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Top of mind –

The plunging pound: Is it time to hedge the US dollar?

The pound, now at record lows, has taken a fresh tumble amid the energy emergency, cost of living crisis, and precarious UK economic outlook. 

Published

29th September 2022

Author

Suzy Waite

Category

The pound, now at record lows, has taken a fresh tumble amid the energy emergency, cost of living crisis, and precarious UK economic outlook. The pound dropped to its lowest level against the US dollar, and some are forecasting it will not be long before the pound slumps to parity with the US dollar and the euro. 

What could happen?

The government’s plan to freeze energy bills for up to two years will cost around £150bn.

Debt levels will have to increase sharply as the government issues more bonds to cover the costs. Flooding the market with more bonds could send sterling even lower. This should however protect the economy from a severe recession. 

Without such stimulus, it is highly probable that a deep recession would ensue, likely causing the Bank of England to halt raising interest rates, potentially sending the pound down further. So, with or without the stimulus, the odds appear to be stacked against the pound. 

The counterargument: Liz Truss’s bailout helps avoid an economic collapse. Business carries on as usual, which helps support the economy. The Bank of England carries on increasing interest rates, which could support the pound. What is crucial is how well the economy fares in the coming months. 

Our view

Our view is the UK is in a vulnerable position. The International Monetary Fund (IMF) future growth forecast for the UK is poor compared to other developed markets.[1]

The UK trade gap widened by £1.2bn to £27bn in the three months to July, due to surging energy imports and weak export performance.

The UK, a net energy importer, has been hit by surging gas prices. Its exports meanwhile are struggling as demand falters amid Brexit trade frictions.[2] This is not an issue when the economy is strong, but should economic performance continue to wane, this could pose problems.

The Bank of England broadcast dire warnings in July, predicting the UK is headed for a prolonged recession as inflation surged to 13%. The Bank of England said households will suffer a record two years of falling incomes as the global gas crisis sends prices soaring.

Crucially, inflation between economies matters, and countries with higher inflation rates could see their currencies weaken as a result.

 

Source: IMF July 2022 [3]

 

Given that the global outlook is still negative, and markets face ongoing pressure, it is highly unlikely the pound will experience a sustained rebound short-term.

US dollar

The US dollar, meanwhile, has continued to strengthen as the Federal Reserve aggressively hikes interest rates to combat inflation. Combined with the US dollar’s ‘safe haven’ status, it has risen against almost every currency so far this year.

The Bank of England and European Central Bank have been slow to raise interest rates by comparison as economic activity in the UK and Europe is weaker compared to the US. This has weighed on both the pound and the euro. 

How does the weak pound affect you?

A weak pound means foreign imports are more expensive. You also get less for your pounds when you are abroad exchanging for another currency, such as the US dollar or the euro.

However, UK-based international businesses that derive most of their revenues from exports benefit from a weak currency, because their goods are cheaper to foreign buyers. This can help increase sales.

Given most of the companies we invest in are global in nature, our clients tend to benefit when the pound falls due to our diversified approach.

Is it a good time to hedge?

The US dollar is trading near all-time highs as measured by real effective exchange rates. The only time in the last 30 years it was higher was in 2001-02.

 

Source: Bloomberg September 2022

 

But at some point, these trends will reverse. It will not happen quickly – currency trends are like aircraft carriers changing direction. It takes a while for a large aircraft carrier to change course, but once it does, it is on that new route for some time. 

Hedging some of our dollar currency exposure will be critical to defending our capital in pound terms. The global outlook remains negative, and markets face ongoing pressure, which means it is unlikely the pound will experience sustained strength short-term. But US dollar/pound valuations are at a level where we think that, over the longer term, starting to hedge some of this exposure, will be of benefit to our clients here in the UK. 

Author -

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Suzy Waite

Investment Writer, Arbuthnot Latham

Suzy joined Arbuthnot Latham in 2021 from Bloomberg. An experienced financial journalist, she previously worked at Euromoney Institutional Investor and Haymarket Media. She’s covered a variety of areas including hedge funds, commodities, equity capital markets and asset management while living in New York, London and Hong Kong.

Working closely with the Investment Committee, Suzy covers committee meetings, client events and writes macro thematic pieces. She also contributes to flagship campaigns.