The Case for Investment in the UK and the British Pound

The British Pound is probably the oldest existing currency of the world. Here is an interesting fun fact – The English expression “spend a penny” means going to the bathroom, and it originated from the need to pay one penny for the use of a public WC! The United Kingdom has been and still is, no small country. It is one of the world’s most powerful nations and arguably the closest ally of the United States. The British Pound is a major currency and ranks 4th in the list of share of national currencies in Global Reserves. The UK has a long standing, well developed equity market with a total market capitalization of approx. $3.9Trillion (May 2021).   

The UK is making its way out of the 2020 pandemic. Vaccinations have been progressing well and the economy is gradually opening up. Should you then consider investing or allocating a part of your portfolio towards UK equities? For instance, the Vanguard FTSE 250 UCITS ETF “VMID” provides a more “domestic” exposure to the United Kingdom by investing in 250 mid-sized companies in the UK (FTSE 100 companies are more "global revenues" than FTSE 250). Once again, as an international investor, currency risk is especially important. What is the outlook for the British Pound? This article aims to arm you with some of the necessary data points and considerations for evaluating an investment in a British Pound denominated asset, especially UK equities and Gilts. 

Modern day governments are highly indebted. And the UK ranks amongst one of the top substantially levered nations in the world. World opinion is divided right down the line on the topic of whether public debt and deficits matter in today’s world. But if they indeed do, the UK, with its Public Debt amounting to approx. 100% of GDP, is in an unenviable position on the debt ranking list! 

(Data approx. end 2020)

When we start conversing on the topic of high government debt, whether in the case of the UK or any other country, the first commonly heard response is – “Look at Japan”! Japan has, historically had a high Public Debt to GDP ratio because of years of fiscal deficits and it has not affected Japan adversely. But hold on ! There are some key differences. Let us summarize those differences in the simplest of words. 

Firstly, and most importantly, a large part of the government’s debt in Japan is held domestically. i.e. by its residents. In contrast, 27% of UK government debt is held by foreign residents. In short, the UK is more dependent on the whims of foreign investors and their view of the performance of the UK economy, the credit worthiness of the UK government and the outlook and stability of the British Pound. Just digressing a bit - Interestingly, the percentage of overseas buyers of JGBs has been increasing as well – from 8.5% in September 2008 pre-GFC to 13% now. And that is a very important point. But we will leave it for another day and another post on Japan’s ageing population.  

(JGB Data as of May 2021. UK Data as of Sep 2020)

Data Reference:

1.     Foreign Ownership of JGBs: https://www.mof.go.jp/english/jgbs/reference/Others/index.html

2.     UK Debt Management Report: https://www.dmo.gov.uk/media/17320/drmr2122.pdf

Second, historically, Japan is a nation of savers. While household savings in Japan have reduced over the years, the savings rate is still much higher compared to that of the UK. Below chart shows the Savings Rate comparison between the UK and Japan since the start of this century. Savings rate, in this data chart, is equal to the difference between disposable income (including pension entitlements) and final consumption expenditure. 

Source: OECD Data (OECD (2021), Saving rate (indicator). doi: 10.1787/ff2e64d4-en)

Corporate savings is another integral component of the savings picture in Japan. On the whole, at the broader economy level, domestic savings is much larger in Japan, compared to the UK. The below chart shows a comparison of Gross Domestic Saving as a % of GDP between Japan and the UK. 

Source: World Bank Data

Lastly, Japan’s net international investment position and current account dynamics vary widely with that of the UK. Explaining the paradox of Japan’s high public debt to GDP and yet its net creditor position to the rest of the world is probably a You Tuber Economist’s favourite topic. In summary, even with the large public debt that the Japan government owes, the nation is still a net creditor to the rest of the world. The below 2 charts reflect the comparison between Japan and UK’s net international investment position and its recent current account history.

