Sterling Stuff

26/09/2014 at 4:04 pm

The British Isles have been living through some historically significant weeks. The Scottish referendum resulted in the continued existence of Great Britain as a nation, but only by a narrow margin. To say therefore that politics has been interesting here lately would be an understatement. But market behaviour, on the other hand, has not been terribly volatile. The stock market has remained completely range-bound. Gilt yields did reach new lows for the year to date in August, but there were never any signs of panic. In both cases prices have been moving in the same direction as other major markets.

Where there was some more eye-catching behaviour was in the currency.

Given the focus on the pound throughout much of the political campaign this is satisfyingly appropriate (and of course its international trading symbol clearly reads: “GBP”). The sharpest move against sterling came after a weekend poll published by the Sunday Times on 7 September showed a narrow lead for the Yes campaign. Monday saw the pound fall by 0.9% on a trade-weighted basis, its biggest one-day tumble for well over a year.

We should not get too carried away here: the euro has fallen further against the dollar since mid-year and shown almost equally great volatility this month, in no small measure due to the operations of the ECB. Still, the pound has experienced a material shift over the past twelve months and this begs the question: what is its fair value?

Trading ranges are one obvious place to look for guidance. Against the dollar, sterling almost fell to parity in 1985, and peaked at over $2 in 2007. The average cable rate for the past thirty years is parked in the middle of this range at $1.64. For almost exactly one half of that three-decade period, the pound has traded within ten cents either side of the average rate, which is remarkable. At its current price of $1.63, therefore, it looks fairly valued.

The euro rate is harder to pin down on this basis. From the launch of the single currency in 1999 to mid-2007 the pound held a range of €1.40-€1.70, broadly speaking; then it weakened dramatically towards parity in 2008 and has occupied a range of between about €1.05 and €1.30 ever since. At €1.28 currently sterling therefore looks a bit toppy on a purely post-crisis view, but a bargain relative to its pre-2008 levels. (The latter also applies if one charts the pound against the old European benchmark of the Deutschmark. If the DEM still existed a pound would buy 2.5 of them, below its averages over both the past twenty and thirty years.)

Fixating on ranges, however, is the proper preserve of traders, technical analysts and all those trying to make short term sense of the foreign exchange market (there but for the grace of God … ) The long run – and textbook – point of reference is the currency’s purchasing power parity. The theory behind PPP is that the same goods and services should cost similar amounts in different countries, assuming perfect freedom of trade between them. In practice, PPP valuations are therefore calculated by reference to the relative costs of similar items of consumption and to inflation rate differentials over time. OECD PPP estimates for the equilibrium sterling exchange rates against the dollar and the euro are $1.38 and €1.11, so the pound is actually looking expensive on this measure at the moment.

More interestingly, perhaps, are the implications of PPP for long term trading ranges. Using the OECD estimates, sterling is about 13% overvalued against the dollar. When it hit the same kind of levels about nine years ago the actual exchange rate was nudging $1.80. In other words, the somewhat higher rate of inflation in the UK relative to the US over that period has shifted the PPP valuation of the pound by about fifteen cents. Another way of looking at this is that the high reached recently of $1.72 is equivalent to $1.87 a few years ago.

Over the last three decades the UK and US economies have exhibited identical average rates of CPI inflation (2.8%), which is consistent with the stability of the cable rate’s trading range over the period. Turn to Europe, however, and the picture is rather different: over the last ten years, the annual rate of CPI inflation in the UK has on average been higher than that in the eurozone by 0.8% (2.7% as against 1.9%). Going back much further is problematic as zone-wide data is not available prior to 1997 and back in the 1980s there was the matter of the separation between East and West Germany. But the twenty year average rates of CPI inflation in France and Germany are 1.5%, compared with 2.2% here in Britain.

This means that the 14.5% undervaluation of the euro against sterling on the OECD measure pits the current rate of €1.28 against a rate of almost €1.60 when the same level of undervaluation could be observed in the autumn of 2002. So while the trading range of the currency alone might suggest that the pound is priced at a rather weak level against the euro, PPP tells us that we need to shift our assumptions to take account of the material inflation differential between the UK and Europe over the last ten to twenty years and perhaps adjust ourselves to something along the lines of the post-2008 range as the new normal.

Between the long-run PPP and the short term trading view of the world are a handful of other significant forces on the exchange rate. The desirability of UK assets, the attractiveness of the country as a place to do business, the development of views on the likely future path of interest rates and (joining all these dots together) the outlook for economic growth are hugely important considerations. But the impact of PPP, and inflation, is observably apparent.

On that basis it is not quite reasonable to interpret the recent fall in the value of the pound as a conspicuous buying opportunity. And when looking at the currency diversification of a portfolio on a medium to long term investment horizon, it is worth bearing in mind the stubborn tendency of the UK economy to inflate more quickly than its major market peers over the last decade or so, especially in the case of Europe, and to consider the possibility that this might persist.

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