Counting currency

British investors may get a shock when they look at their returns this month. For those investing in sterling, overseas stock market performances were downright dismal.

Don’t panic though: there was no abrupt fall in Europe, Asia or the US that you missed. In fact, the S&P 500 actually hit another record high. Like all things, what goes down, must come up – and this time it was the pound’s turn. Sterling has had a miserable time since the Brexit referendum. Valued against a basket of major currencies, it slumped more than 16% and has been trading in a depressed range ever since. That led to some strong one-off gains for overseas assets held in sterling accounts and funds that hold foreign stocks and bonds. That reversed somewhat in September. Sterling rose rapidly to the top end of its recent trading range last month – a 5.2% jump. That meant foreign assets were worth less in sterling than at the start of the month, eating into the returns of overseas share markets. As an example, the Euro Stoxx index rose 4.5% in euro terms last month, but lost 0.2% in sterling.

This may be disappointing for some, but you can take solace in the fact that the pounds you do have are worth more. That should help curb inflation, which has been fanned by sterling’s 18-month weakness, supporting your purchasing power. It may also make your next trip to the Continent slightly less painful.

The reason? After warning for some time on the amount of consumer debt racked up in the UK, the Bank of England suddenly tabled tightening interest rates. The 10-year gilt yield flew from 1.04% to 1.37% in September, while the 2-year jumped from 0.18% to 0.46%.Whether it’s a bluff or not is difficult to say. Several times in the past Governor Mark Carney has turned hawkish in phrase without following up with action. Still, this time round inflation is running hot and the market is inclined to take him seriously. A 25-basis-point rise in November has an 82% probability according to the swaps market. If rates do rise next month, we believe it would have a limited effect on the economy. Monetary conditions would remain much looser than before the referendum, because quantitative easing and the term for lending scheme remain in place.

  Index 1 month 3 months 6 months 1 year FTSE All-Share -0.4% 2.1% 3.6% 11.9% FTSE 100 -0.7% 1.8% 2.8% 11.2% FTSE 250 0.7% 3.5% 6.6% 14.3% FTSE SmallCap 0.2% 3.0% 6.9% 18.0% S&P 500 -2.0% 1.0% 0.1% 14.1% Euro Stoxx -0.2% 5.0% 9.7% 25.6% Topix -2.0% 1.2% 3.2% 12.6% Shanghai SE -4.8% 3.7% 0.5% 8.4% FTSE Emerging -5.0% 4.5% 4.7% 16.6%

Source: FE Analytics, data sterling total return to 30 September 

Debts and a prayer

On the other side of the Atlantic, the Federal Reserve has outlined how it will reduce its $4.5tn of bonds and mortgage-backed securities. It will stop reinvesting coupons and interest payments starting at $10bn a month in October, rising to $50bn in a year’s time. We feel this will have a limited effect on interest rates spread over four years or more.

The main debate is about just how many increases the Federal Reserve will implement in 2018 (it forecasts three). We all know the uncertainties of “data-dependent” central bank actions, but there is a chance that events will overtake the Fed’s plodding cautiousness. President Donald Trump’s tax reform has landed. Well, some of it – there are plenty of details that are yet to be finalised. At the moment, it aims to simplify the tax code to the size of a postcard, streamline deductions, drop many loopholes and create a few more to encourage investment. An admirable, if Herculean, goal.

Despite Republicans controlling both houses of Congress and the White House, there will be bitter fights over this. Like everything, it comes down to money and votes. The plan would cut Federal taxes by $5.8tn and raise an extra $3.6tn elsewhere. That $2.2tn hole has to be funded by greater borrowing. That’s awkward for a party that has lambasted the fiscal profligacy of its opponents for the better part of decade. Some say this void would be filled by extra revenue garnered from significantly higher growth spurred by the reduction in taxes. History hasn’t been kind to this theory. Others say they should balance the budget by slashing entitlement programmes. The 2016 federal budget was $3.9tn, half of that was defence spending, social security and healthcare for the old. There are no votes to be had messing with these areas. If the tax plan is passed, expect a fudge. The tax reductions will have to be pared down or there will be a lot more debt and prayers for higher growth issued by the Republican caucus.

Easier fiscal policy of this magnitude, if it comes, would force the Federal Reserve to tighten its policy to combat potentially runaway inflation.

 

Bond Yields

Sovereign 10-year Sep 30 Aug 31 UK  1.37% 1.04% US 2.34% 2.12% Germany 0.46% 0.36% Italy 2.17% 2.04% Japan 0.06% 0.01%

Source: Bloomberg

Julian Chillingworth, Chief Investment Officer