What does sterling’s fall mean for investors?

International currency markets have responded negatively to Chancellor Kwasi Kwarteng’s ‘fiscal event’. On Monday morning, sterling sunk to $1.035 against the dollar - its lowest level on record. Government bond yields have risen, and prices fallen, as investors anticipate emergency interest-rate rises from the Bank of England to support the currency by making it more attractive to overseas investors. For investors holding UK assets, it is an unnerving moment.

The rise in Government borrowing that is necessary following the tax cuts and spending programmes announced in September’s mini-budget has spooked markets. The UK is reliant on foreign investors to fund this borrowing by buying gilts (UK government debt), particularly now the Bank of England is reducing its bond-buying programme through quantitative tightening. With little certainty on the cost of support for households on energy bills, and Kwarteng talking of further tax cuts, that international support has diminished. It could take higher gilt yields and a lower currency to bring it back. This seems to be the action playing out in financial markets now.

The UK currency was already facing some headwinds. Sterling is historically a cyclical currency – rising when international risk appetite is high and falling when it is low. The dollar, on the other hand, is usually the currency of choice when markets are weak, having proved itself a ‘safe haven’ at times of economic turbulence. The dollar has also been strong because the Federal Reserve is raising rates far more aggressively than other central banks, making it more attractive to investors.

It is also important to consider the impact of sterling’s depreciation on inflation. It is already high and looking increasingly embedded. There is a danger that the weaker currency raises the price of imports and accelerates inflationary pressures. We have already witnessed this phenomenon in petrol prices, for example [1].

There is the uncomfortable historical precedent of Anthony Barber’s 1972 Budget under Prime Minister Edward Heath. This was the last time taxes were cut by a similar amount and precipitated a decade-long economic crisis. Nevertheless, it is worth noting that there are differences. At that point, the Bank of England was not independent so couldn’t act as a brake on government spending. However, in our opinion it may be enough for foreign investors to demand a higher return for the risk they are taking.

The situation certainly complicates decision-making for the Bank of England. The UK’s central bank has been measured in its interest-rate rises to date, but the mini-budget may force it to raise interest rates faster. Markets are now anticipating a peak in the Bank of England base rate of around 6% by August 2023.

A weaker sterling is not universally bad for UK assets. Any company with significant dollar revenues will benefit from the translation effect. This applies to much of the FTSE 100 and, in particular, the large, global energy companies, which were already benefitting from the high oil price. However, it is bad news for those companies that generate their revenues domestically but rely on imports, including UK housebuilders and retailers. This primarily hurts small- and mid-caps over large-caps, where these companies are disproportionately represented.

The current situation also raises questions about gilts. The UK 10-year gilt saw its yield rise by 0.9% and its price fall in the two days following Chancellor Kwarteng’s statement. This makes it hard to defend the historical role of gilts as an asset capable of protecting portfolios against catastrophe. We believe US Treasuries may prove a better option in this climate of considerable uncertainty for the UK.

In the longer term, it is plausible that Kwarteng’s ‘shock and awe’ tactics deliver a revival for the UK economy, with low tax rates bringing in new investment. However, it is a significant gamble, and the consequences of failure are high. In the short term at least, it is too early to see a recovery for sterling, particularly while the Federal Reserve continues its policy of raising interest rates.

If this article has raised any questions, please do speak to your usual Evelyn Partners adviser.

Source

All data is from Refinitiv/ Evelyn partners unless otherwise stated.

[1] Plunge in sterling leaves drivers paying £6 more for tank of petrol, says AA, The Guardian, 24 September 2022.