Currency markets continue to dominate the investment landscape and remain a source of volatility many investors are not accustomed to. For nationals of the U.K., this has acted as a tailwind for performance since the June 23 Brexit referendum, however investors on the other side of the fence have seen their U.K. denominated investments decline.
In order to attempt answering ‘what can we expect from sterling’, we must start with what we currently know about Brexit.
Brexit is most likely to proceed, yet this is not yet guaranteed. The ability to trigger Brexit is likely to require parliamentary approval, of which 74% of MP’s were allegedly against leaving prior to the referendum. While it is likely MP’s will vote according to the wishes of their constituents, this should not be considered a guarantee.
The only solution appears to be a “Hard” Brexit. Theresa May has now announced her intentions to proceed with a clean break from the European Union, which means the U.K. will leave the single market and regain control of immigration. There has been no announced solution on the dilemma of what happens to the estimated three million Europeans living in the U.K., nor regarding the one million vice versa. Equally, there has been no announced solution to the passporting rights of companies that rely on cross-border activity such as the banks. Theresa May has outlined her ambitions for a free trade agreement, but these matters are subject to negotiation.
If Theresa May gets her way, the U.K. will get the best of both worlds. Under Plan A, the U.K. would regain control of immigration, discontinue their payments into the European block and retain access to all global markets as if they were still in the European Union. However, it remains healthy to be sceptical of such developments. The Europeans will be conscious that the conditions must be sufficiently unattractive to avoid other members wanting to leave.
Focus on Fundamentals
With an abundance of unknowns, we must refocus on the fundamentals of currency. Imported inflation will likely be a one-year phenomenon. The lower sterling seems likely to push import prices higher in the short-term, but as inflation is generally calculated as an annual growth rate, the second year will already account for this inflation adjustment. Purchasing price parity remains mostly unchanged between the UK, European Union and even the US.
There is no reason to believe the long-term inflation rate of the U.K. will be substantially higher or lower than it otherwise would be if it were part of the European Union. Immigration changes may alter long-term employment pressures at the margin, however this link is weak when assessed in a very long-term context.
The current account deficit is more likely to improve than deteriorate if sterling remains at lower levels. At this stage, it does not appear to pose a threat to the structural composition of the U.K. and hence should be considered in this context.
As you can see, the link between a Hard Brexit and sterling looks reasonably weak. For this reason, we are fundamentally inclined to believe the fair value of sterling is intact over the long term. This makes sterling look cheap relative to the US dollar, which does not justify the dramatic positioning of investors to the contrary.
What does Undervalued Sterling Mean for the FTSE?
By extension, some investors might think we favour the FTSE 250 over the FTSE 100, as it has a weaker correlation. This is not exactly true. We view asset classes from a bottom-up perspective, meaning we look at the yield, growth and valuation adjustment as opposed to correlation analysis. Therefore, while we are cognisant of the fact Brexit has tightened the correlation pattern between the FTSE 100 and sterling, we should not be dictated by it.
What is more important is to understand the fundamental drivers of the companies in the FTSE 100. We know that approximately 72% of revenues from the FTSE 100 are from offshore sources, which can be expected to have an impact on the revenue stream of these companies as the sterling fluctuates.
However, the link between the short-term revenue of a U.K. company and the long-term value of all future payouts must be considered very weak. We therefore believe investors may be making the decisions based on correlations as opposed to fundamentals.
