What does the rise in sterling mean for your clients' portfolios?

In terms of the strength of the pound versus the dollar, the US currency tends to perform very well in terms of sharp global recession or uncertainty, as it is viewed as a 'safe haven'. 

This happens due to two factors. The first is that in times of market stress, US-based investors tend to sell off the investments they hold overseas and bring the cash back home, which involves turning overseas capital back into US dollars, pushing the value of the latter higher. 

The second factor is the role US government debt, known as Treasuries, plays in portfolios. Market participants tend to increase their exposure to Treasuries during periods of market strife as the US government is viewed as extremely likely to repay the cash.

So at the same time US investors are turning their overseas investments back into dollars, international investors are selling the assets they own in their home market and buying dollars, meaning the US currency rises in value when everything else falls. 

Mahony says the recent sharp decline in the value of the dollar relative to other currencies is a function of investors moving away from safe-haven assets as confidence around the timing and extent of a post-pandemic economic recovery takes hold.

Portfolio consequences 

The best indicator of precisely how the rise in the value of sterling is impacting UK investment markets can be seen in the performance of UK government bonds. 

The yield on the UK 10-year gilt has also risen stoutly in recent months, from as low as 0.2 per cent to the present level of 0.7 per cent.

Investors have not been buying UK equities in such volume as to push sterling up, with the latest flows data from Morningstar showing net redemptions of £2.3bn in January 2021.

Higher sterling is typically viewed as a negative for the FTSE 100; this is because about 75 per cent of the earnings of FTSE 100 companies are derived from overseas. Stronger sterling diminishes the value of those earnings when they are brought back to the UK, so diminishes the returns achieved by investors. This is why, in the immediate aftermath of the Brexit vote in 2016, the FTSE 100 rose even as sterling fell. 

This has a relatively negative effect on the FTSE 100, compared with the mid and small cap indices. In the FTSE 250 around half of earnings are from overseas, making it less sensitive to the movements in sterling.  

The converse of this is that when sterling strengthens, the FTSE 100 tends to suffer.

But data from Coutts investment management show that in January the FTSE 100 performed better than the S&P 500 US index in the month, because the UK also has many shares that are cyclical in nature and so perform best when the global economy is recovering from a downturn.