What could trigger a sterling crisis and what could advisers and client expect as a result?

Sterling did not know what to make of Prime Minister Theresa May’s Brexit White Paper. It dipped, rallied and then dipped again, as (rightly or wrongly) the pound recoiled from the lack of focus on the financial services industry, welcomed the prospect of a ‘softer’ Brexit and then took fright at the thought of possible opposition to the proposed plan from parts of the ruling Conservative Party, let alone the President of one of Britain’s largest single trading partners.

Even some chatter about a second interest rate increase within the space of a year from the Bank of England on 2 August is offering little support to the currency, at least at the time of writing.

The pound is thus nowhere near to recapturing the levels it held on the day before the EU referendum in summer 2016 and remains prey to short-term sentiment swings related to the Brexit negotiation process.

The resignations of Brexit Secretary David Davis and Foreign Secretary Boris Johnson once more raised the spectre of a formal challenge to the Prime Minister, even yet another General Election. Neither prospect, no matter how unlikely they may seem, is offering support to the beleaguered British currency.

Sterling has suffered three crises of confidence since 1945. A repeat cannot be entirely ruled out owing to the current political upheaval and lack of clarity on Brexit, although previous notable plunges have been the result of deep-rooted economic problems rather than any games of musical chairs at Westminster.

  • 1967. Prime Minister Harold Wilson devalued the pound from $2.80 to $2.40 in 1967 as the UK struggled with a rising budget deficit, a trade deficit and a current account deficit, added to a weakening economy. The UK needed to attract capital to fund its triple deficits, or burn through its foreign exchange reserves, and Wilson chose a devaluation to limit national liabilities and lure investment into the UK from overseas.

Rising deficits and a recession forced sterling devaluation in 1967

Source: Thomson Reuters Datastream

  • 1976. Sterling took a battering as then Chancellor of the Exchequer Denis Healey had to turn to the International Monetary Fund for an emergency loan in 1976. Britain was struggling with weak growth, an inflation rate in the mid-teens and – once more – the combination of a growing budget deficit, trade deficit and thus current account deficit. Gilts were unattractive to buyers thanks to inflation and thus the Government turned to external help for near-term funding. Ironically, the IMF loan was paid back quickly as Treasury estimates for the 1976-77 budget deficit proved far too pessimistic.

Inflation and twin deficits hit sterling hard in 1976

Source: Thomson Reuters Datastream

  • 1992. The currency was forced out of the Exchange Rate Mechanism in September 1992 when in the care of the Conservative administration of John Major and Norman Lamont. The UK was mired in recession, burdened by what was seen as an uncompetitive, fixed rate relative to the German mark. The devaluation undid 1990’s move to join the ERM and demolished a key plank of the Major Government’s European policy.

Recession and rising trade and budget deficits contributed to the ERM crisis of 1992

Source: Thomson Reuters Datastrem

Back to the future

There are potential similarities between those three instances and the economic circumstances of today.

  • The UK is still running uncomfortably high trade and current account deficits. Thankfully the annual budget deficit is coming down but Britain is still to a degree reliant upon the kindness of strangers to fund itself, to use Bank of England Governor Mark Carney’s words.

Trade, current accounts and budget deficits tend to mean more to sterling than domestic politics

Source: ONS. Circles signify plunges in sterling (1967, 1975, 1992, 201m

  • Europe was a massive political issue for the Conservative government of the early 1990s and it is every bit as hot a potato today, given how split the party is over the issue of Brexit and how best to implement the withdrawal from the EU mandated by the referendum vote of 2016.

Thankfully there are differences, too.

  • There is no fixed exchange rate to defend, unlike 1967 and 1992, so the Bank of England does not have a big target on its back
  • Interest rates are still near rock-bottom levels, so it easier for the UK to fund its borrowings
  • The annual budget deficit has come down a lot over the past few years, even if Chancellor Hammond has pushed out plans to actually balance the budget to an unspecified date in the next decade

It is therefore hard to say that a new sterling crisis is inevitable although the pound does seem to trade as if it prefers a ‘soft’ Brexit to a ‘hard’ one and particularly to ‘no deal.’ Given the prevailing uncertainty in Westminster over the fate of the Prime Minister and the policy framework outlined at Chequers, the pound could remain under pressure.

Portfolio implications

The performance of the FTSE All-Share before and after those prior crises – and also after the EU referendum of 2016 - could offer some guidance as to what may happen in the event sterling comes under the cosh once more.

FTSE All-Share performance prior to and post previous sterling crises

Source: Thomson Reuters Datastrem

In the run-up to 1967 the market did well but then ran out of steam afterwards as interest rates rose to combat inflation.

In the cases of 1976 and 1992, the economy had been struggling but then picked up speed helped by falls in the pound and a lowering of interest rates, to the benefit of share prices.

In 2016 the FTSE All-Share initially tumbled upon news that Britain had voted to leave but then rallied as the heavyweight multinationals and overseas earners of the FTSE100 in particular dragged it higher – their foreign assets and income were instantly made more valuable once they were assessed in terms of pounds and pence, thanks to the pound’s post-vote plunge.

Sterling has yet to recover the ground lost in 2016

Source: Thomson Reuters Datastrem

If advisers and clients are convinced that debate in Westminster – and subsequent negotiations with the EU-27 – will result for any reason in a weaker pound then another option is to look at buying overseas assets, either directly or through a fund, as their value will rise when translated back into pounds.

However, any such trades bring in other risks, including that their price could fall more than the pound, leaving the client worse off than when they started, and, ultimately, basing a strategy purely on currencies is a mug’s game, given how unpredictable they are. The best reasons for seeking exposure to any asset are (under)valuation and its potential to generate long-term total returns that more than compensate for the risk of holding it. Any currency tailwind is a bonus and no more.

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.

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