The surprise UK general election announcement has led managers and strategists to question their UK equity assumptions in light of a sharp rise for sterling last week.
The pound rose above $1.28 against the dollar for the first time since October last week following Theresa May’s announcement of a planned June 8 election, a spike which sent the FTSE 100 index down almost 2.5 per cent.
Though sterling remains well below the levels seen before last June’s EU referendum, and even the $1.33 mark to which it slumped in the immediate aftermath, further drops are no longer seen as a foregone conclusion.
Sterling bears such as Deutsche Bank scrapped their calls for a continued fall in the pound last week, arguing that the expected election outcome – a large Conservative majority in Parliament – increased the likelihood of a ‘softer’ Brexit.
This would have implications for the FTSE 100, where recent rises have been driven by the weakening pound. The index has already given up its gains for 2017 as investors reassess the benefits of owning ‘dollar earners’ – mega-cap companies for which profits booked in other currencies are flattered by sterling falls.
“In contrast, this could boost UK domestic stocks, which would see production costs overseas go down,” said Colin Morton, UK equity manager at Franklin Templeton.
However, there are a number of factors involved. Bank of America Merrill Lynch’s (BAML) UK team highlighted that mid-cap stocks were not guaranteed to outperform even if sterling weakness had ended.
“A firmer lower bound for the pound probably marks the end for the FTSE translation trade as international stocks are less likely to have another currency kicker,” BAML said.
“Nevertheless, with consumers still under pressure from squeezed real incomes, we continue to favour large caps over domestic mid caps.”
Although there is little doubt over the consensus expectation for the election itself, analysts are at odds as to the true intentions of the prime minister.
BAML believes the election makes a ‘hard’ Brexit more likely, rejecting the suggestion that Mrs May will use a larger majority to move away from the wishes of the hardliners in her party.
Pantheon Macroeconomics went further, suggesting a renewed currency drop could be on the cards once investors come round to this way of thinking.
“We think that sterling’s rally is vulnerable to a swift reversal, as markets appreciate that the chances of an ultra-hard Brexit also rise with a larger Conservative majority.”
But observers believe a dominant Conservative government will make it less likely that the UK will end exit negotiations with no deal at all.
Iain Scouller at Stifel said global investors should also be wary of the impact of a changing outlook for the pound.
“Over 2016 gains resulting from sterling’s weakness were a key factor in the 20 to 40 per cent total returns delivered by many of the equity funds that invest globally. [A reversal] would undo some of the forex-induced gains that many funds have benefited from over the past year.”
KEY NUMBERS
$1.28
Level reached by the pound last week for the first time since October
17 seats
Current Conservative majority in Parliament
