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Stronger pound the ultimate test for UK blue-chips

There is nothing like a surge in the pound to remind UK equity investors that they take their eyes off the currency at their peril. Sterling’s rise after Theresa May’s call for a snap election left the FTSE 100, home to many multinationals that earn revenues overseas, nursing its third-steepest daily drop since the Brexit vote.

Its weakness continued on Wednesday, with the index erasing its gains for the year, and finishing 0.5 per cent lower at 7,114.36. Just a month ago, the UK’s blue-chip share index basked in record territory. While further sterling strength will be a headwind, it is not the only factor for investors weighing whether to increase or cut their exposure to UK equities.

Sterling’s rise this week comes against a backdrop of unease that equity market valuations are frothy, leaving them vulnerable to a bigger setback if global growth slows. A decline in the price of iron ore, a key ingredient in steel and seen as a proxy for the state of China’s economy, was hurting the FTSE 100’s coterie of global miners on Tuesday before Mrs May called for an election.

A glance at the best-performing FTSE 100 stocks this year underscores the importance of the miners to the fortunes of the index, with two making the top 10.

Brendan Mulhern, a global strategist at Newton Investment Management, points out that the tailwinds that developed stock markets, such as the FTSE 100, have enjoyed from economic stimulus in China and monetary policy in the US are fading at the same time.

“The confluence of big worldwide currents on the FTSE 100 is a more important factor than the timing of UK elections, given the truly international nature of the index,” he says. “Markets are also realising that the ability of a US president to enact policy is limited.” Mr Mulhern cautions given Donald Trump has so far not delivered on his promise of tax cuts and infrastructure spending.

Even before the latest twist in Brexit politics electrified the pound this week, there were signs investors were already uneasy about UK stocks. They are the least favoured in Europe, according to a monthly survey by Bank of America Merrill Lynch, which polled investors in the week leading up to Easter.

If UK equity investors need to keep a particularly close watch on Chinese appetite for commodities, the FTSE leaderboard also shows that the health of the domestic economy cannot be ignored. Housebuilders Taylor Wimpey, Persimmon and Barratt are all among the top 10 gainers this year, as the economy has broadly defied pre-referendum forecasts of a sharp slowing.

The outlook for those stocks dependent on the UK economy — of which there are more on the mid-cap FTSE 250 index — will be defined in part by the nature of the exit and future trade deal the UK government can secure with the EU. The mid-cap index is up 7.4 per cent this year.

While there is a strong consensus that Mrs May is favourite to win a bigger majority at the June 8 election, investors are sceptical that any push by the prime minister towards a softer Brexit will have an immediate effect on a UK economy that in recent weeks has shown some signs of slowing.

Analysts at UBS reckon any ambition to use the election to try to “dampen the influence” of those MPs seeking “the hardest form of Brexit” will have a limited impact on the economy for now. “Slowing growth in real incomes is already under way and will probably drag economic growth down this year relative to last,” they note.

James Illsley, manager of JPMorgan Asset Management’s UK core equity fund, says that while the UK consumer has been “remarkably resilient,” inflation looks set to rise more quickly than wages, leaving consumer-facing companies at risk of a drop off in spending.

The relationship between pound and UK stocks has been writ large again this week. While the FTSE 100 is facing drags, the relative weakness of the pound against other currencies — it is still down 14 per cent against the dollar since the Brexit vote — may ironically still offer some support.

“While the pound’s strength is a headwind, its undervaluation continues to support competitiveness and will lift the earnings of international companies,” says Geoffrey Yu, a currency specialist at UBS’s UK wealth management office that forecasts the FTSE 100 will reach 7,550 in six months.

Either way, investors need to keep watch on the currency.