Exchange rate implications on aspects of the UK economy

Exchange rate implications on aspects of the UK economy Exchange rate implications on aspects of the UK economy Project Finance Private Equity Corporates Social Infrastructure Real Estate Financial Risk Advisors jcragroup.com

Contents Executive summary 1 Introduction 2 Currency depreciation 2 Exchange rate movements over time 2 Effects of exchange rate movements on the UK economy 4 Effect of exchange rate movements on UK tourism and trade 4 Property market focus 5 Summary and conclusions 6

1 Your business plan should be at the core of any hedging decision. Executive summary: Volatility in the FX markets has a habit of focusing the mind as KPIs are missed as a result of unexpected changes in exchange rates. Over the past year or so markets have been driven by the large political events such as Trump s election, the UK referendum and subsequent General Election. This has played out against a backdrop of varying market data which has set the trends in the major currency pairs, particular the resurgence of the euro against both sterling and the dollar. The following report shows how FX movements impact different parts of the UK economy and that the conclusions are not always intuitive. Despite the risks that this report highlights, making an FX hedging decision remains challenging. At JCRA, we believe that in order to make an informed decision you need to understand your exposure, the objectives of a hedging programme and the constraints (in terms of liquidity and credit) that are relevant to your circumstances. Once these points are understood it is possible to apply an analysisled, decision-making process which is clear and auditable. Your business plan should be at the core of any hedging decision, however understanding market drivers and conditions helps bring both a sense of magnitude and likelihood to potential outcomes.

2 Whitepaper The trade deficit continues to stand at close to 12 billion, signalling that the depreciation of sterling has not yet led to a significant uptick in the value of exports. Introduction Currency depreciation The preliminary estimate of UK GDP for the second quarter of 2017 showed a slight uptick in growth to 0.3% quarter-on-quarter, up from 0.2% in the previous quarter. Real GDP expanded by 1.7% on an annual basis, down from 2.0% growth in Q1. The small uptick was almost entirely driven by stronger growth in the services sector. Services expanded by 0.5% on the quarter following particularly weak growth of only 0.2% q-o-q in the first quarter. Production and construction both acted as a drag on growth in the three months to June, contracting by 0.4% and 0.9% respectively. The latest data on industrial production already foreshadowed a weak performance in the production sector for Q2. Industrial output decreased by 1.2% in the three months to May compared to the previous three month period. Meanwhile the trade deficit continues to stand at close to 12 billion, signalling that the depreciation of sterling has not yet led to a significant uptick in the value of exports. The combination of rising inflation and subdued wage growth will result in falling real incomes in 2017 and Cebr believes that consumer spending will slow to 1.7% this year compared to 2.8% in 2016. The latest set of results from the YouGov/ Cebr Consumer Confidence Index supports the slowdown. While the index rose from June s 107.1 to 107.3 in July, the last time the index was below 108 for two consecutive months was in the summer of 2013. Cebr projects house price growth to slow from an annual rate of 7.4% in 2016 to 4.4% this year with demand held back by declining real incomes, high transaction costs and political uncertainty. Buyer interest is on aggregate at very low levels, which in turn makes it less attractive for people to put their houses up for sale. On the monetary policy front, Cebr expects the Bank of England to look past rising inflation 1 and keep the Bank Rate at its current 0.25% level until at least late 2018. This view is supported by Bank of England Governor Mark Carney s recent dovish remarks as well as our expectations of an economic slowdown over the coming two years. Cebr projects inflation on the CPIH measure to peak at 3.0% in the second half of the year, with the annual average at 2.6%. Exchange rate movements over time After the collapse of the Bretton Woods system in the 1970s, many currencies including pound sterling became free-floating 2 and, in 1972, the GBP/USD exchange traded at 2.6400, before the pound depreciated sharply as a result of myriad economic and political woes. In September 1976 the British government was forced to apply for a $3.9 billion loan from the International Monetary Fund (IMF). This quickly stabilised the market, with GBP/USD reaching what was then an alltime low of 1.5700 in October 1976. The currency subsequently regained some strength and the GBP/USD exchange rate held steady above 2.0000 until the middle of 1981. Following international intervention in currency markets to strengthen the US dollar, the GBP/USD exchange rate fell to close to 1.000 in 1985. 3 The US dollar depreciated significantly following the so-called "Plaza Accord" under which the governments of France, West Germany, Japan, the United States of America and the United Kingdom agreed to intervene in currency markets. By 1991 the GBP/USD exchange rate had returned to 1981 levels with a pound buying close to two dollars. 1 In its latest quarterly Inflation Report, the Bank of England raised its inflation forecast for this year from 2.4% to 2.8%. 2 https://www.imf.org/external/about/histend.htm 3 On 26th of February 1985, the GBP/USD exchange rate stood at 1.0400.

