Every silver lining brings more clouds for UK

26 February, 2010

The news today that the economy expanded faster that previously thought in the final quarter of last year will surely be welcome news to people living in the real economy. GDP grew at 0.3%, rather than 0.1%, according to updated official figures from the Office of National Statistics (the consensus was for a revision to 0.2%).

The increase in economic activity means that equities and bonds are worth more as companies are in a better position to pay back their debts: in short, investing in the UK economy and markets has just become more attractive.

However, before we pop the champagne corks, we should note that moves in the financial markets since the announcement hardly give a ringing endorsement of ‘the recovery’. Perhaps the biggest concern was that sterling has continued its relentless slide against the major world currencies.

Over the past few months, the relationship between the dollar and the euro has become a proxy for the level of risk aversion in the world's economy. When fear spreads through the market, investors rush to the safe haven of the US dollar. Sterling is also considered to be a risky currency, even more so than the euro, in comparison with the almighty dollar.

This morning, the major bourses across Europe rose between half and one per cent, including the FTSE 100. The rises came on the back of overnight gains in Asia and commodity markets, the bellwether for increasing global confidence. This suggests that the markets consider the global outlook is improving and investors are becoming more relaxed about risk; it means that the euro and the pound should rise against the dollar.

The euro has indeed gained 0.19%. However, the pound, despite an additional fillip from the GDP data, managed to lose 0.62% against the dollar. The markets are not happy with the UK and are singling it out for sceptical treatment.

The loss in sterling today continues a very worrying trend. It has been declining against the dollar since last November, falling from $1.68 to $1.52.

There are widespread concerns over the scale of the UK’s budget deficit, and many fear it is heading into a situation where it cannot afford to repay its debts. Indeed, much the same reason that concerns about the fiscal position of the PIGS – Portugal, Italy, Greece and Spain – have been driving down the value of the euro.

So why is it that sterling fell when the GDP revision suggested that the UK was in a better position that previously thought? It is tempting to think that the reason lies in the upcoming election. Positive news on growth mean that the incumbent Labour Party will get a useful boost ahead of the poll, currently pencilled in for 6 May. If Labour is returned, that means greater levels of public spending and, inevitably, borrowing.

If this analysis is right, the markets are suggesting that positive economic news is outweighed by the negative future effect of a Labour win on the economy. It also means that, whichever party wins, we are approaching the point where the boon of additional government spending is more than offset by the drag of increasing the national debt.