A delayed reaction to parliament’s Brexit bill approval and the rallying cry for a second Scottish independence referendum extinguished the optimistic spark behind a perkier pound. Sterling tested lows not seen since January, but increasing economic uncertainty means sentiment is swinging day to day.
Whilst the pound sank to a 31-year low following last summer’s Brexit vote, the UK economy has so-far failed to buckle under the same pressure, defying pre-referendum doomsayers. The Office for Budget Responsibility upgraded this year’s growth forecasts to 2% earlier this month, although the outlook from next year has been trimmed slightly.
Although headline growth figures are buoyant, everyone is feeling the pinch. With the pound worth so little against the dollar, holidays are costing a lot more and we’ve got less spending money. Signs of strain are also starting to show domestically as prices of everyday items inch higher, due to hedging contracts – agreements to buy a product or service at a certain price – expiring.
It takes time for the effects of a currency hit like this to ripple through an economy, so how can we expect the economy to react over the next three years?
Hitting the sweet spot
Several different measures dictate how financially confident we feel day-to-day. You’ll have heard of GDP, inflation, imports and exports, and probably know they’re used by experts to judge the health of the economy and trade.
Essentially, GDP is the headline figure that reflects whether the overall economy is growing, while the consumer price index measures whether we are experiencing price inflation (growing), deflation (falling) or stagflation (slowing economic growth and rising prices). Central Banks play with monetary policy to try and control this Goldilocks scenario to keep us in an economic sweet spot.
Imports and exports are also crucial for a healthy economy, representing well-over a quarter of GDP in 2015, data from The World Bank shows. Exports help boost employment, economic growth and reduce the current account deficit. High import levels reflect robust demand and a growing economy.
Although most of these key measures are affected by the strength of sterling, the pound doesn’t wield the power you might think.
We looked at how these key economic and trade measures have reacted to three big currency hits between 1985 and 2016. In 1989 and 1992 sterling crashed 11.4%, and the pound sank 18.8% after the 2008 financial crisis.
Crucially, GDP grew in the three years following a double-digit currency hit, above the average three-year growth of 15.2% since 1985 – excluding the 2008 financial crisis. GDP grew by:
- 15.9% after 1990
- 16.9% after 1993
- 6.6% after 2009
Inflation also tracks higher, rallying from a softer middle period to jump:
- 10% after 1990
- 5.1% after 1993, underperforming the 7.5% average
- and 8.1% after 2009
Due to the availability of data from Reuters Datastream, we analysed the impact of weaker sterling on imports and exports in the years 1999 and 2008 instead of 1990 and 1993.
The weak pound predictably boosts export levels as international buyers are lured by cheap prices. Imports also react powerfully, although with no clear trend:
- -8.9% after 1999
- +15.3% after 2008
- +35.3% after 2009
Whilst the consequences of a weak currency on the economy and trade might appear obvious, they can be difficult to highlight as outliers skew results – although it’s reassuring to see GDP grow after these challenges.
This time it’s a bit different; we’re leaving the European Union. The confidence to spend by consumers and businesses could fluctuate as negotiations progress and the agreements promoting trade will be ripped up, with new deals taking their place. The UK reckons it can get what it wants. Europe isn’t so sure.
Global currencies could soon encounter volatility and a diverse portfolio is an effective way to try and smooth out any turbulence. Exchange Traded Funds are a simple, cost-effective solution to help provide retail investors with currency diversification.