That was before it became apparent that the fall in the exchange rate (which has been very large, historically speaking) had had a significant effect upon economic activity (recall that the UK was the first country to see a rebound in the data at the beginning of the year). But the persistent dovishness of the Bank of England (led by the exceptionally incompetent Mervyn King) has taken the shine off things and sentiment has once again shifted to the view that the UK is "finished" and that the Pound will become the new funding currency for the Carry Trade as the Bank of England wants to talk it down. Aside from the fact that the BoE's behaviour is dangerous (it was the BoE selling GBP on the sly in the mid-70s that led to a buyers' strike in the Gilt market), it is inconsistent with its mandate as an inflation-targetting central bank. Specifically, if the strength of the PMI data (which I will discuss below) is confirmed, with inflation remaining stubborn, the BoE will be hiking very quickly.
It is well-known that, thus far, strength in the survey data - such as PMIs - has not been replicated in the hard data (such as IP & GDP). But this is not unusual: there are usually lags of several months as survey optimism based upon orders transmits into actual production. The below chart clearly shows that in both the UK & Eurozone this lag has been 4-7months, and the exceptional strength of the UK Services PMI is remarkable - it is the highest of the developed markets, and sits a full 5pts higher than that of the Eurozone, the next-strongest. It is also well-known in economics circles that the constructioin of the UK official data series is extremely poor - unfortunately, years of low pay at the ONS has resulted in Retail Sales statistics that only cover 20% of consumption (no, I'm not joking!) and GDP statistics that are unrecognisable from the PMI survey until final revisions a long time after. The BoE shares this view, having done much research on the retail sales numbers (that have been inconsistent with their own surveys) and have published research suggesting that the PMIs are a reliable forecast of post-revision GDP. In summary, the PMI data is likely to be correct, not the official data. The BoE are behaving as if they do not believe their own research, but I think this has more to do with their inflation mandate of keeping expectations close to their 2% target.
Next, as with the US, the UK's fiscal position is looking very precarious. But that is nothing new - in fact it has improved significantly as asset prices have rebounded, reducing the probability that the Asset Protection Scheme (APS) will be tapped by any of the participating banks. Moreover, the recovery in financial markets has been accompanied by a V-shaped recovery in banker-pay, and thus, tax revenues. Nevertheless, the deficit is still a significant obstacle to sustained growth, and a fiscal consolidation is now assured, regardless of which government wins the next election. But that does not mean that the UK is heading for a "depression" as Danny Blanchflower publicly declared - in Q4 1976 (shortly after the UK was bailed out by the IMF and forced into a deep fiscal contraction), GDP grew at an annualised rate of 8.4%. The exchange rate matters, as does the question-mark over sustainability being removed - evidence gathered around the time suggested that many consumers had built held back on purchases as a result of the public worry about the deficit. With this resolved, pent-up demand kick-started the recovery. Speaking of consumer demand, anyone walking down Oxford Street will note the following: "never underestimate the stupidity of the UK consumer".A closer look at sentiment indicates that the market is not just bearish, but positioned as such as well. Indeed, IMM speculative positioning shows a 2.7 standard deviation position relative to neutral - and the LARGEST net short in history. The valuation is not helpful for the bears either - GBP sits undervalued by 13% with respect to the EUR and 17% to the USD.
But what I really wanted to talk about is something that people appear to have completely forgotton about the UK, that was one of the reasons why thing kept getting worse as markets fell. That is, of course, the composition of the national balance sheet. The UK is unusual in that it's Net Foreign Asset (NFA) position can be basically described as "long global equities vs short domestic debt" - i.e. it's assets are "risky" and generally denominated in foreign currency, and its liabilities are bond-like and generally denominated in local currency. This composition acted as a feedback loop that made bank balance sheets even weaker as asset prices fell. But now that they are rising, it is having the opposite effect. In fact, the below chart (which has a simple model of the UK's NFA) suggests that with the currency at current levels, a further 10% outperformance of equities with respect to bonds would result in the UK becoming a NET CREDITOR. This is an extremely significant result - recall that the change in NFA equals the Current Account. In such a scenario, it is rather hard to justify being short the Pound.
