UK in the doldrums: sterling's woes are set to continue

The final analysis The UK's emergence from this recession has been slow, and it is clear the country continues to face significant economic and fiscal headwinds.

The most recent GDP data from the UK showed that the economy grew by 0.3 per cent in the fourth quarter of last year, a slight upward revision from the initial 0.1 per cent estimate. While the improvement is welcome, and was expected in light of various survey data, the fourth-quarter figure may well have benefited from certain one-off factors, such as consumers bringing forward purchases to beat the VAT increase. The UK's emergence from this recession has been slow, and it is clear the country continues to face significant economic and fiscal headwinds.

Even if the UK avoids a so-called double dip back into recession, the country appears set for a period of relatively anaemic economic growth at best. Bloomberg consensus data indicates that real GDP in the country is forecast to grow by just 1.2 per cent in 2010, and 2.1 per cent in 2011. This compares with expected growth of 3 per cent for both years in the US, and 9.5 per cent and 8.9 per cent in China in 2010 and 2011, respectively.

Furthermore, the next UK government has the unenviable task of attempting to cut the deficit while ensuring it does not snuff out the fragile economic recovery. However, it remains far from certain who will head the next government; recent polls seem to indicate a hung parliament as the most likely outcome. This uncertainty, combined with a weak economic outlook and a large fiscal deficit, is weighing heavily on sentiment, with sterling suffering widespread and sustained losses against all of the 16 most actively traded currencies and falling to a record low against the Australian dollar.

With the Bank of England remaining bearish on the UK economy, further injections of money into the system cannot be ruled out, and the cranking up of the printing presses would undoubtedly accelerate a further decline in the sterling. The market is now coming to suspect that, given the unavoidably tight fiscal stance that the incoming government would be forced to adopt, a classic solution to the debt mountain will be employed: devaluation, prompted by ultra-loose monetary policy.

While weaker sterling and inflation lowers the real value government debt, if Britain is to avoid insolvency it will need to continue to sell debt at the required rate - which based on Alistair Darling's pre-budget report estimates and the Debt Management Office redemption projections amounts to £210 billion this year, £189 billion next year, and £130 billion in 2013. The bleak reality is that a weaker pound and rising inflation make debt issuance a great deal more difficult.

There are numerous reasons why sterling is tumbling. First and foremost, the UK is carrying a budget deficit of more than 13 per cent of GDP, which is the largest of any major economy. Current UK investment numbers have also worried the market. The fourth quarter of 2009 saw UK firms spend 24 per cent less on new equipment than during same period in 2008, the largest drop on record. This decline in spending clearly signals anaemic future growth.

The Bank of England chief's recent warning that expectations for the UK economy remain "to the downside" has led traders to believe that interest rates will stay lower for longer, which in turn means that they expect returns on a range of sterling assets to be lower. Then, there is the extent to which the UK has already printed money, otherwise known as "quantitative easing". Since March of last year the UK has tripled its monetary base. The last time this happened was between 1900 and 1948, a period of nearly 50 years. The vast majority of this new money has not hit the UK economy yet. Instead, it remains on the off balance-sheet vehicles of the enormously indebted banks. This cash will eventually move into circulation, the recognition of which that is undoubtedly shaping the market's underlying view of sterling.

There are positives, but these are only temporary. A weakness in sterling makes UK exports cheaper, which theoretically attracts inward investment. It also makes the UK stock market more attractive to foreign investors. On the other hand, a weak pound forces up the cost of imports and, consequently, inflation. With the price of oil hovering around $80 a barrel and likely rising, and all that cash waiting in the wings, the inflation outlook for the UK looks alarming.

Dan Dowding, who is based in Dubai, is senior executive office and investment manager at Killik & Co (Middle East & Asia)