The Bank of England has made it clear that it expects not just a technical recession (two successive quarters of negative growth) but a deep and prolonged contraction in output. The prospect of a series of interest rate cuts for the UK economy, along with the expectation that the next cut may be as early as November, sent the pound to a five-year low against the dollar. The speed of the decline is serious and has left the plans of many businesses in tatters; the cost of importing from the US has increased by 20 per cent in three months due to currency movements alone.
Larger companies with well-developed treasury functions may have reduced their exposure to the weakening pound by hedging at more favourable levels, but the effect of sterling’s decline on small and medium-sized importers – who often don’t hedge against these risks – is likely to be more severe.
The point is that Mervyn King’s acknowledgement of the recession will have come as no surprise to many companies who have been feeling the effects of the slowdown for months.
For companies with liabilities in US dollars or euros, 2008 has been a challenging year to say the least. Three months ago, you could get more than two dollars for your pound. At the time of writing, the pound will fetch you just $1.56 – which is a 22 per cent decline in value. Companies dealing in the Eurozone this summer also witnessed the pound slumping to its lowest level against the euro since the inception of the single European currency. The seriousness of the decline in the pound in such a short space of time has not been seen since 1992 when the UK came out of the ERM (Exchange Rate Mechanism).
The demise of the pound can be likened to the snapping of an elastic band. After years of stretching the economy, fuelled by the availability of cheap credit, reckless lending and the unwillingness to accept that this situation could not last.
For companies exporting to the US or eurozone, the declining pound will initially ease the pressure on margins and allow for competitive pricing – but those economies are not immune to the global slowdown. We are starting to see the impact on their respective economies through declining productivity.
For the UK economy, the next 12 months will see a significant reduction in interest rates down to around three per cent and inflation coming back to around two per cent.
So, a final note of advice: be prudent and don’t take unnecessary risks.