x Abu Dhabi, UAEFriday 19 January 2018

Debt and deflation will weaken the pound

The budget recently proffered by Alistair Darling, the UK's chancellor of the exchequer, is widely viewed as lacking in detail on how the country's monster budget deficit would be trimmed.

The pound may soon sail into a perfect storm of negativity. Not only is it assailed by political uncertainty - as the ugly spectre of a "hung" parliament rises with the fall of Conservative Party poll numbers following the televised "Leaders' Debates" - but it also has to contend with another potential threat in the shape of the Bank of England Monetary Policy Committee.

Several members have remained rather bearish on the economy's prospects and have kept on the table the option of rejuvenating the bank's quantitative easing programme. However, the pound may take a little support from the committee's March meeting, at which "some members considered that the upside risks to inflation had risen slightly over the month", possibly increasing the chances of rate rises this year. The April meeting's minutes will be analysed to glean whether the doves on the committee remain in the ascendancy.

Of course, overloading the printing presses would accelerate the pound's collapse, but the market is coming to suspect that this is the plan. Given the unavoidably tight fiscal stance that any incoming government will be forced to adopt, perhaps the powers that be are adopting the classic solution to a debt mountain: devaluation, spurred on by an ultra-loose monetary policy, the traditional death knell for any currency.

Let's also not forget Prudential's monster US$35bn (Dh128.5bn) acquisition of AIG's Asia operation, AIA. How much sterling will be sold to raise these dollars? A rights issue on the London Stock Exchange will raise proceeds in sterling, as will the eventual sale of the Pru stock given to AIG. The prospect of orders to sell almost £23bn is hanging over the market. And then we have the global sovereign-debt problem, possibly the biggest issue for the medium term. I am very uneasy about the next phase of the debt crisis; it is unrealistic for the Western world to believe it can escape from the debt excesses and sins of the last 20 years this easily.

The conversion of private debt into government liabilities seemed like a panacea, but the cracks in this edifice are starting to appear, as highlighted by the ongoing Hellenic headaches. My view is that we are resting on the knife-edge of an unstable equilibrium. When it all topples we won't see the dramatic events of past emerging market debt crises. Rather, the developed world will be drawn towards a slow-motion deflationary spiral as brutal deficit-reduction measures are put into effect.

Because our recent problems weren't solved, but merely moved into another accounting entry line, the markets have reacted with fear; again, Greece is just the latest area of concern. The UK, with similar debt profiles, could be next in line. The budget recently proffered by Alistair Darling, the UK's chancellor of the exchequer, is widely viewed as lacking in detail on how the country's monster budget deficit would be trimmed.

What detail there is seems to be depressingly redolent of "Old Labour" solutions based on higher taxes, rather than the spending cuts that the markets would prefer to see. Gilt issuance for fiscal 2010/2011 will amount to £187bn, fully 13 per cent of GDP; this compares to pre-crisis Gilt issuance in 2007/08 of £58.5bn. Just to round off this grim backdrop, we are starting to see decidedly mixed economic sentiment in the US, the Eurozone and the UK suggesting that economic recovery is fragile at best - this has raised the spectre of "double dips", with their attendant drops in tax revenues that would result from reduced activity.

Is there any wonder that investors are turning to the world's perceived least worst currency, the US dollar? This is exactly what happened in the fourth quarter of 2008, as the financial system teetered on the brink, and this is what we will see happen this year as we enter a new, frightening phase of our crisis.

Nick Beecroft is the senior forex consultant for Saxo Bank.