“I don’t like sterling. I’d even sell sterling against sterling!” — David Bloom, HSBC’s chief currency strategist speaking to CNBC on June 16th 2008. Poor old Britain, literally.

Dragged down by the service sector, the fading heartbeat of UK PLC, our national growth slowed to a miserly 0.3% for the first three months of the year. Don’t hold your breath for a turnaround as forecasts for the rest of the year have raised the odds of recession.

And, it’s not just growth. Inflation, pushed by food and oil prices — two things that the government can do little to counter — is also on the up. It presents a very grim reality…

The UK is in stagflation, a rare disorder where people are no richer but prices rise anyway. On the foreign exchange markets things are no better, with the pound carving out a role as “the whipping boy of international currency markets,” as John Authers neatly puts it.

“But the pound is strong against the US dollar.”

Get over it!

Barring Zimbabwean dollars, you’d be hard pressed to find a currency that wasn’t strong against the US. On a trade-weighted basis, the pound is deteriorating. This is a very problematic situation for consumers and for the economy, but it is not universally bad news.

In fact, some well placed investments — away from the risky foreign exchange market — will actually help you take advantage of sterling’s slide.

To understand this, think about multinational businesses.

Exchange rate risk is a problem for these firms. Fluctuations in exchange rates can wildly affect costs. If the value of the base currency goes down, all associated costs go up… the cost of foreign purchases rise and cost of foreign wages rise.

However, this is only one side of the coin.

Many companies actually profit from their foreign currency exposure, and with the help of a forthcoming special report from the Fleet Street Letter’s investment team, it’s a trend we can safely play from the UK markets…

Successful breeds success

Investing in firms that profit abroad provides crucial diversification to a portfolio. The argument was laid out in Friday’s research note:

“These companies have managed to actually grow their profit margins at a time when the UK, the country they are listed in, dwindled. That is because they boast significant operations with increasing customer bases in these [foreign markets].”

But wait, there’s more!

Not only does a savvy investor get the benefit of a ravenous foreign customer base but they get the knock-on effect of investing in a country with a strengthening currency.

Selling a constant amount of products to Brazil creates more and more money if the Brazilian real strengthens or the pound weakens. As Brazilian profits are eventually converted back to the base currency, the firm can lock in a profit that has nothing to do with an increase in sales.

And this is exactly what happened to British American Tobacco (LON: BATS) last month.

The cigarette giant is active in 180 markets and over the past 12 months, most of these markets’ currencies gained against the pound. As a result “currency swings” added £54m to operating profit… more than a third of overall profit growth!

Burberry (LON: BRBY), Inchcape (LON: INCH) and Standard Chartered (LON: STAN) are other such examples of UK stocks that have made sterling’s slide work for them… but looking long-term, which regions are going to continue to gain against the pound.

As with so many other investment questions, the answer is emerging markets.

Emerging market currencies lead the way

Currencies are priced in pairs. In order for the pound to fall against a foreign currency one of following has to happen.

1. Trader sentiment towards the UK worsens and traders sell pounds.
2. Trader sentiment towards the foreign country improves and traders buy foreign currency.
3. Both 1 and 2 happen.

We are seeing the third case here with sentiment toward the UK falling and towards emerging markets improving. But how can that be so when you look at inflation, a major determinant of exchange rates?

Inflation in emerging markets is even higher than in the UK… 7.1% versus 4% according to the OECD. So why is the pound flagging? Well, there’s more to currencies than just inflation.

Emerging markets top the global growth and global surplus rankings. To take China as a case in point, China boasts the world’s largest trade surplus, the government budget is in the black and GDP growth estimates for the year average around 9.6%.

By way of comparison, the UK is deep in the red, on the verge of recession and money is leaving the country faster than it ever came in.

This demonstrates that a bet against sterling is a good idea in most directions, just don’t look at America, they’re even worse than we are.

Theo Casey

Source: Sterling’s Demise Good News for Blue Chips