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Sterling Could Have Further to Fall

After a strong 2017, the pound has begun this week in negative territory. Here, we assess what a falling pound could do to stock markets over the next 12 months

David Brenchley 6 December, 2017 | 10:17AM

Sterling's short-term fortunes are inextricably linked to the outcome of Brexit discussions

As the turn of the year fast approaches and fund managers across the City consider their 2018 investment forecasts, one pertinent question on many strategists’ lips remains "what next for the pound?"

Sterling’s short-term path is tied to news flow emanating from Brexit negotiations for the foreseeable future. That’s been shown to great effect over the past week or so.

After its rapid devaluation in the second half of last year, sterling has bounced back in 2017. It finished last week at 1.3530 against the US dollar, up 9.64% year-to-date, helped by what had looked a significant break-through in Brexit negotiations late last week.

Last week alone the pound climbed 1.68% after news the UK had upped its “divorce bill” offer to €50 billion.

But Monday's failure to reach an agreement on the Irish border question thanks to the DUP’s intervention sent the pound into retreat once again. It’s currently trading at 1.3443.

As we’ve seen sterling slide in the past day or so, many believe this is a trend that is likely to characterise 2018.

Joshua Mahony, market strategist at IG Group, last week said he believed the breakthrough would be a short-term phenomenon. Turns out he was right. His expectation now is for talks to go right down to the wire, meaning the UK is likely to get a worse deal.

As a result, Mahony expects to see a deterioration in the pound and a knock-on effect to wages, which he thinks will continue to deteriorate. “As it comes down to the wire, businesses will hold off in terms of investment and their investment also includes wages,” he explains. This would hit UK GDP and weaken the pound further.

While Mike Bell, global market strategist at JP Morgan, says his base case is for a transitional deal to emerge, he’s cognisant of the risk of a no deal Brexit. At these levels, Bell thinks the market is currently pricing in a high probability of a transitional deal being forthcoming; the risk of no deal is not being priced in as a result.

Talks between Prime Minister Theresa May and European Commission president Jean-Claude Juncker will continue. While both sides have said they are confident an agreement is on the horizon, talk of one emerging before next Friday’s EU summit seems optimistic.

Dan Kemp, chief investment officer EMEA at Morningstar Investment Management, is more constructive on sterling, claiming it still appears undervalued in fundamental terms. On a long-term view, David Coombs, manager of the Rathbone Multi-Asset Portfolio funds, agrees.

He now thinks the chance of a second referendum has quadrupled to 40%. Should that happen, he says, there’s a strong chance remain would carry the day. That would lead to a rally in sterling as the Brexit discount is unwound.

Implications for Investors

Given the inverse correlation between the pound and the FTSE 100, any weakening of the currency would be good news for the UK’s blue-chip companies. Around 70% of FTSE 100 revenues are derived from overseas and a big slug of the dividends paid out to shareholders are delivered in either euros or dollars.

Mahony notes that, as sterling has strengthened through 2017, so the performance gap between the FTSE 100 and the FTSE 250 has narrowed. “I think at some point we are going to see a reversal towards the downside. That would point to an outperformance for the FTSE 100,” he continues.

Bell and Colin Morton, manager of the Morningstar Silver Rated Franklin UK Equity Income fund, say they are not taking big bets either way on the outcome of Brexit negotiations. “From an investment perspective, I’m almost ignoring it because it’s very difficult to actually put together a portfolio based on something that may or may not happen,” says Morton.

He explains that it’s more important for the companies he invests in, which tend to be large caps due to his fund’s income remit, to be able to “adapt to whatever is thrown at them by not being part of a single market within the EU”.

Bell admits that JPMorgan is taking measures to ensure the performance of their portfolios are not impacted by the outcome of Brexit negotiations. That doesn’t mean being overweight large caps; rather “consciously not overweight mid and small caps”.

Coombs adds that further weakness would also stoke inflation, which would create problems for some income-producing assets like bonds, bond proxy stocks, infrastructure funds and commercial property.

For those that share the concerns on the path for sterling, Bell points out that the average UK-focused fund is around 20% overweight to mid and small caps relative to the FTSE All-Share. “That’s a pretty enormous bet… on the domestic UK economy.”

These include the likes of Neil Woodford and Mark Barnett, who have been forthright in their positivity for the UK economy going forward and, in turn, the outlook for currently unloved domestically exposed sectors like housebuilders, banks and real estate.

Morton says his hope is that, while there’s short-term pain to come, five to 10 years down the line none of this will matter. He says: “I’m just hoping that common sense prevails and that governments realise that it’s sensible for companies to continue to trade with each other, communicate with each other.”

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Securities Mentioned in Article
Security NamePriceChange (%)Morningstar
Rating
Franklin UK Equity Income W Acc2.00 GBP0.27
About Author David Brenchley

David Brenchley  is a Reporter for Morningstar.co.uk