3 Generally, a tightening of monetary policy means that a central bank is confident about the economic outlook for a country. Throughout much of the mid- and late-1990s and early-2000s the GBP/USD exchange rate fluctuated between 1.5000 and 1.7000 and the pound appreciated sharply in 2007 before the global financial crisis unsettled markets. More recently, diverging monetary policies across the world s largest economies have added to currency volatility. The US Federal Reserve Bank has already started the process of normalising interest rates and is expected to raise its funds However, markets also react to communication from central bankers and politicians. Following the Government s announcement of a snap election earlier this year, the pound appreciated against the dollar. With early opinion polls pointing to a larger Conservative majority, the pound continued to strengthen and reached 1.3000 as markets reasoned that a larger majority would ultimately lead to a more favourable Brexit deal. However, with the Conservatives Figure 1: GBP/USD exchange rate between 2007 and 2017 USD per GBP 2.1 1.9 1.7 1.5 UK economy enters a two year recession UK votes to leave the EU 1.3 1.1 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Source: Macrobond, Cebr analysis target range again before the end of the year. Contrarily, we expect the Bank of England and the European Central Bank to wait until next year before tightening monetary policy. Following the results of the EU referendum in June 2016, the GBP/USD exchange rate fell from 1.5000 to 1.3700 an almost 9% decline. In the aftermath of the Brexit vote, the pound continued to depreciate against the dollar, with the exchange rate coming under fresh pressure when the US Federal Reserve hiked interest rates in December 2016. By early 2017, the GBP/USD exchange rate scratched the 1.2000 level, highlighting how currency markets react to central bank policy changes. Generally, a tightening of monetary policy means that a central bank is confident about the economic outlook for a country. All other things being equal, this leads to an increase in demand for that currency, thereby raising its price. unexpectedly losing their absolute majority in the snap election on June 8 and comments from credit rating agency Moody s that the outcome heightens uncertainty over Brexit negotiations and increases fiscal risks 4, the pound fell against major currencies. 5 Although sterling has since recovered against a weakening dollar, its tradeweighted index continues to plumb new lows. 4 https://www.moodys.com/ 5 At the time this report was written, the GBP/EUR exchange rate was 1.1100 while the GBP/USD exchange rate was 1.2800.

4 Whitepaper Counterintuitively, a stronger pound may attract foreign investment. Effects of exchange rate movements on the UK economy The following section investigates how exchange rate movements impact different sectors of the UK economy. Generally, a weak pound makes UK goods and services more price competitive on global markets. Hence, one would expect industries such as tourism and export-oriented manufacturing to benefit from a weak pound. This section also highlights how, counterintuitively, a stronger pound may attract foreign investment. Effect of exchange rate movements on tourism and UK trade The effect of exchange rate movements on tourist numbers and spending by overseas residents is analysed by looking at the annual change in spending by overseas tourists and the GBP/EUR exchange rate. Figure 2 shows that spending by overseas residents has trended upwards over the past two years, while the pound has on average depreciated against the euro. 6 While the GBP/ EUR exchange rate stood at 1.4000 in June 2015, it had fallen to 1.0850 by end of August 2017. A weak pound should therefore result in higher traveller numbers and increase tourist spending as it makes goods and services offered in the UK more competitive. In addition to exchange rates, growth in key export markets also plays a crucial role in a country s trade performance. The US was the primary destination for UK exports in 2015 7, accounting for 18.6% of all goods and services sold abroad. Germany, France and the Netherlands are the UK s next biggest foreign markets. 8 The UK s trade performance therefore depends heavily on demand from, and consequently the economic performance of, the US and the Eurozone. The extent to which exchange rates affect trade also depends on the price elasticity of demand for goods and services. Some of the UK s top export goods are high value products such as machinery, cars and aircraft. These goods are typically not very price sensitive and it is likely that demand for these products is more dependent on demand conditions abroad than on exchange rates. Although one would expect a weak pound to boost UK export growth, Figure 3 illustrates that the GBP/USD exchange rate and export growth do not consistently move in the same direction. This is further illustrated by analysing data from the most recent financial crisis. Although the pound depreciated 18% against the dollar between 2008 and 2009, making UK goods and services more competitive on global markets, UK exports declined 8.8% over the same period. The example Figure 2: Spending by overseas tourists and the GBP/EUR exchange rate EUR per GBP Annual change in spending (3mma) 1.0 1.1 1.2 0.2 0.15 0.1 0.05 1.3 1.4 1.5 0-0.05-0.1 M08-15 M02-16 MO8-16 M02-17 MO8-17 Euro Area, EUR per GBP (LHS) Annual change in spending by overseas residents (RHS) Linear (Annual change in spending by overseas residents (RHS)) Source: Macrobond, Cebr analysis 6 European residents accounted for 74% of all overseas tourists visiting the UK in 2016. 7 Latest available data from the Office for National Statistics. 8 2015 data from the Office for National Statistics: Germany accounted for 9.4%, France for 6.4% and the Netherlands for 6.1% of total goods and services exports in 2015.

