Why sterling might recover - Investors Chronicle

It's easy for an economist to look stupid - he only has to make a forecast. In this spirit, then, here's a prediction - sterling will recover against the euro in the next 12 months.

There are four reasons for this.

First, despite recent lectures on fiscal policy from the Germans, the euro zone economy is in a horrible mess. Latest figures from Germany show that manufacturers' sales fell by 4.2 per cent in November alone, with sales to euro area economies dropping 6.3 per cent to stand 12 per cent below last November's levels. And, in France, industrial production has slumped 7.4 per cent in the last two months alone (that's not annualised, just the raw drop). What has a benefit to the euro zone in the upswing - a larger manufacturing sector more exposed to world trade - has become a curve in the downturn.

Insofar as the pound's weakness reflects a view that the UK economy is the sick man of Europe, it is therefore unjustified.

Secondly, any recovery in global stock markets this year would probably benefit the pound. There's been a close correlation for years (0.45 since January 1991) between annual changes in the €/£ rate and in the All-Share index; when global share prices rise, so does sterling.

So, if investors sense this year that an economic recovery is coming - even if it doesn't actually materialise until 2010 - or if they rediscover their appetite for risk, sterling should rise.

Such a prospect might seem remote now. But remember, 12 months is a long time in financial markets.

It's in this context that the UK's current account deficit matters. When investors are nervous, they traditionally avoid currencies whose countries are running deficits. And when they recover their nerves, such currencies often bounce back. In itself, the UK's deficit is no reason to expect the pound to stay low. After all, we've had it for years, even when sterling was strong.

Thirdly, there's some evidence that the €/£ rate mean reverts. Since January 1990, there's been a significant negative correlation (minus 0.37) between the level of the €/£ rate and subsequent annual changes in it. A strong pound leads to a falling pound, and a weak pound to a rising one.

In other words, foreign exchange markets can be just like stock markets - they over-react, causing prices to rise or fall too much. The very fact that the pound is weak, therefore, might be telling us that it is too weak.

Fourthly, sterling is under-valued. Our chart shows one measure of this, based upon relative productivity in the UK and the euro zone. This measure has some predictive value; in the past, when sterling's been below it, it has risen in the following 12 months. It is now more under-valued than at any time since at least 1990.

We shouldn't make too much of this particular measure. But thinking in vaguer (and, therefore, truer) terms brings us to the same conclusion. It's hard to see a shock to UK inflation, output or productivity in recent months that the euro zone hasn't similarly experienced. So it's hard to see how any measure of sterling's 'fair value' should have collapsed, which, in turn, suggests that the currency is under-valued.

Now of course, exchange rate forecasting is a mug's game, and economists shouldn't set themselves up as futurologists. The message I'd take from this is that it's easy to tell plausible-ish stories about the future. The trouble is, there's an almighty gap between plausible and true.