One € = one £ in 2009?   With more sterling weakness to come?

We're all familiar with the sliding Dollar story...   All those undisciplined Americans spending and borrowing far more than they earn or produce.   The US Government  spending and borrowing.   The US consumer spending and borrowing.   The US trade deficit getting larger and larger.  

America has been having guns AND butter.   And Nobel prize-winning economist Joseph Stiglitz estimates Iraq and Afghanistan will be a 'Trillion Dollar War'.   A TRILLION dollars!   All borrowed.   No wonder the Dollar is on the slide.

But if you have been skiing this winter you will have noticed that things seem more expensive for us Britons too.   The budget doesn't seem to stretch so far.   Something's amiss with the Pound in your pocket.   Because as the chart below shows, since the crisis last August, the Pound too has taken a toboggan ride.  

After years of stability against the Euro (and lots of boasting about our superior economy) the Pound has suddenly nosedived and lost over 15% against the Euro in just 7 months.   It only needs to lose another 20% to hit parity, and at the current rate of slide it could get there in a year!   This is a dramatic decline!

When this decline is projected forwards the Euro and the Pound are at parity in 12 months, by Mayday 2009.

Source:    Data from www.sharescope.co.uk, trend calculated by The Planning Business

Stability... shtability

Of course, many linear extrapolations don't just go on and on.   And many, including the Government, appear to think the British economy is in a stable position... in a better position to ride out the current financial tempest than most of our European colleagues.   Obviously they haven't been skiing this winter.   Or possibly they were asleep instead.   In fact such optimists must have been asleep for the past decade.   Perhaps preferring not to think too hard while they enjoy a consumer boom funded by the largest borrowing spree ever.   

They don't appear to have noticed that apart from a record mountain of debt, we now run the largest trade deficit ever (even when adjusted for inflation - without adjusting it looks even worse).   The UK's GDP may have risen smoothly for the past decade, but at an unsustainable rate as the balance of payments has steadily grown worse and worse in tandem.   Even the mighty financial engine of the City has not managed to hold things up.    The export surplus of services has grown, but not nearly fast enough to offset the faster growth of the deficit in goods.

The end of the Petropound

Since it's peak in 1999, an important additional pressure on the Pound has come from the decline in North Sea oil production.   Its decline has been forecast for some years (C.J.Campbell, "Peak Oil").   Despite the discovery of new oil fields and the application of new extraction technology, North Sea oil production has been steadily declining from its peak in 1999 and is forecast to decline considerably more at a rate of between 7% and 13% per year, depending on assumptions about new discoveries)(Euan Mearns, Oil Drum Europe).

At just the WRONG time

The the double whammy is, that when we had an oil surplus and were sucking it out like there was no tomorrow (every government wanted the money in NOW), the price of oil was only $20-30 per barrel (in 2008 prices), but now, just as the surplus is sliding into deficit, the oil price has rocketed to over $100 per barrel.   So the pain of the deficit is going to be a lot worse than the pleasure of the surplus ever was.

The downwards extra pressure due to declining oil production on the balance of payments is forecast to increase sharply after 2008.   Assuming the price of oil stays around $100 per barrel, this is forecast to add an additional £12 billion to the annual balance of payments deficit between 2008 and 2012.

Implications

The Pound - a long slide

The Pound is likely to continue its slide.   Activity by the Bank of England may slow the Pound's decline to some degree.   But we think several factors will cause the depreciation against the Euro to continue for several years...

    a) The Pound is already depreciating rapidly against the Euro despite UK interest rates being higher than Eurozone rates.

    b) Since its peak of $2.11 in November the Pound has even started to depreciate against the Dollar.   When the Dollar slides, so does the Pound.   But when the

    Dollar recovers, the Pound rarely does.

    c) The shock from the current financial crisis is likely to be more severe in the UK as the UK economy is more dependent on finance.

    d) Historically the UK business cycle is in advance of the Eurozone, thus putting pressure on the Bank of England to cut rates earlier than the ECB. 

    e) The Eurozone has never had much oil, so will not suffer any extra oil shock by running out of something it never had.

