Breakingviews. Just like the cartoon character Road Runner’s nemesis, we have run off the edge of a cliff and are momentarily poised in mid-air with only the canyon below.
Why? Because we have a hideous current-account deficit (worse than Zimbabwe’s as a percentage of GDP) due to our greed for imported goods and paucity of exports; our public finances are grossly overstretched and our economy is in a state. The pound has already fallen to 11-year lows against the euro. But while that sounds like a big deal, odds are it is just the beginning of a nasty collapse of our currency against most others – and that includes the much-loathed US dollar.
The problems with our economy are finally beginning to be understood. We’ve got a debt problem that dwarfs even America’s. Residential mortgage debt outstanding per capita in Britain is 136%, against 103% in the US. But that’s just the start of it. Look at credit-card debt. The UK economy makes up 10% of the GDP of the 27 countries of the EU, but we don’t hold just 10% of the credit-card debt. No, we hold 30%.
Our Government has joined us in this spending spree, of course – that’s why Gordon Brown has to keep finding ways to raise taxes, and why, when he and Alistair Darling backtracked on the abolition of the 10p tax rate (promising to compensate all those who lost out), they had to borrow the £2.7bn required to do so. That means that as our economy slows there is nothing left in the pot to bail it out with.
And slowing it is. Consumers are already stretched to the hilt – a 30% increase in year-on-year personal bankruptcies was reported for March and consumer confidence in Britain is near record lows. We’ve been predicting the end of the consumer boom in the UK – i.e. the thing that has been driving our economic growth – for a while, but it seems that the time has finally come.
At the same time, of course, our housing market is in total collapse (so no more housing-related expenditure and no more stamp duty revenues); unemployment is on the up (we’ll have lost a million jobs by the time this down cycle ends, says Roger Bootle of Capital Economics); and our banks haven’t the heart, or the resources, to lend anyone any more money.
All this puts corporate profits under threat. But it isn’t just the fall off in demand executives should be worried about, it’s also the cost of supply – especially of importing goods from China. Britain plc has made itself dangerously reliant on Asia for cheap production in recent years, particularly in machinery, electronic products and textile materials. But with wages rising fast in China (19% per annum) and the cost of transporting goods from China to Britain soaring, UK firms are beginning to find that using it as their manufacturing base isn’t as cost efficient as it once was.
Add that to commodity price rises and overall factory input prices are rising at 28% a year. That’s a historical record and one with nasty implications for profits and for Gordon Brown’s tax revenues – already on the verge of being ravaged by the shrinkage in our financial industry.
So what’s left to drive UK growth? Not much. While a falling pound should be good for manufacturers, the sector’s share of GDP has fallen from 19% to just 14% since 1995, so it would have to grow very fast to compensate for collapse elsewhere. Then there is the public sector, the real driver of Brown’s fast-vanishing boom. As analysts at Bedlam Asset Management point out, the 100 miles around Trafalgar Square is the only part of the country where Government-related expenditure accounts for less than half of the economy. Over half the nation receives some form of Government assistance and two million people of working age are currently classified as long-term sick or disabled. That’s ridiculous. And unsustainable. It’s also not the kind of environment that would make foreign investors want to hold our currency.
We have dug an unusually deep economic pit for ourselves in this cycle, say Bedlam analysts. And there can be only one immediate result for “obese, incapacitated, Government employed” Britain: “that in the next two years sterling is weak… and especially against the dollar”. Very weak, says John Mauldin of Millenium Wave Investments. Britain has a trade deficit of 5% of GDP and no country has ever run a deficit of more than 5% without at least a 30% drop in the value of its currency. “Over the next two years, the outlook for sterling is… horrible,” says Bedlam.
So if you aren’t going to keep your money in pounds, what do you buy? This is a tricky market, but the two things currency traders watch are forecasts for interest rates and for economic growth. The higher the rate paid on a currency and the more stable its country’s growth, the better a currency should do. In Britain there’s little point in hoping for growth and also little reason to think interest rates will rise anytime soon – despite the talk of inflation. However, that might not be the case in America.
Why you should buy the US dollar
In fact, selling the pound against the dollar with a ten to 12-month timeframe may present one of the best opportunities in the currency markets today, says Jack Crooks for Money and Markets. The Fed has been concentrating on easing troubles in the housing and financial sectors over the last year and the dollar has suffered badly from the consequent low-interest-rate environment.
But “the period of benign neglect is over”, say HSBC analysts, and the Fed could soon move to raise interest rates to ward off inflation and protect the dollar. Expect to see the pound weaken against the dollar from $1.97 to at least $1.79 over the next 12 months, say Lloyds analysts. The nay-sayers on this strategy point out that America has a whopping great trade deficit (just like Britain), something that suggests an unsustainable expenditure on imports against revenues made from exports. But unlike Britain, America not only has scope for closing this gap via rising exports, but has for many years had its deficit covered by Chinese buying of US Treasury bonds, a trend that seems to keep going, despite a constant expectation that it won’t.
