Fall in £ will boost UK market

The risk of a sharp fall in the Pound this year is gaining credibility. A continuing trade deficit, combined with declining North Sea oil production, poses a big challenge. And politicians might even encourage a weaker Pound to restore competitiveness and revive the UK economy. That worked immediately after the 2008 financial crisis. This time round devaluation might not be so readily controlled. Yet, so far, the market reaction has been surprisingly muted. Why is it that currencies are so difficult to factor in to investment strategies?

Psychology is certainly at work; many analysts are good with company data, but uncomfortable with currencies. It seems easier to work with the known numbers, rather than a new environment. Behavioural finance recognises this tendency to lock-on to the status quo as anchoring.

The timescale for forecasting exchange rates and incorporating them into earnings forecasts does not match the normal company results cycle. Whether companies have overseas earnings, or are exporters or importers, the impact of currency is complex. Much depends on pricing power and how global the input costs are. It is not always easy to identify the location of the ultimate customer. Since this may take further meetings with the company to determine, it is easy to see why analysts are reluctant to incorporate potential currency moves. It is simply a break with the normal routine. Why mix up detailed analysis of company numbers, with macro-economic guesswork?

The recent strength of domestic UK businesses, such as retailers and other consumer sectors, suggests a much lower Pound is not yet in market thinking. A devaluation would squeeze consumers, reversing last year’s pick-up in spending power. Certainly, a few retailers are being helped by lower competition, but it will be a tough environment for some of the big national chains. Earnings for the general retail sector correlate strongly with the level of Sterling, albeit with a delay.

The need for a lower Pound was highlighted by the MPC, which noted that over the past four years, UK costs have risen faster than other countries. There has not been sufficient internal devaluation of real wages, relative to productivity, to boost competitiveness. Removing the substantial UK trade deficit against a background of low domestic activity, will involve grabbing a bigger share of world growth. In contrast, some of the southern European nations, and France, could lose out following the recent strength in the Euro.

Fortunately, the global economy is still expanding, and exports should win from a lower Pound. Already some of the small and mid-cap exporters and those with significant overseas earnings, have been picking-up. These could get a real boost if the move accelerates, and the right value of the Pound could be at least 15% lower. Parity with the Euro is a real possibility. Japan has set a precedent, with a big boost to corporate earnings after the fall in the Yen.

The view from the US and Europe seems to be that a run on the Pound, along with a challenge to UK government funding, is the inevitable result of its stance on Europe. But, closer integration with a Europe that is simply muddling through its crisis, may not be the right strategy. Overseas views on UK prospects look too negative.

Markets that reflect company news instantaneously, rarely allow investors the luxury of delay. But, there is every sign a weaker Pound has not yet been fully factored in to share prices. The psychological bias that centres forecasts around the status quo has delayed market adjustment. British manufacturers and exporters look undervalued. It is not too late for investors to act.

This article is for informational purposes only. The opinions in this article are the author’s own. The information presented in this article has been obtained from sources believed by the author to be reliable, however, he makes no representation as to their accuracy or completeness and accept no liability for loss arising from the use of the material. Colin McLean may have an investment in any of the companies mentioned in this article.

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