Premier Miton Chief Investment Officer
This update should not be taken as advice. If you are unsure about any of the content please contact your financial adviser. Please remember that the value of stock market investments will fluctuate and investors may not get back the original amount invested. To assist, where appropriate, a glossary explaining some of the terms used has been provided at the end of this update.
As much as I would love to discuss something else and you might want to read about something else, there is only one topic on the agenda this month; the turmoil in the UK, but I will try to relate my comments to the impact it might have on investment portfolios. However, it is difficult to know where to start, so let’s go back a bit in time.
Just when you thought it was all over, it gets mentioned again. But it is worth putting a little historic perspective on matters. The “leave” result of the referendum in the summer of 2016 initiated a long period of uncertainty for the UK. Since then, the UK has been through Brexit itself, COVID, the inflationary boom, cost of living crisis and now the current turmoil; that’s quite a lot of stress! This manifested itself in political change, social divide, business insecurity, central bank policy changes and UK and international investors alike selling UK assets, particularly stock markets. The referendum result also started the slide in sterling, which was at nearly 1.50 against the US$.
So I could argue that the current situation has been in the making for some time, however, the scale and speed of the most recent moves in financial markets have been severe.
Policy and politics
Politics is a topic I would normally steer well clear of, but that is not possible in this case. The change in Prime Minister and wider leadership in government has brought with it a new approach to the management of the economy. They have many difficult problems to solve, and a perfectly legitimate approach to avoiding recession, rising unemployment and helping consumers and businesses is to “go for growth” in the economy. That can be aided by reducing the tax burden, which is what the government announced in the “not so” mini- budget. The scale of the measures surprised most commentators, as in all likelihood they will bolster inflation, as well as stimulate growth. It is hard not to believe there was political motivation as well, and the nature of the measures upset a number of groups and the electorate, so that seems to have back fired in the short term. Indeed, that resulted in a very quick U-turn on the part of the government, in reversing the proposed removal of the highest rate 45% income tax band. The ongoing uncertainty over policy will not help stabilise markets.
Meanwhile, the Bank of England is trying hard, although maybe not hard enough, to dampen inflation through interest rate rises, which will cause economic growth to slow. We therefore have the Bank of England’s policy at loggerheads with the government’s economic policy. One is tightening policy, the other is loosening it, by cutting taxes with money it doesn’t have.
That, put simply, causes uncertainty. Financial markets hate uncertainty and investors take flight to safer assets where there is more certainty.
As I noted above, sterling has been on the slide for a while. The mini-budget sent it into a tail-spin, hitting lows against the US dollar never seen before, but it fell against major currencies as well. That was unsurprising.
In this note in July, there was a section titled; currency movements can be more important than you think. If you will forgive me, I’ll replicate part of it here.
When markets are being driven by macroeconomic events, as they are at present, these are often reflected in currency markets quickly and significantly. All the economic points such as growth, inflation or employment and any hint of policy moves from central banks are being scrutinised instantly, sometimes causing big currency moves.
Most portfolios have currency risk to one degree or another, ranging from the base currency of an investment to the look through revenues and profits of a company held, the latter of which is a big influence on the FTSE 100 index. Currency risk can quickly become one of the biggest risks in a portfolio when markets are moving and this is complicated by the fact that you have to consider the pairs you have exposure to sterling/euro, sterling/dollar etc. All exchange rates are influenced by both sides of the pair. Like all risks in a portfolio you need to know what you’ve got and want it or mitigate it.
The actual impact of sterling falling is that the value of your investments in another currency rises because of the change in the exchange rate. The same rationale holds for companies with revenues in foreign currencies; which is why the FTSE 100 Index tends to benefit and smaller companies don’t; international versus domestic revenues.
Clearly, the reverse is true as well; if sterling rises, the value of assets in foreign currencies suffer. I do not know what will happen to sterling, but the stresses in the UK suggest it will remain weak. However, when historic extremes are reached, that can provide a floor (or a ceiling). In 2007 sterling touched US$ 2.11, as I write this it is US$ 1.11, having gone below US$ 1.04 on 26 September. Currency moves in your portfolios remain very influential.
These are bonds, or debt, issued by the UK government. They are generally considered very low risk investments as the government will pay you the interest rate due on the gilts and will repay you the capital sum they were issued at on a set date in the future. However, they are traded on markets and their prices move. As we have been in a period of ultra-low interest rates for some time, interest on cash has been zero, for the most part, making gilts attractive to investors, so their price has risen. But the increases in the Bank of England base rate and cash deposits has had the opposite effect: the price of gilts has fallen. In fact, to the end of September, the FTSE Actuaries UK Conventional Gilts Index has fallen 30.2% from the start of 2022 – that is not a very low risk investment over that time period!
This helps to explain why lower-risk portfolios, that typically have higher exposure to government bonds and bonds issued by companies, have often fallen more than higher risk portfolios, which have more in equities. The FTSE All Share Index has fallen 7.9% over the same period (Source: FE Analytics).
Gilts have hit the headlines following the mini-budget as well. The mini-budget makes it likely that the Bank Of England will now need to put up interest rates much more than expected to counteract its inflationary impact; that is bad for gilts, and their prices fell sharply.
This caused very significant stress for a number of investment strategies and, in particular, it threatened the solvency of a number of pension funds. The Bank of England went into full financial crisis mode; it had no option but to intervene and to announce it was going to buy £65bn of gilts to stabilise markets.
Needless to say, sterling suffered through this phase as well, but the Bank’s actions put a floor on gilts and sterling and their prices rallied. However, the problem has not gone away, it is still with us.
At the risk of sounding flippant, I wish I knew.
To be clear, the UK economy remains under pressure from very high inflation, a cost of living that will remain high, central bank policy and government policy that are conflicting, which will, in all likelihood, result in recession. It’s not a great backdrop.
There are significant ramifications for financial markets (bonds, equities and sterling), borrowing rates for companies, mortgage rates or even the ability to get a mortgage for individuals, the housing market, the list is a long one.
However, financial markets do take current information and future prospects into account, so this is all known. It is the unknown that is the potential problem, and it is hard to see, for now, how that could be good news. So, in my view caution is appropriate, but in times of stress, opportunities appear for active investors for the long term.
The last word
As the title of this note may suggest, I initially intended to focus on sterling and the impact currency can have on a portfolio, however as everything is so interlinked, it got a lot longer and covered more than intended.
Finally, the UK equity market does look cheap by international and historic comparison; it needs confidence in the UK to improve, but the collapse in sterling makes buying UK assets much cheaper for international investors.