Why has the British pound rallied so strongly since the start of the year?
The pound has risen nearly 5.3% against the dollar this year and is up 15% from the start of 2017. It is tempting to see this as sterling strength however it is worth remembering that there are two sides to any currency pair. When we look at the move against the euro, for example, it tells a different story. On this measure the pound is up 1.4% this year and is down 2.7% since the start of last year. So, while sterling has seen a pickup, it is not as dramatic as the dollar exchange rate would indicate. The story is more of dollar weakness and euro strength.
Interest rates have been rising in the US and the economy has been robust, which should have given some support to the dollar. A further boost to the economy, and consequently the currency, should have come from tax cuts and proposed increased spending. However, a greater influence may be coming from the other trading partners. The UK and European economies appear to be doing much better than was expected a year ago, with less political concerns in the latter. Even though the European Central Bank ("ECB") is still some way from raising rates, it has been able to reduce the pace of its asset purchases and thus longer dated bond yields have moved higher. Despite Trump's comment last night that ultimately he sees a stronger dollar, the US authorities appear to encourage the dollar weakness. On Wednesday, US Treasury Secretary, Steve Mnuchin, commented that the weak dollar supports US trade and that weakness was "not a concern" which accelerated the move. This appears to support Trump’s 'America First' policies and his attitude to global trade. Davos generally encourages global trade and it will be interesting to see the reaction to his Davos speech. We should hope that this is not the start of a trade war, which would not be good for international markets and Asia in particular.
From a UK perspective, the chances of a softer Brexit appear to be rising and the Bank of England took back the emergency, post Brexit, rate cut in November. Even David Cameron was overheard in Davos saying that the UK economy had not suffered as badly from the Brexit vote as the remain campaign predicted, dubbing it a 'mistake not a disaster'. We are still a long way from a Brexit deal and negotiations will continue to be difficult. The jury is still out and the value of the pound is likely to hinge on the outcome of these talks.
A fall in the dollar is good for US companies who have overseas earnings and make exporters more competitive. So far this year, US equity markets saw further support as a result of Trump's tax changes and have therefore been able to outpace the fall in the currency and generate positive returns for sterling based investors. However as the dollar falls, commodities prices rise considering the global supply chains. The subsequent rising cost of imports together with a tight labour market is likely to push inflation higher, potentially prompting the US Federal Reserve to raising rates faster than is currently priced in. US bond yields have moved higher partly due to rising inflation expectations. For UK listed companies, the fall in the dollar reduces earnings from overseas. The FTSE 100 Index benefitted from a strong dollar and is now suffering relative to other markets as the move reverses.
So can the dollar weakness persist? The short-term outcome may continue to be influenced by political noise making the next move hard to predict. All other things being equal the dollar move may not have further to go. Indications at the ECB meeting yesterday are that authorities on this side of the Atlantic believe currencies should trade freely and not to be subject to political interference. 'America First' policies are unlikely to be met without further opposition.
Have markets become complacent with regard to geopolitical risk?
Over the last two years, terrorist attacks, unrest in the Middle East and threats from North Korea have all, at times, influenced markets. These threats have not gone away but equity markets have generally continued to trade higher. In the past, geopolitical events have had significant short-term influence but it is economic events that tend to guide markets over the longer term. The 9/11 terrorist attacks were one of the biggest events of my lifetime. US equity markets closed for a week and went down 11% in the days after it reopened but still ended 2001 above the level before that terrible day. A war in North Korea could leave many dead and tensions have been high, with raised voices on both sides. However, the Korean Stock Exchange ended the year up 22%, perhaps indicating a lack of concern from those closest to the problem.
While one cannot be sure, it will always be the case, experience leads me to believe, that it is right to look through geopolitical risks and consider the broader economic picture. It appears markets have done just that recently.
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