The UK finds itself in a very uncomfortable position at the moment. Although most of the scary headlines recently have surrounded the question of whether we vote to leave the EU or not, we see the news this week that the UK’s current account deficit has hit a record high as much more disturbing in the longer term. At some point, the deficit will have to be reduced, and unless the World economy is about to enjoy a massive growth spurt, the process will require some tough decisions.

The further we delved into the problems facing the UK, and how the twin deficits (current account and budget) could be rebalanced, the more disturbed we became. This is a far larger subject than can be covered by a short weekend research piece, and so we will publish a more in depth piece next week (please reply to this email if you wish to see this note). So let’s crack on with the shortened version.

Although the UK has been running a persistent current account deficit for a number of years now, the sheer size of the deficit was a shock. In the fourth quarter, the UK’s current account deficit amounted to 7% of GDP, the highest peacetime level since records began 244 years ago. This is a vivid sign that the UK is living well beyond its means as seen in chart 1 below.

Chart 1 – The UK current account as a % of GDP

All deficits have to be funded, and in the case of a current account deficit, this has to be funded by foreign capital, either in the form of long term foreign direct investment (FDI) or short term capital flows. Either way, foreign capital has to be attracted to the UK.
In terms of net foreign direct investment, the UK has many advantages, some of which are due to our historical and geographical position on the world stage. We have no real view on how a Brexit will impact on this, although we suspect that it will discourage capital from seeking a home here in the short term. Perhaps the point to make here is that the current account deficit will remain whether the UK leaves the EU or doesn’t. So let’s consider short term capital flows.

To be attractive to foreign capital, the UK has to offer attractive investment returns, either from equity, fixed income or a cheap currency. As the deficit will be funded, the deciding factor is at what price. At what level of interest rates and currency valuation will foreign capital be happy to fund our excess consumption? Our guess is that it is unlikely to continue at current levels over the long term. Either our interest rates have to go up, which is not an attractive proposition for the domestic economy, or the value of Sterling has to decline. It’s likely to be a combination of these factors, but key in the long term is likely to be a decline in Sterling.

The trouble with being bearish of Sterling in the short term is twofold. First, Sterling has fallen by about 10% on a trade weighted basis in the last four months. This is a big move in a short period of time, short Sterling has become a very popular trade, and nothing moves in a straight line forever (well, usually!). Second, we have to deal with Brexit. As we all know, UK voters go to the polls on 23^rd June to vote on whether we stay in the EU or vote to leave. It’s a binary outcome, and if the outcome is a vote to leave, we along with everyone else expects Sterling to fall heavily. If we vote to stay in the EU, there should be some sort of bounce.

Chart 2 – Sterling Broad Trade Weighted Exchange Rate

So, with the long term prospects for Sterling looking quite grim, we believe that any reasonable rally in Sterling should be sold. As noted above, we will publish an in-depth note next week on the structural problems facing the UK(please contact us if you wish to receive this). Our choice would be to sell Sterling against the US Dollar in the RMG FX Strategy UCITS fund – see HERE for details, using options as a way of controlling risk. We will consider other asset currencies as well as we expect Sterling’s weakness to be broad based.

This may sound a little generic at this stage, however, as can be seen in chart 2 above, not only has Sterling fallen a long way in a short period of time, it is also trying to bounce off a support level that seems important to us. Furthermore, the UK’s problems appear to be structural, and will take a long time to unwind. So, we do not feel compelled to hold significant positions at the current time. That said, Short Sterling trades really need to be considered on any reasonable rallies.

Stewart Richardson
Chief Investment Officer