Sterling, the US Dollar, Inflation, Interest Rates and UK Debt
With the new Government in the spotlight and under criticism on all fronts, this article sets aside the many unhelpful comments across the media and digs a little deeper to look at what’s been going on.
Sterling has been falling against the US Dollar for some time
Whilst it’s true that the value of Sterling is currently in decline, the US Dollar has also been strengthening against Sterling. In fact, due to the Dollar’s status as a ‘safe-haven’ currency and the US’s more aggressive rate raising strategy, the US Dollar has strengthened against most major currencies over the past year, attracting global capital. The US is also a major energy exporter, which adds extra support.
The DXY Index that tracks the US Dollar against six major currencies stands today at a 20-year high. As the chart below illustrates, Sterling is largely unchanged against the Euro and the Japanese Yen over the past year.
Dollar strength is the key driver of currency ‘weakness’ – 1 year to 27th September 2022
Around one third of UK household consumption is made up of imports and as a result of a weaker Pound import prices inflate and consequently have major impact on both importers and consumers.
In Sterling’s favour, the UK has a flexible exchange rate (it is not pegged to any other currency); its financial markets are highly established and liquid; the Bank of England operates independently of the Government; and almost the entirety of its debt is denominated in Sterling.
A rising US Dollar provides a positive contribution to Sterling-based returns as US assets are worth more – over 20% more in the past year. This has helped strengthen portfolio returns for many. The UK equity market is down only around 3% in the past year[1], supported by large holdings to sectors such as energy and low holdings to technology, combined with the fact that a majority of earnings are from overseas, benefitting to some degree from these exchange rate movements. No-one really knows where Sterling will go from here and over what timeframe. Hedging fixed income assets remains sensible as this reduces their volatility and remaining unhedged (i.e. exposed to currency movements) in equity assets continues to make good sense and will support portfolio values if Sterling falls further.
Inflation and interest rate rises
The news headlines may give the impression that rising inflation and interest rates in the UK is a pain inflicted on the population entirely by its Government. If we turn this inward-looking view outward, rising interest rates are a global phenomenon as many countries grapple with high inflation caused by a rapid growth in the money supply (quantitative easing), supply side issues caused by Covid, and the price pressures on energy and food created by Russia’s war in Ukraine. The fact that the UK Government needs to borrow more, as a consequence of the energy cost support packages and its unfunded tax cuts, is also contributing to rising yields. But take a look at inflation, central bank interest rates, and bond yields in a number of major economies in the chart below.
Inflation and interest rates on 27th September 2022
It is evident that inflation is universally high. Five-year bond yields are at or near 4% in all but one of these economies, and all have risen materially in the past six months. Whilst that is bad news for mortgage and other borrowers, who have benefited from an extremely low cost of borrowing for many years, it is better news for those holding cash or investing in bonds. Despite bond price falls as a consequence of yield rises, long-term investors will be better off, over time, from yields at 4% than at near 0%, which we saw 18 months ago. In the UK real (after inflation) yields on index linked gilts are now in positive territory for the first time since 2010. That is good news for investors taking a long term view since although there has been a drop in value of these assets the future expected returns are now higher. As a consequence, investors’ future liabilities are likely to be more easily funded by their assets.
UK Debt
A few commentators have begun to question whether the UK will be able to service its debts in the future. The UK still remains a major global economy and while the debt service burden will be increasingly heavy, it issues bonds in its own currency, can print money to pay its debts (in-extremis) and has a maturity profile with around half of its bonds maturing beyond 2030 (far longer than most major economies), reducing the short-term refinancing risks that often accompany defaults. Insurance against UK Government debt default over five years implies the risk of default is negligible at less than 0.5%.
There is a school of thought, that the recent support for the supply side of the economy (i.e. increasing productivity and output) by incentivising companies and entrepreneurs through tax reductions, may lead to higher rates of sustainable growth in the future, which will, in turn, help to reduce inflation and allow the Government to bring down debt. This will take time. There is no doubt that there will be uncertainty ahead, but investors who own globally diversified portfolios of equities and higher-quality shorter-dated bonds are well-positioned to weather any possible storms.
‘This too shall pass!’, as the late, great John C. Bogle used to constantly remind investors.
[1] Based on Vanguard FTSE U.K. All Share Index Unit Trust GBP Acc (GB00B3X7QG63:GBP) – for illustration purposes only. This is not a recommendation.
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