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?: ?: 'If you want a strong pound, it has to be for the right reasons': The growing strength of sterling is good news for travellers and reflects belief in the UK's recovery. But with world markets already unnerved by conflict, it could hardly be worse for exporters, writes Angela Monaghan: TAKING A POUNDING

August 3, 2014

Angela Monaghan



The current strong pound is starting to bite into the profits of corporate Britain. Aircraft-engine maker Rolls-Royce, defence group BAE Systems, and contract caterer Compass were among the heavyweights who lined up last week to say that adverse currency movements were wiping millions off their balance sheets.

Over the past year, sterling has risen 10% against a basket of currencies: it gained more than 10% against the euro, and 11% against the dollar. As a consequence, London-listed companies with divisions in Europe and the US are taking a hit when they translate their foreign earnings back into pounds.

Adverse currency movements drove more than 20% of UK profit warnings in the first half of 2014, compared with just 3% last year, according to a recent report by accountancy group EY.

Justin Cooper, chief executive of shareholder solutions at Capita Asset Services, said UK investors in Royal Dutch Shell paid the price of a stronger pound last week, when the oil company reported a 4% increase in its second quarter dividend. "Shell declares its dividends in US dollars, so UK investors will actually feel a 4% cut after the strength of sterling is taken into account," he said.

On the face of it, there is a lot to be said for a strong currency. British holidaymakers travelling abroad find their spending money goes further. And more broadly, a stronger currency usually reflects a stronger economy, and a better outlook compared with peers.

The key factor behind sterling's rise over the past year is closely linked to the latter point. Britain's recovery is well-established now and the economy is widely expected to outperform its G7 peers this year. As a result, markets believe the UK will be the first to raise interest rates, and this is pushing the pound higher. It also reflects the relative positions of Britain's major trading partners - Europe and the US.

Scotiabank economist Alan Clarke says: "With the eurozone at risk of slipping into recession and the prospect of the European Central Bank embarking on quantitative easing, the euro should be weakening against the pound. Similarly, the US Federal Reserve is still loosening policy through QE, which typically weakens a currency."

Aside from the negative impact being felt by some of Britain's largest companies when translating foreign earnings into sterling, there is a bigger fear that a strengthening pound will hurt the nation's exporters and, in so doing, derail one of the chancellor's key ambitions. Back in 2012, George Osborne set a target of doubling UK exports to pounds 1 trillion by 2020. In his March budget he prioritised the country's "makers, doers and savers", extending a long-running script in which a strong sustainable future depends on rebalancing the economy.

A stronger pound is therefore far from ideal for an economy which is trying to reinvent itself as a manufacturing power - less reliant on the debt-fuelled consumer spending of the past and more reliant on exports. Business lobby groups are growing increasingly concerned about the plight of British manufacturers and exporters.

"The recent rises in sterling have made life more difficult for both new and experienced exporters, and further strengthens the case against a premature rise in interest rates," says John Longworth, director general of the British Chambers of Commerce. "Early rate rises may limit the growth ambitions of the very firms we are counting on to drive the rebalancing of the economy."

Part of the problem is that Britain did not capitalise on the weaker pound during the crisis years. Last March, one of his final speeches before retiring, former Bank of England deputy governor Charlie Bean said that any further rise in sterling would be unwelcome, damaging hopes of an export boost to the economy. He made the point that the 25% fall in the sterling between the middle of 2007 and the beginning of 2009 - making UK goods and services significantly cheaper abroad - should have been a major boost to exports, despite the slowdown in its main export markets.

But this did not happen, and Osborne's march of the makers is trying to redress that missed opportunity.

Longworth insists, however, that the weaker pound had been helpful to exporters: "It mitigated other factors, such as difficulty finding access to finance and a general slowdown in global demand."