5 One may expect a weak pound to attract foreign investment as property prices become cheaper for overseas buyers. However, this is not always the case. highlights how weak global demand had a much larger impact on the UK s trade performance than exchange rate factors. Another example highlighting how export growth and exchange rates move in opposite directions was observed more recently. Although the pound depreciated by around 13% between 2015 and 2016, UK export growth in fact slowed from 6.1% to 1.8% over the same period. property holdings, UK indirects (listed property & collective investment schemes) account for just over 30%. The remainder is made up of UK private investors (24%) and UK institutional investors (insurance companies & pension funds, 16%). One may expect a weak pound to attract foreign investment as property prices become cheaper for overseas buyers. However, this is not always the case. Figure 3: GBP/USD Exchange rate and UK exports USD per GBP 1.0 1.2 1.4 1.6 1.8 2.0 2.2 Annual change in UK exports 15% 10% 5% 0% -5% 2.4-10% 1981 1986 1991 1996 2001 2006 2011 2016 USD per GBP (LHS) Source: Macrobond, Cebr analysis Annual change in UK exports (RHS) The bottom line is that although a weak pound makes UK goods and services more competitive globally, other factors such as the price sensitivity of the products and global demand have an even greater impact on trade performance. Property market focus While the previous section presented a brief analysis of how currency movements can impact tourism and trade, the following section explores how they influence foreign investment decisions for commercial and residential property. Data published by the Investment Property Forum highlight a growing appetite for UK commercial property from foreign investors. While the overseas share of UK commercial property investment stood at just 14% in 2003, it accounted for 29% in 2016, amounting to a total of 139 billion that year. 9 While overseas investors account for roughly 30% of UK commercial Comparing annual growth rates of commercial property stock value owned by overseas investors with the annual change in the pound exchange rate 10 over a longer period illustrates that there is in fact a positive correlation, meaning that a stronger pound coincides with rising investment in UK commercial property. 11 Investors may rightfully interpret a stronger pound as a sign of the markets economic and political confidence in the UK. Data for 2016 show that the weakening pound coincided with slower growth in overseas holdings of UK commercial property. While the sterling broad trade-weighted basket weakened around 10%, the amount of stock owned by overseas investors rose just 3%, down from double-digit growth rates in the previous three years. 9 Figures are taken from The Size and Structure of the UK Property Market: End-2016 update, funded and commissioned through the IPF Research Programme 2015 2018. 10 Uses the Bank of England nominal effective sterling exchange rate, code XUQABK67. 11 The correlation between the two series for the period 2004-2015 stands at 0.70.

