Yields, Exchange Rates and Equities

by George Hatjoullis

The UK EU referendum produced an instant mark down of sterling. The mark down does not represent a view of what sterling should be worth after exit from the EU. No one has a clue what this should be. If one believes the Brexit camp sterling might be stronger than prior to the vote. The mark down represents an insurance premium against the uncertainty generated by the vote. As the uncertainty dissipates sterling ought, other things being equal, recover. Uncertainty can dissipate simply with the passage of time. Sterling will thus be prone to rally from the recent lows in the absence of some new shock.

The sterling mark down generated a parallel markup of the sterling value of foreign currency denominated assets and revenues. Equities that represent exposure to foreign currency were marked up. This would be equities that have overseas assets and overseas earnings. Indices such as the FTSE 100 have experienced a strong rally since June 23 in part because of this sterling effect. The corollary is that the indices should drift off as sterling recovers.

The impact on this sterling effect on individual portfolios will depend upon the structure of these portfolios and the nature of any hedging undertaken. One of the advantages of the simple asset allocation model I have advocated in previous blogs is that you have a better handle on your currency exposure and can see what is causing variation in your portfolio. This is not always obvious in actively managed structures.

The sterling shock will impact goods price indices though by how much rather ‘depends’. The BoE has ignored this ‘one off shock’ though I am not convinced that it should. If the price effect of the sterling fall is ‘damped’, then it is fine to ignore. However, if it is not then the BoE should take it into account when setting policy. It seems to have concluded that the shock will be ‘damped’ and ignored the possibility of a ‘spiral’. The BoE is probably correct to do so for now. Nevertheless, it does raise question marks about whether it should have cut rates further. Unchanged might be the wiser response.

The distribution of gains amongst individual stocks has been quite varied. Not ony was a currency affect evident but also an interest rate effect. Financials and especially banks performed poorly. Bank profit margins are being eroded by very low interest rates. Banks globally appear to have performed better in August as the Federal Reserve has signalled an eagerness to raise rates given a plausible excuse.

The low rates have been matched by long-term bond yields. This has, at least in the UK, put enormous pressure on corporate defined benefit pension schemes. These schemes are simply deferred income and a liability of the corporation providing the scheme. The schemes are not fully funded and the liability gap, the present value of promises minus the present value of assets committed to the scheme, grows as long-term bond yields fall. Growing liability gaps puts pressure on corporate distributable profits. The corollary is that if bond yields rise, the liability gap will fall, other things being equal.

The purpose of my little wander through the obvious is to talk about diversification. One can look at diversification in terms of the so-called Markowitz framework. This considers the historical standard deviation of the component assets and shows that it is possible to combine assets such as to reduce historical standard deviation without loss of historical return. This would be fine if history was a guide to the future (and the regulator is forever reminding us that it is not). We could then construct an efficient portfolio that maximizes the return for a given level of risk. This is not a bad place to start but there is much more to diversification.

First, which risk are you trying to reduce? Let us say it is a rise in interest rates. Generally rising interest rates are deemed bad for equities though as I have demonstrated in previous blogs this does not follow at all. Second, which interest rates? The interest rate on a deposit is not the same as that on a 50 year bond. You have to decide what is happening to the yield curve, the spread between long and short rates. It is possible to calculate the historical relationship between interest rates and yield curves and individual stocks and use this history to construct a portfolio that is especially efficient with respect to a rise in interest rates and a steepening of the yield curve. In other words maximizes return for the given level of exposure you choose. Of course history may still be a poor guide but qualitatively we can see how such a portfolio might look.

If you expect, fear, or just want to hedge against a rise in UK interest rates (or more precisely, expectations of a rise in interest rates) then you would be overweight financials, overweight stocks with defined benefit pension deficits and underweight stocks that have large overseas earnings. Rising UK interest rates might accelerate the recovery of sterling. Should you be worried about rising UK interest rate expectations in the immediate future? Probably not. However, it does provide an interesting perspective for anyone currently owning a portfolio of individual stocks. Most important, if you can work this into your stock selection without significant opportunity cost then it can add some value.

 

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