We are short the Pound
One of the mottos inscribed on the side of some Pound coins, “decus et tutamen” is a Latin phrase meaning: “an ornament and a safeguard”, a reference to the ridged edges that were developed in centuries past to prevent thieves from clipping tiny pieces of the valuable metal before passing the debased coin back into circulation. In the present, the coin of the realm has been debased by forces that will require more than clever minting techniques to correct.
The Pound Sterling initially collapsed in the vacuum leading up to and following the collapse of Lehman Brothers in September of 2008, and bottomed in late January; conversely the dollar began its burn in March of this year and currently teeters with lows not seen since the abolishment of the gold standard in 1971, except for those of mid ’08. On 9/22 we shorted the Pound via the etf FXB.
This year we’ve repeatedly discussed the imbedded financial leverage associated with the UK economy. Not only have we failed to see leadership from the likes of Brown and King to direct fiscal and monetary policy in a direction that could move the country out of recession, but also ballooning public debt—which currently stands at 13% of GDP (according to a Alistair Darling’s most recent budget statement)—worries us not only in the near term, but on the TAIL (3 years or less) as it should hover well over “acceptable” levels well into 2010 and 2011. Below we’ll discuss our fundamental view on the UK, which we shorted via the etf EWU on 9/9, and our rational for shorting the Pound.
Certainly the extent of the UK’s financial leverage (as opposed to its Western European peers) has prolonged the ability of its major financial institutions to recapitalize and restore confidence, including the ability to extend credit into the broader economy (from first time home owners to larger institutions) to get the economy moving. As in the US, this process has been rocky and politicized, with pressure ultimately exerted on the banking community to ensure that credit trickled into the consumer markets. This easing may have stemmed the trajectory of the contraction, but did little to spark recovery: Q2 GDP figures saw a clear divergence with Germany and France improving +0.3% Q/Q while the UK contracted -0.7%.
While the cost of mortgages and loans have been reduced parallel to the BOE benchmark as it descended to its lowest level ever, 0.5%, broad fundamentals still appear anemic (despite some areas of measured improvement) and we believe they’ll contribute to the country’s ongoing underperformance.
Consumer and business confidence measures for the island economy (not unlike the Eurozone) have improved over the last few months, especially on future expectations, yet there are a slew of data points and metrics that suggest the pain is not over. Unemployment continues to increase sequentially in the UK, not unlike some of its more diversified continental neighbors. Should it continue its upward trend in the next two quarters, which we expect, we’re likely to see erosion in sentiment that will likely carry over to broader fundamentals. Retail sales and housing have yet to yield a discernible trend in either direction over the year, yet should sentiment fade, spending, the housing market, and output could follow with a pullback. UK inflation (CPI) currently stands at 1.6% in August Y/Y and although it’s come down on an annual basis over the last months, it is still well ahead of the Eurozone average of -0.2% in August. We think in the near-term that UK inflation has gotten ahead of growth and that in the intermediate term it will stay there.
Finally, it’s worth considering the components of GDP. The UK economy is a net importer and from January to June 2009 registered the largest deficit of the 27-country EU, at -46.4 Billion EUR. With Investment and Consumer spending down, this leaves government spending as the sole component to generate growth. As we’ve noted above, the ballooning debt, with borrowing at 175 Billion Pounds this year, and a cocktail of “socialist” measures from Brown like raising the income tax on top earners (150,000+ Pounds) to 50% from 45%, shall hinder GDP performance. We think this TAIL risk has contributed to discontent with the Brown government and the underperformance of the FTSE against most global indices.
From a currency perspective, despite the low interest rate environment in Europe [BOE at 0.5% and ECB at 1.0%] both the Pound and Euro have outperformed the degraded US Dollar during its YTD descent. We’ve made our thesis on “Burning the Buck” abundantly clear and the chart below helps illustrate the gains for currencies on the other side of the trade. Versus the dollar the Pound is up +13.3% YTD, while the Euro has gained +6.4% in the same period. In the Chart below, the BOE trade weighted Index reflects this pressure. While the Pound is well off its 2008 levels versus the USD and Euro, affording cheaper cost for buyers of UK exported goods, we’ve yet to see a noticeable pick-up (with some notable exceptions) due to the poor competitive stance of many sectors of the country’s industrial sector.
Along Keith’s call for reflation to morph into inflation in Q4 in the US, with it we expect to see (literally or rhetorically) a boost in interest rates. Associated with a hike should be a stronger dollar, which we believe should depreciate the value of the Pound as it has moved significantly against the USD, but also versus the Euro (+5.4% YTD), despite a negative fundamental outlook in the UK. Price momentum dictated our call to short the Pound, yet we believe the fundamentals support our call.
Matthew Hedrick
Analyst
