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Sterling shunned

• Robert Peston
• 24 Oct 08, 05:04 PM

I've been desperately scrambling around for something positive to say today - and the best I can come up with is that the remarkable fall we've seen in the value of sterling today (again) shouldn't make the Bank of England so anxious about importing inflation that it postpones the widely anticipated further cuts in interest rates.

The Scarborough Evening News is responsible for this insight (if such it proves to be), because it contains some striking remarks by the Deputy Governor of the Bank of England, Charlie Bean:

"This is a once-in-a-lifetime crisis and possibly the largest financial crisis of its kind in human history" said Bean. "In terms of the impact on the real economy we are still in early days."

Those do not seem to me to be the views of an economist whose main anxiety is the outlook for inflation. They're the words of a central banker worried about the possibility of a deep dark slump.

If the Bank of England doesn't cut a further 陆% off the policy rate - either at its next meeting or in another round of global cuts in co-ordination with other central banks - I'll be somewhat surprised.

Also, some of sterling's weakness can be seen as the corollary of dollar strength, rather than a wholesale decision by international investors to shun sterling assets.

The dollar and the yen have both risen today as the last vestiges of the years of the carry trade - in which investors borrowed cheaply in yen and dollars to invest in emerging economies - is unwound.

Hedge funds and other institutional investors are liquidating any assets they perceive as even mildly risky, especially in eastern Europe, Russia and South America (see my note on this yesterday, "Now there are runs on countries").

And such liquidation inevitably leads to purchases of the US and Japanese currencies.

But just because part of sterling's weakness reflects a flight to the safety of the dollar and yen, there's no real comfort there for us.

Sterling today hit a record low against the euro and is at a 12-year low on a trade-weighted basis.

Why don't international investors love our currency any more?

You know where the smell is coming from:

1) our huge and tumbling housing and property markets;

2) a banking sector massively dependent on flighty wholesale funding from overseas;

3) a fast-growing budget deficit that has to be funded by massive sales of sterling government bonds, at a time when central banks, sovereign wealth funds and institutional investors are suffering a squeeze on cash available for such investment (Michael Saunders of Citigroup estimates that the Treasury will have to flog around 拢100bn net of gilts every year for the next three years - which, as a percentage of GDP, takes us back to the horrible deficit years of the early 1990s);

4) oh yes, and we appear to be in recession.

Now the capital flight out of the UK is mild compared with the currency crisis hitting Eastern Europe and Russia, which may well be translated into severe economic difficulties.

But all that means is that we shouldn't expect vast numbers of the recent 茅migr茅s from those countries to return home when the job market tightens here.

If Poles have a choice between being unemployed here or in their homeland, it's not obvious they'll all decide to repatriate.

But while we are on the subject of the vulnerability of Eastern European, Russian and South American economies, here's something positive to say about our banks: their loans to these regions are limited.

If there are big loans losses to be suffered by banks exposed to emerging economies, disproportionate pain will be suffered by continental banks.

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Pricking the profits bubble

• Robert Peston
• 24 Oct 08, 10:18 AM

The noted British investor, Anthony Bolton, recently announced that he had started buying shares again, on the basis that we probably weren't too far from the bottom of the market.

Part of his logic was that the average ratio of share prices to corporate earnings - what's known as the Price-Earnings Multiple - never reached particularly high and stretched levels in the bull market that immediately preceded the .

Unlike the late 1990s, when those price-earnings multiples went into the stratosphere because of mad expectations of the future profits to be generated by dotcom and tech businesses, the rise in stock markets from 2002 to 2007 was driven primarily by sharp rises in corporate profits, rather than a massive and unsustainable rise in investors' optimism about prospective growth rates for those profits.

On Bolton's logic, stock markets ought not to fall too much from where we are now, because average price-earnings multiples shouldn't need to be squeezed too much as an adjustment to the more challenging economic circumstances that companies (and all of us) face.

That's the logic.

But it only works if the earnings bit of the Price Earnings Ratios doesn't collapse.

And that's been worrying me for some time.

Because arguably the debt binge - the credit bubble that was pricked in August 2007 - was artificially inflating the sales, profits and per-share earnings of companies.

How so?

Well consumers and businesses famously bought and invested on credit that seemed cheap.

And companies also reconstructed their balance sheets to take on more debt, again because debt seemed much cheaper than equity, so by borrowing more in this way - what's known as gearing up - there was an automatic enhancement of earnings per share.

To recap, in the upturn the boom in corporate sales, profits and earnings per share were all magnified by the borrowing binge.

So here's why there may be no comfort to be had from the apparent reasonableness of bull-market corporate valuations, the relative narrowness of price-earnings multiples.

The earnings bit of that ratio may have been significantly and unsustainably inflated by the borrowing binge: the debt bubble may have precipitated an earnings bubble.

Now, as you all know, banks and other creditors want their money back, in a vicious process known as "deleveraging".

Companies that borrowed a great deal are now ruing the day - because the cost of their credit, if they're perceived to be vulnerable to the economic downturn, has soared.

And few consumers or business want to borrow to spend any more.

Profits are now being mullered in the vice of high and rising interest costs and falling sales.

In just the past few hours - as we've had official confirmation that the British economy contracted by a bigger-than-expected 0.5% in the three months to 30 September - we've had profits warning after profits warning from huge manufacturers coping with horrible trading conditions.

At the world's second largest motor manufacturer, Toyota, there's been a drop in quarterly sales for the first time in seven years.

Sony has cut its earnings forecast.

The number two car maker in Europe, Peugeot, has reduced its targets for full-years sales and profits. And Volvo AB reduced its forecast for growth in the heavy truck industry this year.

What we're experiencing is a global economic downturn caused by a massive contraction of the availability of credit.

It may shortly be confirmed as a global recession, and - because it's global and because it's origins are in the withdrawal of credit - it's unlike anything we've experienced since the 1930s.

Unlike the 1930s, our governments have both the tools and the knowledge to stave off depression, so it's fair to assume we're in for years of poor economic performance but not serious impoverishment.

That said, I'm not sure many quoted companies can be confident they know quite how far their profits will fall before the inevitable bounce.

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