Others believe the absence of a boost to exports when the pound was weak shows that the impact of currency fluctuations on exports is overplayed. Rob Wood, chief UK economist at Berenberg, says recent signs of slowing growth in British manufacturing probably have more to do with poor global growth and an escalation of troubles in Ukraine than with the strong pound. "The Channel is not wide enough to insulate British manufacturers from wobbles in their main trading partner," he said. "Sterling is not likely to be the main explanation. If the post-2007 devaluation teaches us anything, it is that exports are not very sensitive to sterling."

Nonetheless, fear of a resurgent pound wreaking havoc remains. Members of the Bank of England's monetary policy committee (MPC) have made it clear that they are closely watching the appreciation of the currency.

UK interest rates have been at 0.5% since March 2009, in the wake of the Lehman Brothers collapse at the peak of the credit crisis. With the ensuing economic scars barely healed, policymakers are now left with the difficult dilemma of when to start normalising rates, given that markets, businesses and consumers have become hooked on cheap borrowing.

The MPC is keenly aware that an early rate rise is likely to send the pound sharply higher, possibly doing further harm to UK export prospects. That -along with a lack of wage growth and low inflation - is a factor being cited in the case against an increase. The precedent of Japan is another factor. The world's third-largest economy is a poster child for the way a strong currency can hurt a country's manufacturers. Along with the US dollar, the Japanese yen is considered a safe-haven currency. During the financial crisis, investors piled into the yen, stifling Japan's export-led economy.

While forecasting exchange rate movements can be a dicey business, Scotiabank's Clarke believes sterling is likely to strengthen further in the coming months, at least against the euro.

"I think the pound will continue to strengthen against the euro as the first Bank of England rate rise approaches and the eurozone gets closer to deflation and quantitative easing. However, there is the risk of a setback against the dollar. Assumptions about the UK economy going from strength to strength are likely to be challenged. Business surveys have already suffered a little and that is likely to continue. Meanwhile US activity is looking perkier. So the pound could weaken a bit against the dollar, but it is unlikely to fall off a cliff."

David Bloom, global head of foreign exchange strategy at HSBC, also said potential for a stronger dollar next year would provide some relief for those suffering under the strong pound.

He cautions: "You've got to be careful what you wish for. You can get a weaker currency for a range of reasons, including political and economic uncertainty. If you want a strong pound it has to be for the right reasons - because someone else's currency is stronger."

Political uncertainty is not in short supply in the UK, which is facing a vote on Scottish independence, a general election next year, and a potential exit from the European Union thereafter. Next year, a weak pound could be no cause for celebration.

Corporate Britain's struggle with the pound last week included some of the country's biggest companies in sectors from manufacturing to catering

Compass: In a trading update, the contract caterer noted that sterling had continued to rise against many of its key currencies, including the US, Canadian and Australian dollars, the euro, the yen, and the Brazilian real. Compass said if the trend continued, there would be a likely negative currency impact of 7.3% or pounds 92m in full-year underlying operating profit.

British American Tobacco: The tobacco giant said its half-year results were affected by the weakness of the Brazilian real, South African rand, Australian dollar, Canadian dollar, Russian rouble and Japanese yen. It blamed this for a 9% fall in profits to pounds 2.7bn.

Rolls-Royce: The aircraft engine maker said a strong pound reduced underlying revenue in the first half by pounds 226m and pre-tax profit by pounds 21m, compared with the first half of 2013. About half of its revenue is exposed to currency movements, mainly relating to the US dollar and the euro.

BAE Systems: The defence giant said sales fell by pounds 900m in the first half, to pounds 7.6bn. It attributed pounds 400m of this to currency movements, with pounds 33m wiped off top-line profits. The group said that exchange rates were among the principal risks for the remainder of the year.

National Express: The transport company said that a stronger pound - along with extreme weather in the US and industrial action in Spain - were behind a fall in both revenue and profit in the first half. AM

Captions:

INDUSTRY

George Osborne's hopes for a 'march of the makers' may have been dashed, some analysts say; if exports did not expand strongly when the pound was weak, what chance do they have now?

TOURISTS

British consumers on holiday are enjoying greater purchasing power, not only because the pound is up but because the eurozone crisis keeps the euro weak. Getty Images



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Source: Observer (UK)


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