For fund managers, simply looking at a company’s cashflow, growth strategy and management team may not be enough to understand the movements in its share price. Various external factors have a big effect on portfolio returns, even when the underlying firms announce positive earnings reports or acquisitions.
While a degree in economics isn’t necessary, it is vital for fund investors to assess how these various economic measurements influence portfolio returns. These factors include, but aren’t limited to: interest rates, inflation and currencies.
Theoretically, there’s correlation between interest rates and equities. If a company borrows money to grow, higher interest rates will affect the cost of its debt, reducing profits and dividends, which may result in a fall in its share price. Declining interest rates often send markets higher as they are viewed as a harbinger of economic growth.
However, the quantitative easing programmes and extraordinary measures taken by the Bank of England broke down this negative relationship. The ‘taper tantrum’ in June 2013 showed that investors had become addicted to low interest rates, and any normalisation was viewed as negative for equity markets. Nevertheless, the potential regime shift from monetary policy to fiscal policy is likely to result in a more typical relationship between asset classes.
Inflation is another macro factor that influences stockmarkets. High inflation signals that interest rates will be rising soon, thus slowing economic growth. It also indicates higher consumer prices, which often slow sales and reduce profits. These changes will tend to bring down share prices, and so it is important for a UK equity manager to understand how the invested companies will be able to pass a rise in input prices on to its customer – that is, its pricing power. With the surge in oil price last year, inflation had become one of the main drivers of stock returns.
Currency is also important because the UK equity market is very international in its composition, with about two-thirds of FTSE All-Share earnings derived from international markets. Whereas most equities have recovered post the Brexit vote sell-off in June 2016, sterling has remained anchored to its lows.
There is a belief that UK growth and interest rates will be lower for longer, which makes foreign currencies more attractive for investors.
The question for UK equity investors is whether this is a structural shift downwards, or whether the pound could fall further – or even recover if the Brexit process is not as bad as feared. This currency question has become the main factor affecting UK equity markets.
Using the r-squared measure – which shows the proportion of an index’s movements that can be attributed to various parameters – of the FTSE All-Share against different factors, we could highlight that the sterling/dollar level is the primary driver of stock prices. The three-month r-squared of the FTSE All-Share and the sterling/dollar exchange rate, which had moved to 50 per cent last summer, has slowly decreased to 21 per cent, but remains a primary external factor affecting UK share prices.
It is therefore necessary for UK equity managers to disclose their exposure to this, as well expressing their outlook for sterling. We believe fund managers should be more transparent in disclosing their exposure to macro factors, as their impact on fund performance could be as important as stockpicking.
Charles Younes is research manager at FE
