UK: Against All Odds

Even encouraging data that recently came out of the UK failed to help the pound find some buying support. The December manufacturing PMI, which was expected to improve from 51.8 in November to 52.1, exceeded expectations and printed a strong reading of 54.1 instead. Since the reading was higher than base line 50.0, this means that there was growth in the manufacturing sector.

Lending conditions seem to have improved too. The BBA’s most recent mortgage approvals report showed that they granted 44,700 new mortgages in November, up from the 42,600 mortgages in the previous month. During the same period, net lending to individuals, which measures the change in the amount of money lent to consumers per month, soared from a revised £500 million to £1.1 billion. Generally, this can be considered good. Why? Well, more lending normally leads to more spending!

Still, many are pessimistic over the state of the UK economy because, at the end of the day, UK is still stuck in the recession pool. The latest GDP report revealed that the UK economy shrank by 0.2% during the third quarter of 2009. The important data – those that directly illustrate consumer activity – remain weak. Retail sales in November fell 0.3%, opposite the 0.5% gain initially expected. Isn’t November usually the time of the year when people start shopping for Christmas gifts? It seems like UK consumers didn’t feel the holiday rush…

Now, if there’s anyone feeling the pressure to restore economic glory to the UK, it’s BOE Governor Mervyn King. Along with the rest of the monetary policy committee, King is hopeful that their £200 billion asset purchase program and the BOE’s current benchmark rate of 0.5% will be enough to carry their economy out of the recession.

In their monetary policy statement this Thursday, BOE policymakers are expected to keep interest rates at their current level and to maintain the size of their easing program. Recall that, during their previous monetary policy meeting, BOE officials expressed their concerns about the uncertainties of growth and inflation in the coming months. The central bank would most likely maintain this cautious stance for now. But at some point, they will have to put an end to their quantitative easing.

How will the UK be able to fund its ballooning budget deficit then? Remember that the UK government employed fiscal monetary expansion in order to boost the economy’s output. At that time, they hoped that higher government spending would lead to increased consumption greater than the initial amount due to its ‘spill over’ effects. As the government spends for say, roads, more people will get jobs and more businesses will appear. While this might be true, spending that is funded by debt also has a potential to “crowd out” private capital investments, which is another component of the nation’s output.

I took a look at the data and found out that the UK’s public sector net debt as a percentage of GDP now stands at 60.2% as of November 2009. A year ago, it was “only” at 49.6%! Net debt rose at an astonishing £844.5 billion during the period, up from £706.2 billion posted at November 2008 as the British government pumped up their spending in an effort to curb the economy from contracting. However, rising debt effectively increases the interest rates on loans to compensate for the additional risk of default. With higher borrowing costs, it will be harder and more costly for firms to fund their capital investments, eventually limiting their business and employment.

So, as of now, the British government is pretty much left at an impasse. What then does this mean for the pound?

Let’s take a quick look back at what happened at the end of 2009. In December, we saw a nice run by dollar bulls. Presumably, it was good data from the US triggered confidence in the US market. This led to something we haven’t seen in quite awhile – both the dollar and equity markets rising at the same time! Now you’ve heard me give this question before, but let me ask it again: Could it be that traders are starting to shift focus on fundamentals?

If fundamentals are truly driving the market, the beginning of 2010 might prove to be a cloudy one for the pound. As I’ve just pointed out, UK’s economic is riddled with typhoons and if this kind of weather continues to worsen, traders could put on their raincoats and begin turning their back on the pound. Heck, we may even see those famous guards at Buckingham Palace move an eyebrow – ha!