Is the British Pound the Next Shoe to Drop?

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Though the Fool has extensively covered the euro crisis, few people have mentioned that Great Britain may be in even deeper trouble. The British economy grew at only 0.3% annualized rate in the last quarter of 2009, while the U.S. economy grew at a much faster 5.6%.

Britain is expected to have a budget deficit of 12.6% of GDP for this year -- pretty much the same level that has made Greece a headline issue, and caused international investors to stay away from its bonds. In comparison, the U.S. budget deficit is expected to be around 10%. Such elevated deficit-spending levels have spurred Moody's to declare that the AAA-ratings of both the U.S. and Great Britain are in danger.

Everyone is printing
On top of this horrific deficit spending, the U.K. central bank is printing in overdrive, which is bearish for the British pound, given the weaker economic performance and higher deficit spending. However, this is all super-bullish for gold bullion -- if and when it decouples completely from the dollar. In the past, gold bullion used to trade almost inversely to the dollar -- a strong dollar meant weak gold, and vice versa. But there are signs that this is beginning to change, as many fiat currencies get printed at an accelerating rate. Because of the issues with the euro and the pound, the dollar has stayed firm -- but so has gold.

Gold has reached all-time highs not only in euro terms, but also against British pounds. It's clear that investors on the old continent have lost much of their faith in their own financial systems, and are reaching for hard assets. This is why corrections in gold bullion should be viewed as buying opportunities, and declines of the Midas metal below $1,000 become increasingly unlikely.

Just like gold bullion, you can trade currencies like ETFs on the NYSE. The ETF that represents the British currency is the Currency Shares British Pound Sterling Trust (NYSE: FXB  ) , while the one that represents the euro is the Currency Shares Euro Trust (NYSE: FXE  ) . You can even trade the broad US Dollar Index via the Powershares US Dollar Index DB Bullish Fund (NYSE: UUP  ) . People love to hate the dollar, but it has been going up, if only because the other alternatives listed above are actually in worse shape.

How far could the pound decline? 
Unlike the euro, which had a purchasing power parity of about $1.25 (and is trading above that level), the pound has a purchasing power parity of $1.58, and it's trading below that level. But with budget deficit levels double that of the Eurozone, and a total debt levels of 466% of GDP (60% higher than that of Germany, and about 50% than that of the U.S.), the pound deserves to be cheap. What's more, if public finances do not improve soon -- and I see no way how that may happen -- the pound can get much cheaper. Currencies have been known to deviate far away from their purchasing power parity, like the Euro's move to US$0.82 in 2001. A similar decline could send the pound to parity with the dollar.

How to profit
In such an environment of British pound weakness, one should stay away from British stocks whose U.S. ADR share prices reflect the currency's weakness, and instead focus on comparable stocks that don't have currency translation issues. For example, you can see the recent pound weakness in the share prices of HSBC (NYSE: HBC  ) and compare it to strong JPMorgan Chase (NYSE: JPM  ) , which is trading close to a 52-week high.

Even though I don't think that inflation will be a problem in 2010, it may turn out to be a huge problem in 2011 or 2012. Any further dollar rally and/or pound weakness may give you an opportunity to purchase quality shares domiciled in the U.K., like BHP Billiton (NYSE: BHP  ) and British Petroleum (NYSE: BP  ) , which in turn will give you the pound-related currency discount. BP yields 5.9% and trades at only seven times forward earnings. The lower the pound goes, the better deal you will get on BP shares. Currencies devalued by their governments' decision to print more of them can only be bullish for oil prices, especially as the global economy recovers.

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Fool contributor Ivan Martchev does not own shares in any of the companies in this story. Try any of our Foolish newsletters today, free for 30 days. The Fool has a disclosure policy.

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 06, 2010, at 8:56 PM, minnjim1 wrote:

    You mention that BHP is "domiciled in the UK." Actually, its headquarters are not in the UK but in Australia. It operates in Australia, the Americas, and southern Africa. Do you expect that the Australian Dollar will weaken along with the British Pound, even though the AU$ floats independently of the Pound?

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