Investment Strategy: Sterling Based

by George Hatjoullis

I have been revising my investment strategy in the wake of June 23, 2016 and thought I would share my thoughts. The first consideration is Sterling. Unfortunately the first rule of FX trading is do not try to pick tops or bottoms so I have no idea how low Sterling might fall. From a UK trade perspective a 20% devaluation is probably sufficient to offset the loss of the customs union so one might conclude the Sterling decline has run its course. Unfortunately FX markets have a habit of overshooting so we could still see lower levels, albeit temporarily. On the upside one does not yet know what kind of trade deals the UK might achieve and this could raise what might be tentatively termed the equilibrium exchange rate. In short if EURGBP rises much above 0.90 or falls much below GBPUSD 1.20 I am inclined to increase my Sterling exposure. By the same token I am inclined to sell any material bounces in Sterling from these levels until the Brexit process takes shape. Given the way FX markets work I expect Sterling to trade weak until Article 50 is triggered (March 31, 2017 ?), providing buy opportunities and rally somewhat afterwards providing sell opportunities. This may sound perverse but markets tend to discount events and this often confuses the uninitiated.

My interest in Sterling is not because I plan to trade it much (though I will have a punt for old times sake) but it is key to everything else in this context. If you have investments in overseas funds the chances are your Sterling gains since June 23 are largely because of the unhedged exposure to foreign currency. Also the rally in FTSE 100 has been primarily driven by the Sterling decline. You may think you do not have currency exposure but you do. Everyone does to some degree. The Bank of England will face a decision as inflation pops up following the Sterling decline (and recent rise in energy prices). The BoE is likely to not respond initially to the rise in inflation but this may not stop the gilt yield curve from steepening. Importantly this will not hurt everyone. Companies with large pension deficits will gain a boost from higher long-term yields and annuity rates should rise. Moreover anyone with RPI linked products should gain relative to the CPI, especially if the steeper curve nudges up mortgage rates. And you thought the Sterling fall did not affect you!

So, what to do? Inflation may be the key issue. The one-off shock may be large but unless the economic mechanism is set to amplify the shock it is not necessarily a concern in the long-term. The absence of labour bargaining power tended to damp shocks in recent decades but has the context changed? Hard to say but with an increasingly hostile environment for immigrants and emboldened local workforce it may be that skill and general labour shortages might just increase the amplification a bit as Brexit takes its course. UK bond yields are now at unprecedented low levels so I am not inclined to sit in bonds in this context. It is cash or something else.

The property market has been very profitable in recent years and now looks stretched in many respects.Residential property is trading at many multiples of average income (on average 10) and this is historically and logically ridiculous. It is offset by historically low mortgage rates and foreign inflows for investment purposes. If mortgage rates do nudge up a bit there could be a problem as most new buyers have little margin for variation. Foreign investors are more difficult to gauge. The decline in Sterling has cut the overseas price of UK property. The State is desperately trying to discourage investment flows into property (without actually prohibiting them) and the Brexit event does rather change the logic of owning UK property for many investors. I hesitate to say UK residential property has peaked but certainly the conditions for it to do so are there. My personl indicator, the Foxtons share price, is making new lows.

My only exposure to UK residential property is my home so there is no adjustment I can reasonably make. I am in effect short as my two sons need to move out. Commercial property however is a different matter. Here I invest through closed-end property funds (if you own an open-ended fund I suggest you revisit). The prospect of Brexit should logically raise the prospect of excess supply as businesses quit the UK. It might be best to limit exposure to this sector until the Brexit process becomes clearer. However, it might also pay to look at your fund(s). Some funds may look to increase exposure in overseas growth markets. UK commercial property may come at better yields down the road so I would be inclined not to be overexposed to UK commercial property at the moment but look to get in at the ‘right price’.

Finally, we come to equity. This is, as I have noted, complicated by the currency decision unless one can efficiently overlay a currency strategy. In theory I am able to do so but in practice I am disinclined. It is unlikely that equities will be immune to a steepening yield curve. Moreover the currency issue is forcing me back into UK equities at the moment. This may not be such a bad thing. UK equities may well outperform (currency adjusted) in the coming year. For the moment I have settled for a 70% cash and 30% equity exposure with the bulk of the equity in UK listed companies. The intention is to increase equity and other exposures at better levels. In an uncertain world it is not what you are doing so much as what you are positioned to do that matters. There is enough equity exposure to cheer me on a continued rally and enough cash to add on a sell off. The intention is to increase non-UK assets (Sterling permitting) and property exposure (at the right price).