30 September, 2022; London, UK
As sterling tumbled in the currency market last Friday and continued its slide early this week, a massive market rout ensued with the FTSE 100 share index dropping sharply by 2.3 per cent, and the 10-year gilt yield rising by 0.27 percentage points.
Analysts attribute sterling’s nosedive to Chancellor Kwasi Kwarteng’s mini-budget speech on Friday and the proposed tax cuts that panicked investors.
In this special report, we’ll look deeper into how the pound has plunged to a historic low, and what its depreciation means for property investors in the months to come.
Our analysis focusses on:
· Similarities between current and past currency crises
· Factors driving sterling’s downward pressure against the dollar
· Winners and losers in the current sterling crisis
"A year ago today, we warned clients of impending surges in interest rates and the risk of stagflation, recommending they lock into long fixed-term rates then where possible, even considering paying ERCs early to lock in cheaper rates. Thankfully many listened to us, many others said we were scaremongering"
How is the pound doing?
As soon as PM Liz Truss stepped into office, her fiscal measures to support struggling households and enterprises caught in the middle of a cost of living crisis have been met with support and criticism at the same time.
In particular, investors have become concerned with fiscal and monetary policies seemingly pulling in opposite directions. While Kwarteng reassured the public that his plans will work, the market response proved to be savage. Just minutes after his mini-budget speech on Friday 23rd September the pound fell 4 per cent to $1.0859 against the US dollar, then hit a record-low $1.0689 on Monday morning.
The UK is no stranger to a currency crisis. As early as 1931, the pound suffered a -33.0 percent decline against the USD. Several notorious currency crises also occurred in the following years:
· 1976 - Still reeling from an oil crisis due to the Yom Kippur War, the UK was forced to borrow from the International Monetary Fund (IMF); the pound reached $1.6529 at the start of November 1976.
· 1985 - The pound hit $1.2360 in March 1985 when the USD continued to squeeze major global currencies; the UK government announced tax cuts and increased borrowing as a response.
· 1992 - Also known as Black Wednesday when the government withdrew sterling from the European Exchange Rate Mechanism (ERM) after it did not succeed in maintaining the exchange rate above the lower limit. A massive sell-off of sterling occurred initiated by currency traders including George Soros.
· 2016 - After the pound suffered yet another slump during the 2008 recession, it collapsed when the UK finally voted in favour of Brexit.
The 1976 and 1985 currency crises are by far the closest to today’s turmoil— massive tax cuts, huge borrowing and a strong USD affecting other currencies. But the similarities end there.
The 1976 IMF debt was repaid a day after the general elections in 1979 since only half of the total planned loan was borrowed.
The pound’s volatility wasn’t to blame for its weak performance in 1985 as most economists believe. It was the USD’s strength against other currencies that put others in peril, which eventually forced the United States to depreciate the value of the USD when it signed the Plaza Accord with France, West Germany, Japan and the UK.
Today’s geopolitical risks coupled with global economies that have yet to recover from the COVID-19 pandemic have created sceptics out of global investors.
Why has the pound dropped so low this week?
The pound’s plummet to a record low against the USD was swiftly triggered by Kwarteng’s fiscal announcements during his speech. However, even before Truss won the election, uncertainty in the currency market was already evident that put sterling on track for the largest weekly drop since the pandemic decimated markets in March 2020.
Some of the factors that continue to influence the pound’s downward trend include:
1. Massive tax cuts and heavy borrowing
Kwarteng’s promise of more tax cuts in the coming months raised further concerns on the future of the UK’s trade and budget deficits. His assurance induced extreme volatility in the financial market.
The IMF has already warned Truss on her fiscal measures, which does not align with the hawkish approach of the Bank of England (BOE) to stave off inflation that reached a 40-year high in July.
2. Growing investor anxiety
When investor uncertainty rises, they tend to flock to US-denominated financial assets and away from more unstable currencies, thus they require more USD to purchase these assets.