6 Whitepaper The exchange rate movements impact different parts of the UK economy, in both expected and unexpected ways. Figure 4: Commercial property investment and change in sterling exchange rate Annual change in overseas investor holdings in UK commercial property 25% 15% 5% Annual change in sterling broad trade-weighted basket 10% 5% 0% -5% -15% -25% -5% -10% -15% 2004 2006 2008 2010 2012 2014 2016 Annual change in overseas investor holdings in UK commercial property (LHS) Sterling broad trade-weighted basket (RHS) Sources: Investment Property Forum, Macrobond, Cebr analysis Although the number of investors buying UK nonresidential property rose 6% between 2015/16 and 2016/17 12, the future of UK commercial property investment is at risk, with an expected economic slowdown 13, political uncertainty and ongoing Brexit negotiations likely to deter investors. Recent research from Lipper shows that while UK commercial property funds have returned 18.7% over three years, the return over the past year was only 2.4%, thereby suggesting that investors will start seeking different investment opportunities, especially if the return on investment falls further. 14 Summary and conclusions Our research has shown how exchange rate movements impact different parts of the UK economy, in both expected and unexpected ways. The annual change in spending by overseas tourists increased over the past two years while the pound sterling depreciated. Therefore, we can conclude that, as one would expect, a weak pound boosts tourism spending. become more competitive on global markets, our research shows that this is not always the case. This sometimes inverse relationship can be explained by the fact that there are other important factors determining export demand, such as the global economic environment and the price sensitivity of goods and services offered. The final part of the analysis highlights that there is a positive correlation between foreign property investment and the strength of the pound. A strong pound can be seen as an indication of a stable economic and political environment, thereby attracting foreign investment. Likewise, increased foreign investment leads to a strengthening pound due to rising demand for the currency. Although foreign investment in UK commercial property has been strong in recent years, Cebr expects overseas investors appetite for UK commercial property to weaken in the coming period due to political uncertainty, an uncertain outcome of Brexit negotiations and the already observed slowdown in UK economic growth. The relationship between exchange rate movements and trade, however, is less intuitive. While UK exports should in theory rise when the pound depreciates as UK goods and services 12 Data from HMRC show that the number of non-residential property transaction completions with value of 40,000 or above rose from 119,370 in 2015/16 to 126,910 in 2016/17. 13 Cebr projects GDP growth to slow from 1.8% in 2016 to 1.5% in 2017. 14 https://www.ft.com/content/4c53b54a-5c0c-11e7-b553-e2df1b0c3220

7 About JCRA JCRA are independent financial risk advisors, specialising in hedging and debt advice that is strategically aligned to what you and your business want to achieve. We have over 25 years experience structuring and advocating for competitive pricing in derivative products. We formulate and execute interest rate, foreign exchange, inflation and commodity hedging strategies and provide debt advice to real estate, project finance and infrastructure, private equity, social infrastructure and corporate clients across the globe. Helping businesses and organisations stay one step ahead. jcragroup.com For more information, or to discuss this whitepaper, please contact: About Cebr Centre for Economics and Business research (Cebr) is an independent consultancy with a reputation for sound business advice based on thorough and insightful research. Since 1992, Cebr has been at the forefront of business and public interest research. They provide analysis, forecasts and strategic advice to major UK and multinational companies, financial institutions, government departments and agencies and trade bodies. For further information about Cebr please visit www.cebr.com Benoit de Benaze, Director T: +44 (0)207 493 3310 E: Benoit.deBenaze@jcrauk.com James Stretton, Director T: +44 (0)207 493 3310 E: James.Stretton@jcrauk.com Jonathan Lye, Director T: +44 (0)207 493 3310 E: Jonathan.Lye@jcrauk.com Disclaimer J.C. Rathbone Associates Limited is authorised and regulated by the Financial Conduct Authority (FCA) in the United Kingdom under reference number 145229. This document is intended for persons who would come within the FCA s definition of professional clients and eligible counterparties only and should not be relied upon or distributed to persons who would come within the FCA s definition of retail clients. No other person should rely upon the information contained within it. This document has been issued by J.C. Rathbone Associates Limited for information purposes only and does not constitute investment advice and is not to be construed as a solicitation or an offer to purchase or sell investments or related any financial instruments. This document has no regard for the specific investment objectives, financial situation or needs of any specific person or entity. The information contained herein is based on materials and sources that we believe to be reliable, however, J.C. Rathbone Associates Limited makes no representation or warranty, either express or implied, in relation to the accuracy, completeness or reliability of the information contained herein. The information in this document is not suitable for use in any jurisdiction where such activity or its distribution is prohibited. Any persons resident outside the United Kingdom must satisfy themselves that they are not subject to any local requirements which prohibit or restrict them from doing so. In particular, the information herein does not constitute a solicitation in the United States of America to or for the benefit of any US Person as such term is defined under the United States Securities Act of 1933, as amended. The above data and graphs are provided for illustrative purposes only and are not to be reproduced in any form without the express consent of J.C. Rathbone Associates Limited. Data has been smoothed in their preparation and have been based upon prevailing market rates as at the date given. 2017 jcragroup.com