The Swiss franc
As the era of low interest rates and easy money unravels, many of the UK-style currencies will strain under the weight of large current-account deficits – think the New Zealand and Australian dollars and the Turkish lira, says The Economist. But one currency that has no such worries is the Swiss franc, which has a healthy 15% surplus on its current account and is about as defensive a currency play as you are likely to get in the current environment. The Swiss franc has been shunned by investors for higher-yielding currencies, such as the Australian dollar, over the last few years, but they should soon come crawling back to the safe haven of the franc in the next year or so. Morgan Stanley sees the pound falling to CHF1.95 from the current rate of CHF2.02 in the coming months.
The Brazilian real
Unlike the other commodity-backed currencies, such as the Australian and New Zealand dollars, the Brazilian economy has managed to maintain a healthy balance of trade. But the real attraction of the country, according to analysts at Morgan Stanley, is the strong stance that the Brazilian central bank is taking on escalating inflation. Growth might be slowing in Brazil and the currency might already have had a good run, but with the central bank looking likely to hike interest rates 300 basis points to 14.25% by the end of 2008, there is a lot to like about the Brazilian real.
Five ways to bet on the collapse of the pound
Spreadbetting
Trading in the global forex market itself is probably too tall a task for the average private investor. A cheaper, simpler way to bet on a falling pound is to spreadbet. Go to spreadbetting site CMC Markets, or Capital Spreads, for example, and you can very easily take a direct bet on sterling taking a dive against the dollar. It’s tax free, you can decide your own level of risk, and you have a good choice of currencies to bet on.
Currency spreadbets are done as pairs. So if you think the dollar is going to strengthen against the pound, you pick a “USD/GBP pair” and buy to benefit as the pound weakens. The currency you are betting on rising or falling is on the left of the quote. Currency points are expressed as “pips” or “ticks” and are always small because exchange rates are quoted to five figures.
So say the offer for a USD/GBP pair is 0.50675. You buy the pair for £5 per point, and have been quoted a bid-offer spread of 0.50670/0.5675. If the dollar strengthens against the pound over the course of a month to, say, 0.50745/0.50750, you get a profit of £350 (70 pips times £5), tax free. But if the bet goes the other way you can lose money just as quickly.
Depending on the direction and how much you are prepared to bet per point, you will need to put down a deposit. If you bet £1 per point with Cantor Index, who set a deposit rate of 300 per pair, you would have to hand over a £300 deposit at the outset. If your bet backfires, your broker will deduct losses from the deposit and return the rest. If, like Morgan Stanley, you can see the pound sinking against the Swiss franc, then buying a CHF/GBP pair looks a good idea. Buying a YEN/GBP also looks attractive.
Currency ETFs
If spreadbetting is a bit too daunting a prospect, then there are a number of exchange-traded funds available from some American fund managers, such as Wisdom Tree and Currencyshares that allow you to tap movements in currencies cheaply. These are bought in just the same way as shares and track how individual currencies perform against the dollar. You also receive a dividend based on the interest rates in the underlying currency.
So the Australian Dollar Trust (NYSE:FXA), for example, will offer you 6.03% annually. Although you would probably be better served going for the Japanese Yen Trust (NYSE:FXY) or the Swiss Franc Trust (NYSE:FXF), for example. You could also simply invest in a basket of currencies through a multi-currency fund. The Investec Managed Currency fund holds everything from US dollars to euros, yen and Swedish krona. The fund carries an initial charge of 5%, however, so you might be more interested in the Barclays GEMs fund (AMEX:JEM), which has an expense ratio of 0.89% and will give you very broad currency exposure across five regions, from Asia, Latin America to the Middle East.
Foreign currency bank accounts
Setting up a foreign-currency bank account might also seem like an easy way to sidestep a collapsing pound. You open a bank account in sterling and the bank will then convert your money into another currency, such as dollars or Swiss francs. Most of the UK’s big banks offer this service for a range of foreign currencies. A word of warning, however. Opening a foreign-currency account is a taxing process. The time, effort and cost involved, combined with the large minimum deposit requirements on those currencies that pay a competitive rate of interest, means that this option might be best suited to wealthy investors or small businesses grappling with regular foreign-currency payments.
Dollar earners on the FTSE
Picking up the FTSE companies who draw most of their cash in dollars can also work. A big defensive healthcare firm such as AstraZeneca (AZN) or BG Group (BG) would be a good way to sell out of Britain. Both are reasonably priced on forward p/es of 9.8 and 11.4 respectively. GlaxosmithKline is another big pharmaceutical outfit that is making good money abroad. Glaxo has been sold down indiscriminately, despite a slew of regulatory approvals in America, say analysts at Killik. The stock is now trading on an attractive forward p/e of 11 and offers a prospective dividend yield of 5.3%.
Gold
Finally, gold is quoted in dollars and buying this is probably the simplest and most fire-proof course of action you can take – outside of emigrating – to protect yourself against the collapse of the pound.