A powerful pound

Following the completion of a raft of corporate earnings reports in the first half of 2014 for UK listed companies, one of the recurring themes as to why earnings had disappointed was the negative impact of a strong pound. Corporate news flow from a wide range of FTSE 100 and FTSE 250 companies has been dominated by talk of currency headwinds, with ailing companies including marketing giant WPP, building products distributor Wolseley, and emerging market fund management group Ashmore, to name but a few. In each case, aside from certain stock specific issues, results were tempered by the strength of sterling and its effect on revenues generated overseas.

For example, if we look at Ashmore, 90 per cent of the group's revenue is generated in dollars, for Wolseley 60 per cent, the impact of foreign exchange on WPP's first half sales was -8.3 per cent. A strong pound also makes the goods and services of UK exporters relatively less attractive, as it makes them more expensive to overseas consumers. The result has been a reduction in profits and earnings for companies exposed to currency fluctuations and in certain cases, investors selling their shares as the investment case worsens. Roughly 70 per cent of revenues of FTSE 100 companies are derived from abroad and when currency movements are particularly volatile, it can clearly have
a significant impact on the market.

Sterling has been relatively strong during the first half of the year
(in particular against the dollar)
for a number of reasons. This includes improving UK economic growth, along with improving industrial production and retail sales numbers. Ultimately however, the primary driver of exchange rates is interest rate expectations, i.e. how base interest rates will move against each other in the future. Rates in Europe, the UK and US are at all time lows and investors have been pricing in a rate hike in the UK before that of our US counterparts. Earlier in the year, Bank of England Governor Mark Carney stated that the bank would not only look at unemployment when deciding on interest rate policy, but a wide range of indicators including wages, productivity and spare capacity within the economy.

The improving backdrop in the UK, alongside comments from the Federal Reserve that they are not in any rush to raise rates, and Europe continuing to ease monetary policy, led to a strong rise in sterling over the spring and summer months. A rate rise in the UK before the US would mean an increase in relative yields, making sterling more attractive. Sterling traded at 1.5888 versus the dollar in November last year, before climbing to 1.7160 in July - a rise of
8 per cent.

More recently sterling has suffered a correction against a basket of currencies, including the dollar (falling almost 7 per cent from recent highs) as the referendum on Scottish independence has come to the fore. Following Scottish voter's 'no' to independence, sterling has staged a small relief rally and some commentators believe most of the expectations regarding potential rate rises are fully priced in, and short term factors have run their course.

One factor that is likely to be more critical in determining inflation and interest rate expectations is wage growth, and the strength of the relative labour markets is likely to be crucial in deciding when rates are raised either side of the Atlantic. Some analysts also believe that at some point, currency markets will have to start accounting for longer term fundamentals. For instance, Britain's current account deficit has been widening while America's narrows, thanks to a lower foreign energy bill as it produces more shale gas onshore. Britain's persistent current account deficit equivalent to 4 per cent of
GDP should put downward pressure
on sterling.

The next point of focus for Britain may now move to the potential for longer term strength of the dollar rather than UK domestic issues. Dollar strength could provide a boost to the UK stock market with its high level of dollar earnings, though any weakness in the euro has the potential to offset this to a large extent. Taking this into account, stock picking is likely to be very important in this kind of environment. Companies which suffered in 2014 could in fact benefit from currency tailwinds as we head into 2015 and beyond; certainly the headwinds mentioned above appear to have dissipated somewhat and investment characteristics will remain critical when deciding where to allocate capital.

Claire Bennison is regional director at Brooks Macdonald in Manchester

She writes a regular in-practice article on asset management for Private Client Adviser