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Has the plummet in sterling run its course?

26 June 2017

In the first part of a series, FE Trustnet talks to UK equity fund managers about Capital Economics’ latest report on why the FTSE 100 is likely to stagnate from here, focusing on their stance on the pound’s weakness.

By Lauren Mason,

Senior reporter, FE Trustnet

The weakness of sterling is likely to have run its course, according to the latest report from Capital Economics, which means the FTSE 100 will no longer benefit from a significant currency tailwind.

This comes following its update published last week entitled, ‘Will the FTSE 100 continue to climb?’, where the firm states that the global-facing blue-chip index is likely to deliver sideways returns from here throughout the rest of 2017.

“Our upbeat view on the outlook for the UK economy might suggest we would expect the FTSE 100 to record significant further gains this year and next. But even if the economy remains resilient, there are at least four reasons to think that the index will now stagnate,” Andrew Wishart, assistant economist at the consultancy, wrote.

He said there are at least four reasons why the index is set to finish the year at 7,500 – only a little above its current level.

One such reason – which we will be exploring today – is the sustained weakness in sterling seen over the last year, which has bolstered the returns of global-facing exporters and therefore a large proportion of FTSE 100 constituents.

Performance of currency vs US dollar over 1yr

 

Source: FE Analytics

“First, the boost to the FTSE 100 from the depreciation in the pound has probably run its course,” Wishart said. “Declines in trade-weighted sterling were tightly correlated with gains in the FTSE 100 index throughout 2016.

“However, the pound has stabilised over the last six months, depriving the stock market of this tailwind. Moreover, we expect the pound to strengthen ahead, as the performance of the economy exceeds expectations and monetary policy tightening comes onto the agenda.”

While many UK equity managers agreed that sterling has provided a significant tailwind for the FTSE 100, not everybody believes a rise in the value of the pound will put a stop to the index’s strong performance.

Alan Custis (pictured), head of UK equities at Lazard Asset Management, said: “I wouldn’t disagree with the statement that the depreciation of sterling has been one of the key drivers of the FTSE 100’s performance, but in terms of whether we’re likely to see any further weakness, I’m not sure it has run its course.

“What we saw around the election and the uncertainty post the 19 June was that sterling weakened. I think it is going to remain pretty volatile.

“Do we think that’s the full driver of the FTSE’s performance recently? It’s probably been the principle driver but I think there are more economic factors at play.”


Richard Penny, who heads up the four crown-rated L&G UK Special Situations Trust, said the boost that the FTSE 100 received following the fall in sterling was “remarkable” in the context of the past 40 years.

“It is unlikely that we would see such a move again,” he argued. “In fact, we believe the currency is undervalued in the long term, though we caution that sterling may remain undervalued with risk through Brexit negotiations to the downside.

“From a different perspective, weak sterling may lead to inbound M&A activity from overseas, which would be positive for FTSE 100 levels.”

Phil Harris, who runs the EdenTree UK Equity Growth fund, agreed there is a very mechanical relationship between the level of the pound and the FTSE 100, given a vast majority of the index depends on overseas earnings.

“What you have to remember is a lot of the underlying companies in the FTSE 100 - such as Unilever or Diageo - don’t actually grow that quickly, so the underlying growth rate is low single figures,” he reasoned. “So, swings in currency can have a material impact on how people perceive the earnings stream and the valuation.”

The manager said the swings in the pound will therefore determine what investors are willing to pay to hold certain stocks.

“I agree that this mechanical re-rating has largely gone and, given the low underlying earnings growth of a lot of companies in the FTSE 100 index, it is going to struggle to make particular headway,” he continued.

“If we do get a small rally in the pound, earnings could struggle to grow at all among some of these companies.”

Adam Laird, head of ETF strategy in Northern Europe at Lyxor, said Capital Economics’ stance on the pound is “fair”, as the struggling currency has indeed boosted the index over the last year.


“However, it’s hard to see a scenario where sterling will rebound in the short run,” he reasoned. “The cheaper pound helps exporters – whose goods become cheaper overseas. And since imports become cheaper, domestic producers should see some increase in business. At this level, the pound could lead to more profitability in the near term.”

Robert Scammell, senior portfolio manager at Kempen Capital Management, is wary of looking at the FTSE 100 as being solely reflective of the UK. Even if the index’s performance did flatten out, he doesn’t believe investors should therefore stop allocating to it.

“There is no doubt that the FTSE 100 has seen a substantial benefit from the fall in sterling over the last year,” he agreed. “The FTSE 100 is up 25 per cent whilst sterling is down 13 per cent against the euro since the referendum vote.”

Performance of sterling vs euro since 23 June 2016

 

Source: FE Analytics

He said the FTSE 100’s dependence on foreign currency-denominated earnings has indeed been one source of the equity returns seen over the last year.

“It would require sterling to continue to fall significantly in order to provide a similar boost to earnings. However, whilst unlikely that is not impossible with Brexit and political uncertainty still high,” he added.

“Given this, the FTSE is far less exposed to the UK economy than it is internationally, with around 75 per cent of earnings coming from abroad.”

Trevor Green, head of UK equities at Aviva, warned: "As we now reached one year anniversary of Brexit, that translation gain has now passed. Investors have to look forward and the focus will be much more on underlying trading and companies delivering underlying growth will be more obvious and rewarded accordingly."

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