By Hans Guenther Redeker from BNP Paribas
The market consensus has been expecting Sterling to rally against the USD. But it is not only the weakness of the euro dragging cable lower, sterling has lost in trade weighed terms as well, identifying sterling weakness as more broad based. The sterling bullish consensus view is based on rising interest rate and growth differentials leaving growing internal and external imbalances aside. However, the third quarter CBI trend survey indicated a growing recession in the manufacturing sector.
According to the CBI, export prospects are the poorest since 1980 and although some of the export weakness is related to global demand weakness, overvaluation of the currency has played its part as well. While manufacturing profitability has been in the red for some time, non manufacturing profits are now in retreat with the financial sector being especially hard hit by slowing business in this sector. Nonetheless, shrinking profitability has reduced the scope for companies to buffer declining business volume via a further reduction in profits. Restructuring of the corporate sector will become a major issue with private employment in retreat. While fiscal policy is highly expansionary, adding 0.8% of GDP in the next year, it is entirely directed at higher expenditure, unlike the US where the main focus has been put on lower personnel taxation. PM Blair has also enriched the debate by the suggestion that higher taxes might be required to increase the quality of public services.
UK fiscal policy seems to lean more and more on the European model, which might be politically intended in preparing the country for EMU entry. However, with fiscal policy diverging from the US and the trade relationship to Western Europe rising, Sterling should be increasingly traded like aneuro currency. So far, the UK has been the role model for a successful implementation of a supply oriented policy and full employment combined with price stability has been the impressive result. Inward investment boomed from 1996 to 2000, but the first figures for 2001 provided by Ernst&Young, indicate that the UK has started to lose out in the competition of foreign investment. In the first six months of 2001, the UK’s share of European inward investment has declined by 21%.
Even foreign portfolio investment is set to decline as Gilts and the sterling denominated corporate bond markets offer little liquidity and diversification possibilities. With long-term investment moving out of the UK, short-term sterling positive interest rate differentials will not be sufficient to keep Sterling strong.