Are UK investors ready to pay for 2016’s ‘free lunch’?

Tue 07 May 2019

In 2016 investors in global equities experienced a fretful start to the year as concerns about a possible Chinese hard landing caused a fall of over 10% in the first quarter of the year.

As has been the pattern over the last few years these concerns quickly subsided in the face of continuing ultra-loose monetary policy, and markets quickly rebounded. The year ended with a return of nearly 10% for the MSCI World index.

That is unless that investor was based in the UK and had not hedged out any currency risk. In that case the return on global equities was nearly 30%. The transmission mechanism being Sterling, and its dramatic fall in the run up to, and wake of the EU referendum. The Pound sold off sharply on the morning of the 24^th June, and again following Theresa May’s conference speech to the Conservative party conference which was interpreted as leaning towards a ‘hard Brexit’. UK investors had a free lunch from Brexit if they held overseas assets.

Since the start of 2017 the value of Sterling against other major currencies has been volatile but range bound. During the last three months it has traded at roughly 1.30 to the US Dollar despite, or perhaps because of, the various machinations of the UK’s Brexit negotiations and failure to agree a consensus position in Westminster.

Never in recent history has British politics been so divided across, and more to the point within, party lines. Consensus has been impossible, ministerial appointments have had less longevity than a summer internship, and splits in both major parties have led to the creation of entirely new political parties. Anyone who tells you they know what the outcome of the Brexit process will be (and admittedly I haven’t come across anyone recently who has claimed as much) is deluding themselves. When our team considered the possible routes to Brexit some months ago we ended up with 127 different possible permutations – not a strong basis for making predictions.

And so it is in currency markets. When the latest twist in the Brexit saga – a six month extension granted by the EU – was announced Sterling barely moved. Currency traders, as political commentators and the man on the Clapham omnibus, remain unable to see a likely path to Brexit, whilst trading algorithms are equally unequipped to pick through the headlines.

This lack of direction must not cause UK investors to be complacent. As the graph above shows, ignoring how and when a Brexit resolution might be achieved, when it does come to pass it is a reasonable deduction that currency markets will express a view and probably very quickly. It is also reasonable to suggest that the move could be significant in magnitude.

The Brexit outcome is a binary question with a crash exit on one side and a soft Brexit or indeed Remain on the other. Eventually one of these scenarios will play out, and if the latter does it is reasonable to expect that Sterling will rally on a trade weighted basis. In this event holdings in overseas equities and UK large caps which source their revenue in foreign currencies will lose value comparatively in Sterling terms. Accepting the impossibility of predicting the outcome, some currency hedging for UK investors is surely prudent.

David Baker, CIO