A currency crisis isn’t something typically associated with a large, developed country like the United Kingdom, and yet that is exactly how some economists are characterizing the massive plunge seen in the pound sterling in the past few days.
The exchange rate between the pound and the U.S. dollar briefly tumbled to 1.035 on Monday—a record low—and now currency analysts are calling for the exchange rate to reach parity (£1 = $1) in the coming months.
The Invesco CurrencyShares British Pound Sterling Trust (FXB), with $163 million in assets, is perhaps most affected by the pound’s woes. The exchange-traded fund, which gives investors long exposure to the pound against the dollar, is down by 21% this year. It has closely tracked the performance of the pound itself, which is lower by the same amount and is currently the worst performer among all major currencies.
An Economy on Shaky Ground
While the plunge in the pound caught investors’ attention this week, it’s only a symptom of broader troubles within the U.K. economy. The world’s sixth-largest economy is widely expected to fall into a recession this year (if it already isn’t in one) and inflation in the country is running at a sky-high 10.1%.
But things could be even worse. In August, Goldman Sachs Group Inc. forecast that consumer prices in the U.K. could grow by as much as 22% early next year, while Citigroup Inc. predicted they would jump by nearly 19%.
The reason for the dire forecasts is energy. Record-high natural gas prices across Europe have been painful for the United Kingdom. In September, Russia cut off all gas exports to the continent, sending prices of the fuel soaring. While the U.K. never imported much natural gas from Russia directly, it now must compete with the rest of Europe for the remaining limited supplies.
Fortunately, the jaw-dropping inflation forecasts from Goldman and Citi might not come to pass—but not because the energy crisis is over. Far from it; today, U.K. gas prices are six times what they averaged between 2016 and 2021.
Rather, energy price caps proposed by the new U.K. government headed by Prime Minister Liz Truss, will help shield households from market prices. Those caps will hold the cost of a typical U.K. household’s annual energy bill to £2,500 for two years.
Though providing much-needed relief to U.K. households, the energy price caps come with a steep cost of £100 billion, a bill that the government will have to foot somehow. That was already putting pressure on the pound, and then the market was hit by a shocker late last week.
On Friday, Prime Minister Truss’ government unveiled a package of tax cuts designed to boost growth. The budget contained tax reductions for Britain’s highest earners and corporations in a model that reminded many economists of the “trickle-down economics” of the Reagan and Bush administrations in the U.S.
The package is estimated to cost £161 billion over five years. Many are predicting the policies won’t work to sustainably boost growth. Moreover, any short-term economic benefits would run counter to the Bank of England’s goal of slowing the U.K. economy to bring inflation down.
As the U.K. is already running steep budget and trade deficits, the government’s spending must be funded by foreign investors, who will demand steep discounts on British assets before they step in.
Currency traders certainly had this in mind when they sent the pound plummeting earlier this week.
Value In UK Stocks?
Things look grim for the U.K. economy and asset prices in the near term. But with the pound at its lowest level ever, British assets could be attractive for value investors who can look past the current economic turmoil.
The iShares MSCI United Kingdom ETF (EWU), which holds U.K. stocks, is down by 21.5% so far in 2022, which might not seem like much in a year in which the S&P 500 is lower by 22.8%.
But valuations for U.K. stocks are much cheaper than their U.S. counterparts. According to data from Bloomberg, the forward price-to-earnings ratio for the MSCI United Kingdom Index is 8.2 versus 15.4 for the S&P 500.
In fact, valuations for U.K. companies are the cheapest they have been since the financial crisis. To be sure, “cheap” alone isn’t a good enough reason to buy, but it could be the starting point of a more extensive due diligence process.
In any case, investors in U.K. assets will have to brace for a lot more potential volatility as the country’s economic and currency crises potentially intensify.