Sterling is set to come under strong selling pressure into the close of 2012 with a deterioration in fundamentals and fresh economic concerns. There will be a renewed GDP setback for the fourth quarter and, even if negative GDP growth is avoided, the underlying trajectory will not be strong enough to deliver a sustainable improvement in government finances. The type of perma-recession suffered by eurozone peripheral economies is not on the agenda for the UK, in part because sterling is free-floating and the strain of economic vulnerability will be taken through a weaker currency. The relative perspective will lessen the threat of severe depreciation and certainly offer some protection, but sterling is likely to weaken toward 1.50 against the dollar.
1. GDP is liable to contract for the fourth quarter.
The UK recorded a much stronger-than-expected GDP growth of 1.0% for the third quarter, the strongest rate of expansion for five years. Once distortions were stripped out, underlying growth was around 0.3%. PMI surveys have weakened again and the Bank of England has warned over the threat of a contraction for the fourth quarter. The UK would in all probability be joined by the eurozone with negative growth for the final three months of 2012, but it remains an important negative factor for sentiment, especially as a triple-dip recession would shatter credibility.
2. Bank of England will keep monetary policy loose.
Although the Bank of England held off from further quantitative easing in December, the MPC will remain determined to keep a loose monetary policy. New Bank of England Governor Carney may adopt a different stance from next July, but tensions within the MPC are likely to be running high in the short term and underpinning the economy will have to take priority.
3. The government will only meet budget targets through accounting tricks.
Chancellor Osborne will present the government's autumn statement on December 5. The headline public-sector bowing data will be boosted by the Royal Mail pension fund switch this year. The underlying deficit has deteriorated by around GBP5bn this year as revenue flows have been disappointing. The statistics office is due to rule early next year whether the transfer of coupon income from the Bank of England resulting from quantitative easing bond purchases will be counted as income. The government may be able to show that the headline deficit is meeting targets, but markets are unlikely to be convinced.
4. The AAA credit rating is likely to come under renewed threat.
The UK has clung to its AAA rating during the double-dip recession. Policy independence has been a critical element in keeping the AAA rating, especially with a floating exchange rate. Nevertheless, there has been a net deterioration in the underlying debt dynamics, especially with weak growth. Moody's is likely to rule on the rating early in 2013 with a high risk of a downgrade. Rating cuts in the U.S. and eurozone have not caused major damage, but the UK is unlikely to fare as well. Currency and fixed-income markets are likely to be increasingly uneasy on ratings fears, especially if risk conditions deteriorate.
5. Reduced scope for safe-haven buying
Sterling has been an important beneficiary of defensive capital inflows in its role as a refuge from the eurozone. Although underlying eurozone fundamentals remain bleak, any approval of the next loan tranche for Greece would at least ease the immediate sense of fear. In this environment, defensive inflows into sterling are likely to fade.
6. The trade position remains vulnerable
The UK registered a third-quarter current account deficit of GBP20.8bn from GBP14.5bn previously, the highest nominal deficit on record and above 5.0% of GDP. The underlying trade situation remains very vulnerable with exports unable to gain significant traction. There will be a short-term impact from reduced oil and gas revenue and the longer-term energy account is also set to deteriorate.
7. The Bank of England is looking for a weaker exchange rate.
Bank of England members have made explicit references to the exchange rate and the damage that has been caused by Sterling gains. The bank has made a clear preference for the exchange rate to weaken or at least not strengthen. In the latest inflation report, for example, Governor King stated that Sterling appreciation over the past 15 months was not a welcome development. The UK is hardly alone in pushing for a weaker exchange rate, but there is a clear danger in wishing for a lower currency as it may get a lot more depreciation than it bargained for.