    f) If the UK economy is hit harder than the Eurozone economy, there will be more pressure to cut UK interest rates - which should cause the Pound to depreciate more.

    g) It has happened before.   In the 20 years between 1963 and 1983 the Deutschmark appreciated 300% against the Pound.   Think of the Euro as a new Deutschmark.

    h) Even if, as has been speculated, weaker members (Italy, Ireland perhaps) drop out of the Eurozone, it will simply make the Euro - now limited to those that CAN stay

    the course - stronger than ever

Interest rates - too high for comfort, too low for 'prudence'

The Bank of England will be caught in a very difficult situation - between a rapidly slowing economy, and imported inflation from the depreciating Pound.   We believe that interest rates will not be cut as fast as the economy demands due to fear of inflation, but too fast to bring inflation below the Bank's target as quickly as it would wish.   The Bank may slow the Pound's decline, but it will not be able to stop it.   As the Bank's mandate is to keep inflation within bounds, not to keep the economy going, we believe there will be no avoiding a severe 'growth recession' in 2008-2010, and possible real negative growth for a few quarters.

Business activity - sharp slowdown in 2008, with subsequent export-led recovery

Higher interest rates, high debt levels and imported inflation will initially cause a sharp slowdown in activity, particularly in consumer focussed industries.   However, the lower Pound should eventually lead to growth in export industries, though this will be counter-balanced by a worldwide slowdown in economic growth.

Unemployment

Unemployment will rise, amplifying the slowdown, but eventually employment should increase in exporting/import substituting industries.   (N.B. Unemployment tends to lag the general economy, so the fact that it hasn't risen yet means nothing.)

Losers

Overseas holidays - As with the slowdown of 90-92 there will be a major contraction in foreign holidays - due to the weaker Pound, less disposable income and higher savings ratio, and higher air fares.   More expensive holidays will suffer most.

Airlines - Airlines that depend heavily on UK-originating leisure travellers will suffer badly, due to reduced consumer spending power and higher fuel prices. 

Housing market - We believe that credit will stay scarce and expensive for some time, and the over-valuation of UK housing will bring about a long and steep decline in prices, comparable to the early 1990's decline, certainly of at least 20%, with the market not steadying until 2010/2011.   This will be a brake on consumer expenditure.  

Industries associated with housing (housebuilders, estate agents, soft and hard furnishings, DIY stores, etc.) - These will not recover as fast as some appear to expect.

Winners

UK tourist trade - More Britons will holiday in the UK, and more Europeans will holiday in Britain due to the weak Pound.   The weaker Pound should help make the 2012 Olympics a great success in terms of London's economy, and by then the re-balancing of the economy should have led the UK into its next upswing.

Exporting industries - Exports of both physical goods and services should benefit from a significantly lower pound.

Major UK multi-nationals - Larger UK companies with significant overseas earnings that are stated in pounds should eventually benefit from the exchange rate.   FT100 companies should decline less than smaller UK companies that depend more on the domestic market.

The pound in the medium term

Eventually the value of the Pound will stabilise as exporting industries are encouraged by a competitive advantage due to the weak Pound.   However the pressure from declining North Sea production will continue for a decade or more, and if the Government does not slow GDP growth this will drive the deficit higher and the Pound lower.

The reckoning has arrived!   In the medium term (2009-12) we believe the Pound may decline significantly below parity with the Euro before it stabilises.   Any efforts by the Bank of England to prevent this will make what promises to be a nasty growth recession worse.

OPPORTUNITIES

1)   If our forecast proves correct, in sterling terms there is an opportunity to make 25% over the next year (before exchange costs) by holding cash deposits in Euros rather than Sterling.   Deposit rates will be lower... c.3% rather than c.5%, but the gain due to appreciating Euros should substantially offset this.

2)   Where UK branches of European companies earn in sterling, but are judged by remittances in euros, hedging profits against exchange rate changes may be a viable option for the next year or so as the rate of decline of sterling may be considerably faster (25% annually) than the cost of hedging.