The BOE continues to give assurance that it is doing its best to prevent a looming recession. But its decision not to call an emergency meeting the week after Kwarteng’s mini-budget to discuss another hike was met with negative reaction when sterling hit $1.0689 on September 26 from $1.0859.
3. Oil supply scarcity and ongoing Ukraine-Russia conflict
Russia’s aggressive stance against Europe and the United States continues to place heavy pressure on European economies. As of September 2022, only 20 per cent of the agreed gas supply has been flowing through the Nord Stream 1 gas pipeline.
Adding to the geopolitical risk is the ongoing conflict in Ukraine. The UK is heavily exposed to gas price volatility because of its dependence on imports and is vulnerable to wild market swings since it does not have enough gas storage facilities to accommodate larger reserves.
As long as these conflicts remain unresolved, which is unlikely to happen before the year ends, investments will continue to take flight to safe-haven assets outside the UK.
4. US dollar’s pressure against other currencies
The USD is a safe refuge among foreign investors during domestic financial crises. As the world’s reserve currency, it is often preferred in international transactions. Investors pile into the greenback especially at times of economic uncertainty brought by high inflation and recession.
Such global appetite was observed on September 26 when investors were pushed towards the dollar a few days after the proposed steep government borrowing to finance the tax cuts. Their sell-off indicates not only concerns about the budget deficit but also rising interest rates.
Adding to the investment flight is the impact of the U.S. Federal Reserve’s interest rate hike by 0.75 percentage points in September 2022 that induced a rally in the USD. As US interest rates increase, it becomes more attractive for foreign investors to swap their currencies for USD, thus raising the value of the greenback.
Are there winners in a currency slump?
A plummeting pound means that imports cost more. The most disadvantaged are:
Households and businesses whose consumption is tied to imported raw materials such as wheat and crude oil. Since imports are more expensive, these non-discretionary purchases will push inflation higher unless the government and the BOE’s interventions work to tame inflation.
Retailers whose products now have higher shelf prices will suffer from lower sales.
Manufacturers who rely on gas and key ingredients sourced from abroad have to contend with higher input costs.
But while a weaker pound is often linked by the media to a slumping economy, this does not mean that everyone is worse off.
Those that benefit the most from a currency crisis include enterprises that sell their goods and services in overseas markets. Around 70% to 75% of FTSE 100 companies earnings are denominated in USD and earn more when they convert their dollar revenues back into sterling. This was the case when the FTSE surged 10.4% in March 2017 when the pound lost 12.8% against the greenback.
The UK real estate market can be more attractive to foreign buyers as well. In 2016, when the pound slid to a 31-year low after the Brexit vote, there was a pick up from wealthy foreign investors from China and the Middle East who flooded the UK property market with enquiries for bargain UK real estate. In fact, the country secured 14% of total worldwide commercial real estate investment deals as a result of the surge in property buying from foreign investors.
A 2021 report from the Centre for Public Data (CFPD) also indicates that the number of foreigners who own properties in England and Wales has increased by twofold since 2010. In particular, there has been a faster acceleration in the total number of UK properties owned by investors from Southeast Asia and the Middle East.
The impact of Truss’ trickle-down economics will not be evident in the short term, thus it could create further swings in the market as consumer and investor uncertainty grows. Kwarteng will not be making any definite announcements until his fiscal plan presentation on November 23rd. This may trigger further shocks in the economy until there’s a clear assurance from the government on how the proposed measures will work, and how its funding can avert a deep recession.
Also, the BOE must take a more aggressive stance not only in raising interest rates but also at aligning its monetary strategies with the fiscal measures of Downing Street. However, we also acknowledge the BOE’s need for careful decisions on interest rate hikes to avoid pushing the economy into recession. Without transparent fiscal prudence, the country will find it difficult to be insulated from volatility in financial markets that have been battered by economic shocks since the pandemic.
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