For investors holding USD denominated bonds as a way of profiting in the event of a falling AUD, the GBP offers a strong alternative to the USD or a way of diversifying a foreign currency bond portfolio
In previous reports we have flagged the Great British Pound (GBP) as the second best foreign currency for Australian investors after the USD. The USD has since gained 20% against the AUD, but the GBP has only gained 10%.
As Australian investors, when we invest in foreign currency assets like bonds, we are in effect betting against the Australian Dollar (AUD), as well as backing the other currency to perform. When the AUD/USD was at $0.94, we believed that the USD was underpriced and the AUD overpriced, hence our strong conviction on USD denominated assets.
Nine months later, and with the USD’s strong performance against all currencies we believe that the USD is approaching fair pricing against the major currencies. However, our view remains that the AUD/USD exchange rate still has 10% or more to fall because the AUD remains overpriced, as repeated constantly by the RBA.
Currency markets are confusing to many investors as they involve two prices combined. So when we say that the USD is at “fair value” and the AUD “overpriced”, this means we think the AUD/USD is likely to keep falling from its current $0.77 level. The change for the USD from “underpriced” to “fair value” just means that the speed of this fall will slow as we’ve already seen.
So, rather than focussing on just one currency, investors should now focus on how to profit from the falling AUD and look for opportunities to diversify into other strong foreign currencies. In this report, we look at the GBP.
Economic outlook
In the past few months, British economic prospects have continued to rise. The UK economy had the developed world’s fastest growth in 2014, and it has started 2015 with the same positive momentum, despite the challenges of its largest trading partner, the EU.
Like all major economies at present, the UK has its challenges. Aside from the EU’s volatility, trade and manufacturing growth is slowing due to the rising GBP. But compared to Australia, the UK’s outlook over the next few years is relatively strong. Employment growth has been high, consumer confidence is strengthening with retail spending at 27-year highs. Small business growth has been extraordinary and construction now looks to be a new positive contributor.
The relative strengths and weaknesses of the UK economy compared to the Australian economy appear at the end of this article.
Bond market outlook
Most economists believe the Bank of England will leave rates steady until 2016. The biggest risk to this forecast is wage growth, offset by the uncertainty surrounding the EU referendum.
Unemployment is still above the economy’s capacity, meaning more jobs can be added without creating wage growth (and therefore inflation) pressure, but employment growth has been very high.
But given the Euro area's current economic problems, the best bet may be that rising real wages in Britain attract a steady and growing flow of workers from Europe, boosting the size of the labour force as well as the numbers employed. Steady inflows of talent from abroad would do wonders for the long run growth potential of the British economy, and would also enable Her Majesty’s Treasury to approach interest rate rises patiently and for as long as the supply of European migrants holds up. This would leave rates lower for longer, but provide strength for the GBP (see below).
In the immediate term, key data out last week showed inflation has turned positive again after a short dip below zero; unemployment remaining at 5.5% (lowest since August 2008) and wage growth at the highest level in four years. Retail sales continued toward their strongest level in a decade. This will shift the BoE’s bias toward raising rates sooner, although like the US Federal Reserve, the Bank of England will be very patient rather than risk quelling these early signs of recovery.
If the AUD/USD rate continues to fall as expected below 70c, the AUD/GBP rate could fall even further given that the GBP hasn’t run as hard as the USD in the past year. We could be looking at an AUD/GBP back around 40 pence for the first time since 2006.
GBP Bonds on offer
Strengths and weaknesses of the UK economy compared to the Australian economy
