Both stocks and bond markets made ground in May, with global equities gaining a little over 2%. Emerging Markets and UK stocks were among the brighter spots.
Bonds did well too, with yields on UK gilts falling to 1.04% by the end of the month, close to record lows. The Pound rallied somewhat in May, as markets priced the prospect of an enlarged majority for the Conservative government, yet that rally partially reversed in the wake of the shock failure of the government to achieve a majority.
Political surprises of the last year or so have made mugs of many forecasters. Not only have we seen surprise outcomes in elections and referendums, but we have seen markets reacting in sometimes surprising ways. Labour’s surge in polls during the run up to the election at least highlighted that a possible surprise might be on the cards but few predicted the scale of that surprise and the weakening of Prime Minster May’s mandate as a result. While our usual focus is on traditional market drivers like the global economic cycle, corporate earnings and asset valuations, shifting political drivers remain hugely important; perhaps more so for government bonds and currencies, than for equities.
Markets are now firmly focused on downside risks to the UK economy, partly as a result of Brexit uncertainty, but we are acutely conscious that the Pound, at current levels, is pricing in significant risk already, with the real effective exchange rate close to forty year lows. Our portfolios have benefited from overseas currency exposure over the last year; all else equal, weak Sterling increases the value of assets denominated in foreign currencies but the scope for a surprise seems increasingly to be shifting towards the Pound’s strength.
Markets are now firmly focused on downside risks to the UK economy, partly as a result of Brexit uncertainty.
What could drive Pound’s recovery? Surely not the economy, which is showing signs of strain. Last year’s Brexit-induced fall in Sterling has led inevitably to higher inflation, which is squeezing consumers at the same time as a slowdown in wage growth; wages are now falling again in real terms. Indicators of consumer and business confidence suggest that Brexit-related uncertainty can have a further effect. All else equal, that would be unhelpful for the Pound.
Perhaps interest rates? The level of the Pound vs the Dollar in particular seems very sensitive to the difference in short term interest rates in the two currencies. The US Federal Reserve has begun increasing interest rates (helpful for the Dollar in this comparison) but there are signs of a change in tone. A sharp fall in the tone of recent economic data in the US, with many indicators starting to lag market expectations, suggests that the US is experiencing a few headwinds: perhaps enough to keep the Fed to just one rate rise in the second half of the year. Conversely, some within the Bank of England are openly contemplating a rate rise, in the face of higher inflation. One might argue this would be a mistake. Inflation coming from higher import costs after a currency fall can often be a transient factor. The economy faces a great deal of uncertainty over the next year or two that suggests a rise would be premature but we cannot now take it for granted that UK interest rates will stay in the basement.A rise would be premature but we cannot now take it for granted that UK interest rates will stay in the basement.
But the biggest swing factor for the Pound is likely to be politics, and the politics of Brexit in particular. The election result surprised almost everyone, but has now clearly exposed the Pound to buffeting cross currents. The possibility of a left-wing government, bringing higher spending, higher taxes and higher borrowing has moved from an improbable tail risk six weeks ago to a decent each-way bet: it should come as no surprise; looking at markets through a traditional left-right political lens; that this prospect has led to a slightly weaker tack for Sterling. However, we cannot look at Sterling simply through the lens of traditional politics and our key question must be whether the political surprise of 8 June changes the trajectory for Brexit. It seems to us quite likely that it does.
Many scenarios are still possible: May may battle on; we may have a change of Conservative PM; we may see a Labour minority government or new elections by the end of the year. A new Prime Minister; or indeed an embattled Mrs May; may choose to take a less aggressive stance on Brexit than was suggested by government policy before 8 June. It seems clear that the House of Commons will not now support the idea of the UK leaving the EU with no deal at all (not intentionally, anyway – some still fear that time could simply run out before a deal is reached).
This is encouraging as most commentators substantially underestimate how damaging and complex such an outcome could be. It seems possible that the government will place a higher priority on securing a transition period and close trading links, even if this means compromise on freedom of movement. And it is conceivable, if public opinion continues to shift in response to weakness in the economy, that the form of Brexit will soften further; perhaps to a Brexit in name only, or even (via another vote) to Remaining. The market is not putting a high probability on such an outcome at present, but we believe it is wrong to dismiss the possibility of such a shift. Some damage has already been done, to the UK economy and the UK’s reputation abroad, but a softening of the Brexit stance would be helpful for foreign investment in the UK and for the cyclical economic outlook; therefore likely to be helpful for the Pound too.
This would actually present challenges for investors! A rebound in the Pound would be very painful for investors holding overseas assets, unwinding currency gains made over the last year. It would also be a headwind for UK equities, which are dominated by large multinationals generating most of the profits abroad (those profits are worth less in Sterling when the Pound rises). The possibility of a sharp rebound by Sterling may not be imminent; it may not be a high probability yet.
The possibility of a sharp rebound by Sterling may not be imminent; it may not be a high probability yet. But it would be very damaging if it happened, so it’s prudent to adjust our positioning to take account of this risk – and that means holding more Sterling in our portfolios.
A higher allocation to Sterling means that there is simply less currency risk in our portfolios than before – in either direction: if the Pound falls further, portfolios would still see a small positive impact - much less than a year ago (and perhaps much less than other strategies which do not have the flexibility to change currency exposure), but still positive. However, if policy changes and the Pound starts to recover, and that recovery gathers momentum, we are much better protected than we would otherwise have been.
Forecasting exactly how and when the UK government stance may change is unclear, but it seems to us that the direction of travel is towards a softer Brexit (and, crucially, tighter trading arrangements with the EU) – no matter who is in the driving seat. Markets may be focusing on short-term uncertainty, but if the UK’s divorce ends up being less dramatic, this should be good for the Pound. It’s time to be protecting portfolios against that possibility.
Deputy Chief Investment Officer
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