Key Questions: The Pound Is Getting Pounded. What Does It Mean for Your Portfolio?

George Mateyo, Chief Investment Officer, October 2022

<p>Key Questions: The Pound Is Getting Pounded. What Does It Mean for Your Portfolio?</p>

The Key Wealth Institute is a team of highly experienced professionals from across wealth management, dedicated to delivering commentary and financial advice. From strategies to manage your wealth to the latest political and industry news, the Key Wealth Institute provides proactive insights to help grow your wealth.

The US is not insulated from international events; higher borrowing costs in the UK could lead to slower growth here.

When reading the tributes profiling the extraordinary life of Queen Elizabeth II, one of her many notable moments that struck me was a speech she gave in late 1992. As she reflected on the year that was about to end, she plainly stated: “…it has turned out to be an ‘annus horribilis’,” a Latin phrase meaning “horrible year.”

Her Majesty’s description of 1992 was an unmistakable and understandable acknowledgment of the pain she felt as the result of many personal challenges her family faced that year.1 But to economic historians, it also may have been a nod to an event that transpired on September 16, 1992.

In 1990, the United Kingdom entered the European Exchange Rate Mechanism (ERM), a system designed to reduce currency volatility and increase financial stability. A key component of the ERM was a requirement that stipulated the UK government would have to buy or sell British pounds (GBP) if its currency moved beyond a pre- determined range. This requirement was frequently tested.

Despite hopes for economic harmony, the UK’s financial condition differed significantly from other ERM members.

To wit, in 1989, the UK had inflation three times the rate of Germany, significantly higher interest rates (15%) and a far less productive economy. Nonetheless, the UK joined the ERM with great fanfare, explicitly signaling its commitment to fixed exchange rates.

By 1992, the UK’s financial differences failed to improve. Consequently, the government had to buy billions of pounds of currency reserves to prop up its pound sterling to avoid a breach of the ERM-prescribed range. On September 16, 1992, however, the pressure became so intense that the UK government was forced to unceremoniously exit the ERM, an event coined “Black Wednesday.” It was an enormous blow politically to the government and economically to its citizens.

One week before Black Wednesday, one GBP was worth more than two US dollars. The day following the pound was 12% weaker, a week later it was 18% weaker, and by the end of 1992, it had lost over one-third of its value, falling to $1.50. It would roughly remain at that level for the next 10 years. The UK’s financial credibility was badly damaged, and it would take years to recover. Annus horribilis indeed.

Fast Forward to Today…

The UK financial system today is again under stress. Slightly more than a week ago, the government announced a new economic policy consisting of lower income, payroll and corporate taxes and billions of dollars to subsidize Britons’ energy bills over the next two years.

Such measures are noble; however, they necessitate substantial levels of increased government indebtedness, which coincides with sky-high inflation, rising interest rates and consumers and business reeling from soaring energy prices sparked by the war in Ukraine. In short, the UK government proposed spending as much as 7.5% of gross domestic product (funded by debt versus new taxes or other revenue sources) when inflation is at 10%. The timing of these new tax cut policies could not have been worse.

In response, the GBP plummeted and currently trades close to parity (£1=$1), a level not seen in over two centuries. Prices of long-dated UK government bonds collapsed over 30% in four days, a clear indication of the market’s displeasure with the government’s actions and a lack of confidence in its credibility. Notably, interest rates typically rise when a government’s or corporation’s ability to repay its debts is in doubt.

Fearing a “tightening of financing conditions and a reduction of the flow of credit” the Bank of England (BoE) intervened by buying bonds, abruptly reversing a policy of selling bonds it announced earlier this year in hopes of staving off inflation.

“The purpose of these purchases will be to restore orderly market conditions,” the BoE declared in a statement. “The purchases will be carried out on whatever scale is necessary to effect this outcome.”2 In brief, the BoE quickly became concerned over the UK’s financial stability and was forced to act.

The BoE’s actions did achieve its intended result: GBPs and UK bond prices stabilized. But the BoE said it would provide such support only on a temporary basis. Meanwhile, the BoE also indicated it remains committed to combatting inflation. Both comments suggest further volatility may lay ahead.

What Does It Mean for Your Portfolio?

As we have stated in previous articles,3 the US enjoys many economic, geographical and cultural advantages relative to other nations, but it is not fully insulated from international events. Moreover, government indebtedness is not just high in the UK, but it is high in the US and several other developed economies. The risk, therefore, is that higher borrowing costs could lead to slower growth. If fiscal policies are deemed irresponsible, financial instability and market volatility could ensue.

And so long as inflation persists, central banks such as the Federal Reserve and the BoE will be confronted with difficult choices creating additional uncertainty, which commonly results in lower multiples on stock prices. One takeaway from this episode, therefore, may be that deficits do matter, and because debt levels are already elevated, volatility will continue, at least until inflation subsides.

Longer term, US investors should consider themselves fortunate that the US dollar continues to be the world’s preferred reserve currency, still viewed as an important store of value amid financial chaos in the world.

Key Takeaways:

That said, I also believe that investors would be wise to note that GBPs were once considered as the world’s reserve currency of choice. Demographic, technological and economic forces emerged as severe headwinds, however. Combined with episodic policy errors, those forces caused the pound sterling to lose its luster as it recently did again.

Should the US fail to heed these lessons of history, the US dollar could experience a similar fate. The odds of the greenback losing its reserve currency status in the near- to-medium term are very, very low, although should it occur, that too would be an annus horribilis, for sure.

For more information, please contact your advisor.


George Mateyo Biopic

About George Mateyo

As Chief Investment Officer, George Mateyo is responsible for establishing sound investment strategies for private and institutional clients, expanding internal and external research capabilities, and managing the delivery of solid risk-adjusted investment performance.

In previous roles, George spent more than 15 years in investment management and investment consulting, where he acquired firsthand knowledge and insights into the capital markets and the stewardship of investment portfolios for institutional and high net-worth investors.

George received his MBA from the Weatherhead School of Management at Case Western Reserve University and completed additional studies at the London School of Economics.

The Key Wealth Institute is comprised of a collection of financial professionals representing Key entities including Key Private Bank, KeyBank Institutional Advisors, and Key Investment Services.

Any opinions, projections, or recommendations contained herein are subject to change without notice and are not intended as individual investment advice.

This material is presented for informational purposes only and should not be construed as individual tax or financial advice.

Bank and trust products are provided by KeyBank National Association (KeyBank), Member FDIC and Equal Housing Lender. Key Private Bank and KeyBank Institutional Advisors are part of KeyBank. Investment products, brokerage and investment advisory services are offered through Key Investment Services LLC (KIS), member FINRA/SIPC and SEC-registered investment advisor. Insurance products are offered through KeyCorp Insurance Agency USA, Inc. (KIA). KIS and KIA are affiliated with KeyBank.

Investment and insurance products are:

NOT FDIC INSURED NOT BANK GUARANTEED MAY LOSE VALUE NOT A DEPOSIT NOT INSURED BY ANY FEDERAL OR STATE GOVERNMENT AGENCY

KeyBank and its affiliates do not provide tax or legal advice. Individuals should consult their personal tax advisor before making any tax-related investment decisions.