The pound is in trouble - here's what you should do

In November and December last year it was all but impossible to turn to the feature pages of the papers without reading about the joys of shopping in America.

Journalist after journalist picked up free flights to spend a few nights in New York, returning to write about the strength of sterling, and how far your pound would go.

But the bit about sterling's strength isn't all that true. Even as our currency was rising against the dollar it was falling against pretty much every other currency.

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Against a basket of major currencies, the pound actually fell more than 6% in 2007 (with almost all of that decline happening since August) and it is now trading close to its lowest level against the euro since the European currency was introduced back in 1999. Worse, it is now even back down below $2 against the much-derided dollar.

UK economy is in a pickle

So what's going on? The sad truth is that, as much as any one thing can, the price of a currency reflects the state of the economy of the country it represents. And the UK economy, just like the US economy, is in a pickle.

The commercial property market is in mid-collapse with prices down 9% last year and deals falling apart all over the place, and the residential-property market is close to finding itself in a similar condition according to estate agent Savills, even prime London prices fell 2% in the last three months of 2007.

Our retailers are already feeling the resulting pain of a consumer slowdown (note the warning from Dixons owner DSG International on Thursday pointing out sales were down 10%).

Repossessions are rising, we are mired in record levels of personal debt and more than 140,000 people are forecast to go bankrupt this year. There are also signs that the manufacturing sector is fading. And, finally, our public finances are a complete mess: Gordon Brown is running a budget deficit of well over 3% of GDP (having had a perfectly good surplus at the end of the 1990s).

This is a big deal. It means that even as the economy slows Brown won't be able to up public spending to bail us out. Instead, handicapped by the biggest budget deficit in western Europe and the fact that the fading fortunes of the City will mean falling tax revenues, he's going to be looking to spend less rather than more.

Why interest rates are likely to fall

All this means that interest rates are likely to fall over the next few months as the authorities work to stop slowing growth turning into recession. I've said before that the Bank of England's job is not to worry about housing bubbles nor to fuss about stock markets and the economy as a whole but to keep inflation low.

However, governments and central banks tend not to have cores of steel in times of crisis: I suspect inflation worries will soon be trumped by falling house prices and slowing growth, and rates will be cut sharply as a result.

As rates fall so will sterling, given that it cuts the yields available on investments made in Britain why hold pounds paying you 4.5% interest when you can get 6.75% in Australia?

The outlook for the pound looks all the worse given our current-account deficit (we are importing goods and services worth more than those we are exporting and in effect having to borrow money from other nations to pay the difference).

Latest figures for the third quarter showed that the deficit amounted to 5.7% of GDP, the highest since records began, and as deep in the red as America in percentage terms This is not a sustainable situation in the long term and is one that is usually resolved by a currency falling in price. This makes imports more expensive so we buy less of them and exports cheaper so other people buy more of them and so evens things out.

This shift doesn't always happen immediately but it always happens in the end as it is now in the US, where the sinking dollar has cut the size of the current-account deficit.

Add it all up and it looks like the one thing we can be pretty sure of at the beginning of a very uncertain year is that the pound is in trouble. The only question left is what can investors do about it?

What to buy now

Last year I suggested a few things that would work. You could buy European shares via an income fund with a view to getting the uplift from the euro and the fact that good dividend payers tend to perform better than other stocks in volatile times (Argonaut's European Equity Income fund is the one to look at).

You should also make sure you have some gold. The price has just hit a new high, but as the world's default currency, it does best when things are bad which they are.

Another option and I think a very good one at the moment is to look at multi-currency funds. There aren't many of these about (though there are bound to be more launches as the year unfolds) but one to consider might be the Investec Managed Currency fund, which holds everything from US dollars to euros, yen and Swedish krona. The fund has a nasty initial charge of 5% but if you can get a discount on that, I doubt buying it will turn out to be a worse option than continuing to hold all your cash in pounds and nothing else.

First published in The Sunday Times 6/1/07