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
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.
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
This report was written by Philip Scott, Director at SI
Capital on 25/9/17 when the FTSE 100 was trading at 7301.