Thursday May 19, 2005 - 13:50:39 GMT
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Could Sterling collapse?
There are certainly grounds for concern over the UK economic outlook. It is increasingly likely that consumer spending will no longer be able to support the economy as a whole and this will increase the risk of a growth downturn, especially if the industrial sector remains weak. There will also be fears over a sharp slowdown in the housing sector which could push the UK economy into recession as consumer spending retreats. Sterling yield support relative to the dollar will also continue to weaken over the next few months.
The relative performance will, however, be important as well as the absolute performance. The US and Euro-zone economies have their own difficulties with the Euro-zone plagued by weak growth and political uncertainties while the US has serious structural weaknesses. These difficulties will help protect the UK currency from heavy downward pressure against the dollar and Euro.
Sharp Sterling depreciation should certainly not be ruled out and the currency is still overvalued, but the UK dynamics suggest that rapid and sustained Sterling falls should be avoided with a longer-term and more gradual decline. The housing sector, for example, is more likely to deflate slowly and painfully over a number of years rather than suffer a crash. The most likely outcome is that Sterling will depreciate gradually on a trade-weighted basis with support between 1.75-1.80 against the dollar this year.
UK economy deteriorates
The UK data has been weak over the past month, raising fears that the UK economy is deteriorating. There have also been fears that there could be a rapid loss of momentum. Sterling has weakened in response to the data with modest losses against the Euro and a sharp decline against the US dollar to lows just below 1.83 compared with levels near 1.92 last month. Sterling has not been helped by a sharp decline in oil prices and a general US dollar rally.
The industrial production figures for March were very weak with a 1.2% monthly decline while there was also a sharp fall in manufacturing production. The monthly drop was the worst for over 10 years and there was an annual decline in output. The manufacturing sector has been persistently weak over the past two years, undermined by poor competitiveness, but there will now be greater concern over the wider implications due to fears that the services sector of the economy will also slow.
Doubts over consumer spending
Over the past two years at least, weakness in the manufacturing sector has been offset by strength in consumer spending. This combination has allowed firm growth in the economy as a whole with comfortable GDP growth rates in the region of 2.5-3.0%. There are, however, now signs that the consumer sector is coming under downward pressure. The British Retail Consortium (BRC) reported a sharp sales decline for April. Although the official figures released for the month, recorded a 0.5% monthly increase, the annual increase slowed to a 2-year low of 2.3%.
The house-price data has been volatile on a monthly basis, but there has been a clear and sharp slowdown in the annual growth rate and prices have been broadly static for 2005 as a whole. Consumer spending has been supported by rising house prices over the past 3-4 years as consumers have been happy to increase debt levels and maintain high spending on the back of appreciating housing assets. As asset inflation slows, there will be a greater reluctance to increase debt and spending further. The implications of a sustained downturn in prices could be very serious for consumer spending levels, especially as household debt levels are already at unprecedented levels historically at around 140% of disposable income. Interest payments on mortgage debt will also rise as discounted rate deals taken out in 2002 and 2003 have to be re-financed at a higher rate. There will be considerable concern that personal bankruptcies are still rising at a time when the economy is still strong.
Is recession a risk?
Some caution is required as the March and April figures may be distorted by seasonal considerations. It is certainly possible that the industrial sector will record a recovery for April and there could be a wider improvement in the economic data.
There will, however, still be additional difficulties in sustaining strong growth, especially as government spending will not be able to provide significant support after strong increases over the past five years. Overall, it is likely to be a question of how fast the economy will slow rather than whether it will slow at all.
It is possible to paint a bleak picture for the UK currency as a downturn in the economy creates a vicious circle. Falling house prices, for example, could cut consumer spending and reinforce downward pressure on housing prices as distressed selling increases. The Bank of England could also be restrained in its ability to cut interest rates if inflationary pressure increases. With fiscal support limited, the economy could slide into recession. The more likely outcome is that the housing bubble will deflate slowly over a period of years rather than rapidly. This could prevent a recession, but would increase the risk of sustained below-trend growth.
Yield support likely to weaken
Global interest rate trends will be important, especially as the Bank of England appears to be moving away from an interest rate increase. At the May meeting only one member of the nine-person committee called for a rate increase compared with two at the previous two meetings. There is the potential for a small reduction over the second half if the economy continues to slow. US interest rates are likely to rise further on a 2-3 month view and it is possible that UK rates could fall to meet US rates at around 4.0% by the end of 2005 or early 2006, although this still appears unlikely at this stage.
UK interest rates were over 3.5% higher than US rates 12 months ago and a substantial narrowing of the yield gap will pose a tough test for Sterling confidence over the second half of 2005. Sterling is also overvalued on a trade-weighted basis.
Despite interest rate considerations, Sterling should still be able to draw support from international considerations. Euro-zone growth is weak which will offer important support to the UK currency and there is little prospect of a near-term Euro recovery which will offer medium-term Sterling protection. The underlying US structural weaknesses will also continue and will protect Sterling in relation to the UK currency.
The underlying current account deficit is in the region of 3.0% of GDP and is a source of medium-term concern. The US economy is, however, also vulnerable due to high debt levels and a wide current account deficit with the 2005 shortfall likely to be in the region of 6.0% of GDP. In this environment, Sterling should be cushioned from a sharp decline against the US currency, particularly with central banks unwilling to increase dollar reserve levels further. Overall, the similarity of fundamentals between the US and UK should help limit substantial Sterling/dollar moves.
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