Sterling fell sharply after the referendum, but it is on the slide again – and this is highly likely to continue as three forces come together. Clear signs that the government is going for a hard and fast Brexit, plus a shift from austerity to fiscal stimulus mean that to attract overseas buyers to UK Gilts will need lower sterling and a steeper yield curve.
Autumn Statements are not usually renowned for their weighty content. But this year could mark a turning point. While newly appointed Chancellor Philip Hammond has paid lip service to the need to ‘keep the lid’ on day-to-day spending, he’s more focused on the prolonged uncertainty that will ensue pre- and post-triggering of Article 50.
Suddenly, the need to eliminate the budget deficit by 2019-20 has vanished. In its place the Chancellor is talking of the need for ‘targeted high-value investment in [our] economic infrastructure’. The baton is slowly passing from monetary stimulus to fiscal.
The Autumn Statement will reveal the extent of fiscal stimulus. Will it be fiscal-lite…or fiscal-heavy? A modest attempt to put pounds in consumers’ pockets by lowering petrol duty, or rouse a slowing housing market by cutting stamp duty? Or could it be something larger and much more significant: massive issuance of UK Gilts to fund large-scale infrastructure projects? The effect of the latter would be to unwind the huge compression we have seen in bond yields courtesy of central bank manipulation of bond and equity markets.
A fund which benefits from a rising bond yield environment
Either way, the budget deficit is not going to be falling as quickly as previously intended – and it could even start to widen again – no doubt temporarily, it will be argued. The resultant supply of UK bonds should cause the yield curve to steepen much more than we have witnessed thus far. The rhetoric from the US Federal Reserve is becoming more hawkish and even the European Central Bank is muttering about tapering its QE. Wary though one is of calling the end of the 30-year bond bull market – we have tried and failed before – but it seems likely we are heading into an environment of higher bond yields. Rising bond yields of longer-dated maturities would be a way of restoring confidence in UK banks through improved net interest margins and, hence, profitability. Either a steepening yield curve or a further lifting of US interest rates would mean that excess deposits of major banks such as HSBC would finally start to earn money. Both scenarios are notable tailwinds for our holdings in banks and financials, an area that accounts for over 20% of the fund.
Investors might even wake up to the fact that, unlike their eurozone peers, UK banks are well capitalised, have significant liquidity buffers, and have passed vigorous stress tests.
A fund positioned to gain from weaker sterling
The government’s hard line on Brexit, the probability of Britain losing its passporting rights into the single market and the clear indifference of the government to the interests of the City suggest that the UK’s current account deficit is also going to come into greater focus. It is the surplus on invisibles, of which financial services makes up the bulk, that limits our deficit to the levels it is currently. Put that in jeopardy and markets may well demand a significantly lower exchange rate to attract buyers to UK Gilts. The sterling/dollar rate fell from 1.50 to 1.30 in the immediate aftermath of the referendum result – it could well fall to 1.15 or lower in my view.
With around 50% of the fund’s holdings in US dollar-related stocks, there have already been meaningful currency upgrades from many of the large-cap, overseas earners including Glencore, GlaxoSmithKline and AstraZeneca.
There are additional, more fundamental reasons behind the upgrades. In the case of Glencore, the company has worked hard to re-introduce balance sheet discipline. A capital raising, disposals, and a suspension of dividends last year and this should result in a resumption of dividends next spring. GlaxoSmithKline is benefiting from strong growth from its HIV franchise, has seen the end of a multi-year run of profits downgrades, while AstraZeneca is making impressive strides with its immunotherapy treatment for lung cancer, giving grounds for optimism that dividends are sustainable going forward.
A fund aimed at exploiting growth and recovery opportunities
Up until now, those companies that have produced solid, dependable earnings growth, irrespective of the vagaries of the economic cycle, have been well bid. In their search for quality yields and earnings streams, many investors (ourselves not included) have turned a blind eye to valuations. It is too early to say whether or not some of the performance of defensive stocks will unwind relative to their financial and cyclical counterparts. However, it is encouraging to see how the slightest shift in bond yields (as we saw in the first week of September) can have an almost disproportionate effect on ‘bond proxies’. While I am wary of bond proxy companies, particularly in the consumer staples sector, I do not avoid growth companies per se. I have some reassuringly expensive growth companies in my portfolio, such as global information services group Experian, and secure payment processors Worldpay. However, given my long-term investment horizons I am happy to invest in unloved, unwanted companies where I think true value exists and which stand to benefit from minimal pick-up in economic activity.
We may be sorely disappointed by the content of the new chancellor’s first Autumn Statement. We may be subjected to an infinite drip-feed of news on public investment projects, rather than one large injection. But one thing is certain. We are nearing the end of the effectiveness of monetary policy as we know it. Quantitative easing has become counterproductive. Change is afoot – and that means a change in the type of stock market winners.