Sterling's slide to help decide the winners and losers

Early October’s split-second plummet in the pound to $1.18, its lowest level against the dollar since 1985, further raises the importance of currency movements to advisers and clients with exposure to the UK equity and bond markets, as even a rebound to $1.24 leaves the British currency some 17% below where it was before the EU referendum.

On a big-picture basis, this leaves advisers and clients with three issues to address, if they think the pound will continue to weaken (and the Bank of England is showing no inclination at all to defend it, via the traditional method of interest rate hikes):

  • First, they need to think about foreign fields rather than home comforts. This may seem counter-intuitive as the FTSE 100 barrels toward a new closing all-time high above 7,104 but if the pound drops it increases the value of assets held in overseas currencies, assuming their price stays the same.
  • Second, they need to take a look at their fixed-income exposure. Five-year forward inflation expectations have surged beyond 3.0% in the UK and the 10-year Gilt yield is still only 1.04%, even after a huge sell-off from lows near 0.50% in August. If inflation expectations keep rising then bond prices could keep falling, impacting the performance of actively-managed bond funds and bond trackers, like ETFs. Bond prices fall as yields rise and few advisers and clients are going to want to hold a 10-year Gilt yielding 1.04% if they really think inflation will be north of 3% in five years’ time as this locks in a guaranteed 2%-a-year real-terms loss.

UK Gilts, as benchmarked by the 10-year issue, have sold off hard since summer

Source: Thomson Reuters Datastream

  • Third, if they feel equities are a better option than bonds when it comes to coping with rising inflation expectations (since stocks can potentially generate faster growth and higher dividends, unlike bonds where the coupons are largely pre-set), they need to find the right funds. In the view that “a bad stock in a good sector will tend to outperform a good stock in a bad sector”, looking at sector trends may be one way to cut down on the research needed to identify suitable funds, or at least provide a list of questions to ask at those all-important money manager meetings.

Sector detector

In theory, a weak pound favours exporters and sectors which have large amounts of overseas revenues or assets. The ideal combination is high sterling costs and high overseas revenues (top left) while the worst one is high sterling sales and high overseas costs (bottom right).

Source: Thomson Reuters Datastream

The graphic above illustrates this and the latest year-to-date performance data for the sectors which comprise the FTSE All-Share look to confirm this view:

The best and worst performing sectors in the FTSE All-Share in 2016

Source: Thomson Reuters Datastream. (Covers 1 January to 12 October 2016.)

Trends in sector performance since the EU referendum vote on 23 June also suggest pound weakness favours certain sectors.

AJ Bell tracks data for 39 sectors within the FTSE All-Share and ranks them by performance, one to 39, each week. The biggest gainers and losers since 23 June are as follows, with the gainers advancing most rapidly up the performance league table (by rank) and the losers ceding the most places (by rank).

The FTSE All-Share sectors with the best and worst momentum since 23 June

Source: Thomson Reuters Datastream. (Covers 23 June to 12 October 2016.)

This suggests these may, in some cases, be sectors to consider (or avoid) if the pound keeps falling.

It may therefore pay to look at which funds are exposed to which sectors, in terms of their key over and underweights, at least when it comes to actively managed funds and investment trusts.

Best performing UK Large Cap Equity OEICs over the last five years

Source: Morningstar, for UK Large-Cap Equity category.
(Where more than one class of fund features only the best performer is listed.)

Best performing UK equity investment companies over the last five years

Source: Morningstar, The Association of Investment Companies, for the UK All Cap category.
(* Share price. ** Includes performance fee)

This is less of a consideration with passively-managed Exchange-Traded Funds, although it is worth advisers and clients thinking about just exactly what exposure this passive approach could bring them.

Best performing UK Large-Cap Blend Equity ETFs over the past five years

Source: Morningstar, for UK Large-Cap Blend Equity category.
(Where more than one class of fund features only the best performer is listed.)

Sector split

The table below highlights which sectors are the most – and least – important in the FTSE 100, when it comes to market capitalisation.

FTSE 100 split by market capitalisation

Source: Digital Look, Thomson Reuters Datastream

The next two tables outline individual industry sectors’ forecast contribution to profits and dividend payments for 2016 and 2017, to provide a further gauge of which sectors really matter and which ones do not, when it comes to moving the market.

FTSE 100 split by pre-tax profit contribution to index total

Source: Digital Look, consensus analysts’ forecasts

FTSE 100 split by dividend contribution to index total

Source: Digital Look, consensus analysts’ forecasts

Currency conundrum

There are two final considerations.

  • Not all sectors have stuck to the currency script, so this makes it clear using forex movements alone as the basis for a short-term investment strategy is a bad idea. Gas, Water & Multi-Utilities have done badly even though the bulk of National Grid’s assets are in the USA – this sector has done badly because of fears interest rates and bond yields may rise around the world. Electronics & Electrical Equipment, another dollar earner, has done relatively badly.
  • The pound could rally, in which case all of the considerations above need to be seen in reverse. Admittedly, the chart looks terrible with little evidence support all the way down to the $1.05 mark seen in the early 1980s, but sterling did rebound sharply in 1993-94 after its 1992 ejection from the Exchange Rate Mechanism so it would be unwise to assume the currency keeps crashing. The UK runs a budget, trade and current account deficit, a situation which Bank of England Governor Mark Carney has stressed means we are dependent on “the kindness of strangers” – in other words, overseas investors willing to fund our debts by owning them, in the form of bonds. A collapse in the currency could deter investors from wishing to hold sterling assets and, in a worse case scenario, leave Britain exposed when it comes to funding itself. This is why the traditional response to falls in the currency is a series of interest rate hikes, to offer enhanced returns that compensate would-be buyers for the currency risk they are taking, even if this is clearly not the path the Bank of England wishes to take for now.

The pound reached $1.05 in the mid-1980s

Source: Thomson Reuters Datastream

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.