The unpredictability of currency movement can be seen in the surging value of the pound relative to both the dollar and the Euro, even as the country is gripped by recession and lockdowns, having moved from a low of £1.15 against the dollar to more than £1.40 over the past year. In the wake of the Budget, it dipped slightly to £1.39 against the dollar.
Josh Mahony, senior analyst at IG Group, says the bulk of the positive momentum is accounted for by the signing of the Brexit trade deal. He says currency markets had priced in a much worse outcome, probably a “no deal” scenario, and as a result, when the deal arrived, the market’s expectations were surpassed, with the result that sterling rose, despite the wider economic uncertainty.
With the advent of the pandemic every economy slipped into the doldrums, leaving the UK as less of an outlierThis less-bad-than-expected effect has been amplified by the advent of the pandemic. This is because one of the reasons UK assets were so very out of favour with investors was that before anyone had heard of Covid-19, the UK seemed to be the only stricken economy in the world.
With the advent of the pandemic every economy slipped into the doldrums, leaving the UK as less of an outlier, with UK assets already trading at levels that reflected a disaster; when a crisis came in the form of the pandemic, they had not got as far to fall as others.
Mahony says the apparent progress of the UK’s vaccine programme relative to that of the eurozone may mean the UK can re-open more quickly, and so grow at a faster pace.
So the rise in sterling is actually accounted for, says Oliver Blackburn, multi-asset investor at Janus Henderson, by UK bond yields looking relatively more attractive than those of the US right now, while investors are also more optimistic about the prospects for the UK economy with the Brexit cliff-edge removed and the vaccination programme.
He says the market has noticed the Bank of England has retreated from introducing negative interest rates in the UK, while in the US the central bank chief has continued to caution that interest rates will remain very low for a long time.
This has helped sterling as investors believe it is a sign the UK will recover more quickly than previously expected, while also meaning the dollar is falling in value relative to sterling.
Borrowing boost
This could mean UK government borrowing falls at a faster pace, or that actions that put a break on a currency, such as very low interest rates or quantitative easing, end more quickly in the UK than in other countries, which would, at least theoretically, mean the pound would gain against the Euro in future.
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.
Andrew Hardy, investment director at MGIM, a multi-asset fund house, says sterling is a currency that does well when investors want to take more risk, and such a climate also tends to boost UK equities.
Higher sterling makes many UK exports more expensive, while potentially making imported goods cheaper, helping to keep a lid on inflation.
The strength of sterling relative to other currencies may also make the future cost of UK government borrowing lower, because overseas investors in UK government debt get repaid in sterling, so if sterling is rising in value relative to the currency they spend money in, this increases their spending power.
David Thorpe is special projects editor of FTAdviser
david.thorpe@ft.com
