UK’s Financial Sector Smack-Dab in the Crosshairs, and So Is the Pound

I think it’s fair to say the UK benefited most from the cross-border financial services boom measured from 2000-2007, which abruptly ended thanks to the credit crunch. And on the flipside, the UK will be the developed-world country that is hit the hardest as private market deleveraging intensifies and the cross-border global financial services industry declines.

And if I am right, it will be bad news for the UK economy, and its currency … the pound.

During the heydays of credit growth earlier in this decade, the financial services’ contribution to the UK economy was quite large. It’s easy to see why …

The explosion of sophisticated derivatives, spawned during the era of free credit, was perfectly suited to the highly educated and skilled workforce in London. The credit crunch that followed was a sea change secular event in the global economy.

Now the UK Is
Directly in the Crosshairs!

Two major reasons:

First, on a household debt-to-gross annual-disposable income measure, the UK consumer ranks among the world’s highest. Interestingly, consumers in the UK have only just begun to pay down their debt. And they have a long way to go, according to consulting firm McKinsey and Co.

Below is what McKinsey dubs its “Global Deleveraging Scorecard.” As you can see, the UK consumer is highly indebted and has made little progress in paying it off over the past three years. In fact, their debt ratio is down just 6 percent from its peak, whereas the U.S. ratio has fallen 11 percent.

Note: You may also notice the Spanish consumer has also made little progress along this path, which doesn’t bode well for the future of the euro.

And second, the Bank for International Settlements (BIS) — considered the central bank for central bankers — expects the global financial sector to decline in the years to come. This is bad news for all global financial centers. But it’s particularly bad news for London, which is still highly leveraged to global financial services.

Stephen Cecchetti, Economic Adviser at the BIS believes the global financial sector has a dark side, is too big, and will shrink in the years to come. Speaking at the 11th BIS Annual Conference in Lucerne, Switzerland, 21-22 June 2012, he said:

“For most people, the term globalisation means cross-border trade in real goods and services; something that we would all agree has brought the greatest benefits to a large number of people. Trade very clearly supports middle-class living standards, among other things putting literally tens of thousands of different products on the shelves of even a modest-sized supermarket.

“But this real side of globalisation relies on financial intermediaries to fund the trading of all this stuff across borders. And the recent crisis showed how problems both on and off the intermediaries’ balance sheets can have very large, very real and very bad implications. Many of us have started to ask if finance has a dark side.

” … It sure sounds like finance is great. But experience shows that a growing financial system is great for a while — until it isn’t. Look at how, by encouraging borrowing, the financial system encourages an excessive amount of residential construction in some locations. The results, empty three-car garages in the desert, do not suggest a more efficient use of capital!

“Financial development can create fragility. When credit extension goes into reverse, or even just stops, it can induce economic instability and crises. Bankruptcies, credit crunches, bank failures and depressed spending are now the all-too familiar landmarks of the bust that follows a credit-induced boom.

“Instead of supplying the oxygen that the real economy needs for healthy growth, it [the financial sector] sucks the air out of the system and starts to slowly suffocate it. Households and firms end up with too much debt. And valuable resources are wasted. We need to do something about this.”

Financial Services Sector
Set to Shrink

The new global regulatory regime for financial services is still evolving and is in a state of flux. But it is a good bet that at the end of the day the financial services industry will be much smaller than it was during the heyday of free credit that spawned the credit crunch. That’s not good news for any major financial center but particularly bad for the UK which drew an inordinate amount of its wealth from this sector.

Thus, on a relative basis, I believe the UK economy will continue to underperform the U.S. And the Bank of England will be forced to maintain its easy money policy even longer than our Fed. This should put the British pound in the cross-hairs against the U.S. dollar.

My weekly wave chart of the GBP-USD pair suggests the long-term trend for the pound is clearly down.

The longer-term view of this pair may appear a bit extreme. But if the UK is facing the double-whammy of private deleveraging and falling employment from one of its key sectors, a move back toward 1.35 into 2013 is indeed probable.

Best wishes,

Jack

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