What keeps me awake at night

Sterling is more capricious than a cat with a vendetta argues David Coombs, our sleep-deprived head of multi-asset investments.

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17 August 2022

We all have things that keep us up nights. For me, it used to be a cat that would regularly clamber on my face at the witching hour. I got rid of the cat – callous*, I know, but it does show that I’m not afraid to cut something that isn’t working.

Still, my sleep has been troubled again lately; this time sterling is the culprit.

Even before last year’s referendum we believed that the pound would become a Brexit barometer. And this is most definitely the way it’s gone. After the leave vote, sterling fell more than 15% against a basket of major currencies. We benefited handsomely from that – as did many other UK investors with substantial foreign assets (and the FTSE 100, with its predominantly oversea earnings). It has since remained in that lower trading range, stoking inflation and giving manufacturers a discount on their wage bill. It broadly ticks higher on conciliatory Brexit news and falls on evidence of cross-Channel antagonism.

Recently, sterling has become a much harder game to play. We think that, on a long-term view, sterling is significantly undervalued. But a lot can happen in the shorter term: unclear and shifting political stances are vying against changeable UK monetary policy; a strengthening Continental economy is clashing with greater political uncertainty in the EU; and unclear US fiscal spending is making it difficult to determine the likely path of US interest rates.

In short, currency markets are more capricious than a cat with a vendetta. And that’s before you account for the – unlikely, but rising – risk of a second referendum on Brexit. Such a vote would play havoc with sterling forecasts.

As the Brexit negotiations have dragged on with little evidence of progress, there have been increasing murmurs about holding another referendum to gauge whether the public is really happy with the path ahead. In my mind, the chance of a second vote has jumped from 10% to 40%. It seems to me that, if a vote were called today, there’s a strong chance that remain would carry the day. That would lead to a rally in sterling, in my view, as the Brexit discount is unwound.

Meanwhile, the UK public finances are straining under lower growth and labour productivity that’s even worse than first thought. The November Budget is looking like another austere affair, which may anger poorer sections of society and the public sector. We may start to see more strikes popping up in the coming months, at a time of dampened economic growth, which could hurt foreign investors’ appetite.

And then there’s the Bank of England. It has to adapt to fiscal policy, but with inflation well above target and growth slowing, it’s backed itself into a corner. Raising rates too quickly could bring on recession and another slump in sterling that would send inflation higher again: stagflation. Still, not intervening may lead to further sterling weakness and make inflation even worse.

All this matters to us when managing our funds currency fluctuations can ruin lots of painstaking work that goes into buying the right equities, bonds and funds. At the moment we have reduced our exposure to the UK economy and sterling earnings considerably, so a snap back in the pound is a material risk to our portfolio. We have hedged most of our sterling assets so we are partially protected if the pound falls, but we would miss out on gains if it rises.

That’s why I’m pondering the pound at night instead of sleeping: sterling is so potentially volatile in either direction.

Unfortunately, we’re stuck with sterling so I’ll just have to deal with less sleep till we get more clarity.

*Ozzy the Cat went to a happy home where he’s pampered by a colleague’s teenage daughter, so no animals were harmed in the making of this blog.

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