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Marcuard's Market update by GaveKal Dragonomics
By Nick Andrews
Over the last three months, the pound has ranked as the world’s best performing major currency. Supported by the relatively strong growth of the UK economy — GDP grew at 3% year-on-year in the first quarter — a buoyant property market, and hints from Bank of England governor Mark Carney that he could begin to raise interest rates before the end of this year, the pound has climbed 2.25% since mid-April to touch a post-crisis high against the US dollar. However, there are grounds to believe sterling may not have the legs to make significant further gains in the near term. At US$1.71, the currency is now looking close to the top of its range against the US dollar.
One reason to doubt the pound’s stamina was on display last Thursday, when hundreds of thousands of Britain’s state sector employees staged a one-day strike to demand higher pay. Despite heart-rending tales in the media about the hardship suffered by nurses, fire-fighters and lollipop ladies, the strikers failed to garner the general public’s support.
That’s because state sector workers have done well in recent years compared to their private sector counterparts. Since 2008, the average public sector wage has risen by 2.1% annually, compared with just 1.3% in the private sector. Greater wage flexibility among private businesses has allowed job creation in the sector to recover, with total private sector employment now at a record 25.1 mln, up from 23.5 mln at its pre-crisis peak in 2008. As a result, the UK economy has beaten most forecasts, prompting the market to bring forward its expectations of rate hikes.
Those expectations may be over-blown. Recent weak wage growth will be one of the key indicators the BoE will consider to gauge the strength of the UK economy and the amount of slack in the labour market. In its May inflation report, the Bank estimated the slack to be 1% to 1.5%. In other words, April’s unemployment rate of 6.6% was only around 1ppt above the estimated non-accelerating inflation rate of unemployment.
There are other reasons why sterling will not move much higher.
1. At 1.5%, inflation is subdued, well below the BoE’s 2% target. Inflationary pressures are being kept in check by the strong pound, which is helping to fuel a supermarket price war. Meanwhile, poor productivity growth is limiting the prospect of future wage increases. There are some signs that productivity growth may begin to pick up, as business investment has grown for five consecutive quarters. Meanwhile, some sectors are suffering skills shortages, which will start to put upward pressure on wages.
2. The UK’s first quarter economic outperformance was achieved against the backdrop of a bad weather-induced soft patch in the US. The latest jobs data show the US economy is now accelerating again, with unemployment falling to 6.1% and June’s non-farm payrolls well above average at 288,000. In contrast, the UK’s economic data appear to be softening. Construction output slowed last week to 3.5% year-on-year and exporters are struggling with the strength of the pound. Over the last year, exports have contracted -4.2%. In short, the UK’s relative outperformance has diminished. If the US economy accelerates further, expectations will rise of an early rate hike from the Federal Reserve, reducing sterling’s relative attractiveness.
3. House price rises of 10% y-o-y across the UK and 25% in London have increased pressure on the BoE to raise rates. However, the Bank recently introduced a new set of macro-prudential tools including limits on mortgage-to-income ratios and more stringent stress tests of borrowers’ exposure to rate hikes. The latest data suggest the tools may be working, with surveys suggesting that the London market has lost momentum.
All these factors — weak wage growth, plentiful labour market slack, low inflation, struggling exporters, moderating growth, and the new macro-prudential constraints on the housing market — suggest rate hikes will come later rather than earlier, diminishing the pound’s attractiveness against the US dollar, especially if the US economy accelerates further.
Against the euro, it is a different matter. The European Central Bank is still in easing mode and rates are likely to stay low for at least two years, widening the interest rate differential between the UK and the eurozone and supporting the pound against the euro.
Employment and inflation data to be released this week should give a better indication of where the BoE stands in gauging the strength of the economy. Still, it looks likely that sterling has little room to move higher from here.