The Net International Investment Position is simply the difference between what a nation owns in foreign assets and the assets that foreigners own of that nation. Needless to say, a large part of that build-up of the NIIP is attributable to the consistent current account surpluses generated, thanks to Japan’s massive exports.   

Long story short, the difference in macro-economic factors for the UK and Japan are as radically different as the culinary treatment a salmon would receive between becoming a pan fried fillet and being served on a sashimi platter. 

However, coming back to the topic of the investment case for the UK and the British Pound, I go back to the points I mentioned at the start of the article. The UK is still a major economy, a 2 trillion pound GDP powerhouse and well rated (AA / Aa2). UK gilts are still sought after by foreign investors, more importantly central banks worldwide and large private investors like the Japanese pension funds. The UK, in the last 5 years, has witnessed a fair amount of tumult on account of the Brexit decision, fears of a hard exit, public finance challenges, the constant threat of a Scottish referendum, etc. However, there have been some fortunate tailwinds in the recent past. Most important of those being a superb roll out of vaccination throughout the country and a fairly cordial and soft exit out of the EU with some trade issues and agreements satisfactorily settled. Let us then further list down some of the key aspects to consider and key data points to watch out for in the near term to supplement the case for investment into a UK asset. 

1.   Monitor the Current Account Trends: 

Needless to say, the UK has been increasingly dependent on foreign investors to buy UK gilts and fund its balance of payments shortfall. The current account deficit needs to be monitored carefully and signs of increasing deficit might just set the cat amongst the pigeons as far as overseas investors of UK gilts are concerned.   

2.   Exports to the EU:

The key data point to monitor, in order to stay informed on the current account deficit trends for the UK, is exports to the EU. With the risk of a No-Deal Brexit now behind us, the key test for the UK is whether it is able to keep up its exports or in fact, be able to grow its exports to the EU. March data was encouraging (see the spike to the right). Services exports will be key and there are still significant questions unanswered about the impact on the London financial services industry on account of Brexit. 

Data Source: https://www.ons.gov.uk/economy/nationalaccounts/balanceofpayments/bulletins/uktrade/march2021

3.   Performance of UK Gilt Auctions:

The demand for UK Gilts has remained resilient throughout this crisis. With an increasingly positive vaccination outcome and the risks of a No-Deal Brexit having subsided, the outlook for the demand for UK Gilts continues to remain favourable. In April 2021, the sale of a 30 year Gilt was fairly successful amongst heavy investor demand. 

4.   Early Tapering by BoE:

The Bank of England recently announced that it was slowing down the pace of its bond purchases. But it stressed that it is not reducing the total size of its QE. The market could perceive this as some form of tapering and with US and Europe still well into an expansionary stance, the latest BoE move augurs well for UK Gilts and the British Pound. 

5.   Projected Fiscal Deficit and Actual Borrowing:

To top it up, the latest releases from the UK Debt Management Office suggest that the net borrowing for FY 2021-22 might be lower than previously anticipated (from approx. GBP290bn to GBP250bn). In simple words, this means a further curtailed supply of UK Gilts, which might be viewed favourably by the markets. 

In summary, the UK looks well positioned compared to a lot of the other countries, given recent tailwinds. Lastly, even from an valuation perspective, UK equities look cheaper compared to more lofty US equity valuations. (The FTSE 250 index is trading at approx. 15.0x PE – Data Source : Vanguard FTSE 250 UCITS ETF “VMID” as of 17 May 2021). 

Key risks to monitor, as explained above, –

1. Underperformance at UK Gilt auctions
2. Falling exports especially to the EU in the coming few months and a worsening current account deficit situation
3. A unexpected surge in Covid cases (and probably the most important one to monitor! Cases have already multiplied in the last 2 weeks)
4. Increase in political instability, Scottish referendum anyone?

Happy investing folks !

Disclaimer: Not meant to be investing advice ! Do your own research! I am long multiple GBP denominated assets and might enter into a long position in the VMID over the next 72 hours. Also, do note the views expressed above, are strictly my own and have nothing to do with the collective organisational views of my employer.