If investors had some comprehension regarding the impact of FX rates on the market before, they now fully understand the importance of this variable. The weakness of the pound has been a semi-permanent feature of market dynamics for an extended period, certainly since the country decided to leave the EU in June 2016. Whilst the UK market temporarily sold off back then, it was soon fighting back largely on the back of said weak pound (further weakened incidentally by an emergency rate cut by the BOE the following August) as many of the FTSE 100 blue chip companies earn significant amounts of their profits overseas. Once such earnings are translated (switched) back into pounds, large increases in profits have been seen. It was rewarding to be calling clients post the Brexit vote last year to advise of meaningful increases in value reference some elements of their portfolios at a time when many were too afraid to turn on their screens.
I mention ‘some’ elements of portfolios with honesty as other sectors have not enjoyed the weak pound environment ; retailers in particular have struggled as import costs have risen, putting (profit) margins under pressure. In fact any business with non sterling costs has been having a tough time because without raising prices (something customers never take kindly too), making money becomes harder.
So it has been of particular interest over the past 10 days to witness a meaningful leap in the value of the pound fuelled by the BOE making the case for a rate rise possibly in November, certainly by February next year. Largely due to inflation running over 3% (possibly also linked to low levels of unemployment), it seems increasingly likely that a quarter per cent base rate hike (back to 0.5%) could soon be seen. Some feel the UK economy is strong enough to absorb this lift in borrowing costs which after all, will only take us back to the pre Brexit vote level. Some believe the emergency rate cut after the Brexit vote was unnecessary in any case; the central bank would argue because of it, the economy has been protected throughout a very difficult period. But the generally accepted thought process is that without tightening policy sometime soon, it will mean aggressive tightening will be required in short order in the future. A slow and measured pace of lifting rates will be more palatable to all; delaying brings about greater eventual risk: at least that is the theory.
The shift in belief regarding the direction of monetary policy has brought about a rally in the pound. We have accordingly seen international earners (many in the FTSE 100) retrace and retailers (for example) move significantly higher in a reversal of the trend that has for so long been in place. Marks & Spencer Group (349p) shares for example are 7.5% higher since the 14th September. Banking stocks are also trading higher as net interest margins will improve in the event of a rate rise (and possibly further rate rises). Lloyds Banking Group (66.4p) stock is 4% higher now than it was on 14th September (the date at the BOE minutes). The larger market weighting of the ‘dollar earning’ companies has meant the FTSE 100 index has been slipping, certainly struggling to move materially higher as a tug of war is underway between weak pound (low rates) and stronger pound (higher rates) beneficiaries.
So we have this somewhat perverse situation where a rise in rates (which should ordinarily be interpreted as favourable) could actually bring the market down (certainly hold it in check) as the FX translation effect will now decrease some companies profits. However let us also not forget the simpler reality to understand, that any increase in borrowing costs will not be great news for many companies and/ or individuals. Record low rates have been in place since early 2009 and such a macroeconomic change is bound to bring genuine anxiety. Companies and individuals with debts will face higher interest charges and this leaves less for investment and /or expenditure. In fact some have concerns that a tightening in policy might yet prove the catalyst for some form of market correction lower. That is if World War 3 doesn’t commence beforehand.
The next 3-6 months shall be interesting to navigate. The generalist hope is that markets can withstand central bank policy shifts (the US Fed is already raising rates and tapering QE) and that withdrawing stimulus does not choke off the relatively meagre economic growth being reported. Valuations whilst not excessive and not cheap either.
Market Specific Comment
Time will tell whether we may have already seen the best of sterling’s rally. Short termers will be banking profits having taken contrarian buy opportunities in unloved value sectors such as retail. Holding some cash within the portfolio always makes sense to me. Not only is it an asset class in its own right, bar inflation risk, it never goes down in value and as such is an uncorrelated asset, ideal for diversification and risk management. North Korean provocations, far from perfect relations with the Chinese and unrelenting uncertainties regarding how exactly a Brexit will play out, all represent viable factors as to why volatility may present itself sometime soon. Not that I believe the market is necessarily complacent currently, nonetheless there seems little by way of a ‘fear’ and this worries me slightly. It is a mistake to never be slightly on edge when watching share prices.
Oil is rising rapidly with momentum traders well aboard. We have seen Brent crude rise over 30% since June to the current level of $58.46 per barrel. This will be welcome relief to the likes of Shell and BP whose dividends are being closely scrutinised and solid short term gains in these shares have been seen over the past 2 weeks. Oil bulls see prices rising further as additional production cuts are forecast into 2018 from OPEC and non OPEC countries.
This report was written by Philip Scott, Director at SI Capital on 25/9/17 when the FTSE 100 was trading at 7301.