HAMISH MCRAE: Pound shrugs off Labour gloom over financial system

Angst: Chancellor Rachel Reeves

Why is the pound climbing on the foreign exchanges if the UK’s economic situation is so dreadful?

Why is the FTSE 100 index within a whisker of its all-time high? Why are consumers so confident, with the Bank of England reporting a sharp rise in their borrowing in July?

Let’s focus on the pound, because you can explain the stock market boom as part of the global surge in prices, and you can rationalise rising consumption due to the climb in real wages as inflation falls.

We have a current account deficit of around 3.3 per cent of GDP, which means – since the balance of payments has to balance – that there is a capital account surplus of that amount.

So foreigners must be investing enough in Britain to push the pound higher. How does that square with the relentless gloom from Sir Keir Starmer and Rachel Reeves?

There is a short answer. Overseas investors don’t have to pay UK taxes. It is not the money men and women in New York, Zurich or Dubai that are going to be clobbered in the budget on 30 October, and why should they care about what happens to us?

They are making a judgment on the likely return on a UK investment vis-a-vis other opportunities. They are concluding – this is the long answer – that for several reasons sterling-denominated assets look attractive.

For a start, the pound is undervalued. One yardstick to gauge the underlying value of a currency is purchasing power parity. That’s the exchange rate that enables you to buy the same bundle of goods and services in different countries at the same price.

Some currencies remain above or below this rate for many years. The Swiss franc has long traded much higher as it is a haven for savings in troubled times. Turkey has had a bumpy ride, so the lira is well below. If you want a cheap holiday you go to Turkey, not Switzerland.

But it is a useful measure and according to the OECD the pound/dollar parity rate is $1.44. I would settle for $1.50, roughly the mid-point of the range this century, for the pound was over $2 in 2007 and below $1.10 in October 2022.

At $1.32 it should have some way to go. As for the exchange rate against the euro, at €1.19 it is towards the top of its five-year range, but well below the €1.40 peak in 2015. It was trading around €1.25 on the eve of the Brexit vote in 2016, so as with the dollar, some potential upside there.

Second, quite aside from the currency aspect, UK assets look reasonably-priced to foreign buyers. Flats in posh parts of London, such as Kensington, may seem outrageously expensive to most Britons but they are at least 20 per cent cheaper in cash terms than they were in 2017.

Houses in such areas are cheaper than in 2014. Shares, even at near-record levels, seem cheap too. The Footsie price/earnings ratio at 13 is way below that of the S&P 500 p/e of about 30.

Third, UK government securities offer a high return for a mature economy. The yield on ten-year gilts is 4 per cent, against 3.85 per cent on US treasuries, 2.25 per cent on German bunds, and 3 per cent on French bonds.

That is despite the fact that the UK fiscal deficit is lower relative to GDP than the US and France, though higher than Germany.

By the way, that ten-year gilt yield is sharply higher than it was before Rachel Reeves made that speech about a £22billion black hole at the end of July. Not very bright if you want to borrow more money to say your finances are even worse than you thought.

Finally, a general point. It seems likely now that UK growth this year, while slower than the US, will be somewhat faster than most other developed countries.

That makes all those dire official forecasts about the economy look plain stupid. So it makes sense for investors to put a bit of money into Britain – as long as they don’t have to pay our taxes – and that is pushing up sterling. I expect the pound to climb still higher in the months ahead.