Take equities first. Since January 1991 there has been a significant positive correlation (0.37 in monthly data) between annual changes in sterling's trade-weighted index and in the All-Share index. Falls in sterling are more often than not associated with falls in share prices. This was most spectacularly the case in late 2008, when then financial crisis caused shares to slump and sterling to fall as traders closed carry trades. But we've also seen the two fall together in late 1998, 2002-03 and in the summer of 2011.
There's a simple reason for this. The circumstances in which sterling falls are often circumstances that are bad for shares - weak UK growth and increasing risk aversion among global investors which causes them to prefer safer currencies such as Swiss francs or US dollars. (Granted, we shouldn't rule out the possibility that another leg of the euro crisis would hit shares, but the experience of its previous episodes suggests such a crisis might have much effect on the sterling/euro rate.)
However, sterling and shares don't always fall together: the correlation is 0.37, not one. Most obviously, the pound's fall in 1992 when it left the exchange rate mechanism was great for shares because the devaluation and the fall in interest rates that accompanied it raised hopes of an economic recovery.
This poses the question: if the pound continues to fall would we get a repeat of 1992 or of the more usual pattern in which a falling pound is accompanied by poor equity returns?
My suspicion is the latter. The fact that we're at the zero bound means that looser monetary policy now would do less to increase growth expectations than it did in 1992; back then, Bank Rate fell from 10 per cent to 6 per cent within a few months, but we will not see that sort of monetary stimulus this year. And with export volumes being relatively insensitive to exchange rate moves - and having a high import content - any fall in sterling will not do much to raise hopes of export-led growth.
Turning to gilts, you might be surprised. There's a small positive correlation (0.17 since January 1991) between annual changes in sterling and in 10-year gilt yields. Slightly more often than not, gilt yields fall when sterling falls.
This is for the same reason that shares usually fall - the weak growth and increased risk aversion that's bad for shares and the pound is often good for gilts, as they cause a flight to quality.
Although this relationship isn't strong, it is revealing. This low positive correlation tells us that while investors sometimes worry that a falling pound would add to inflation, they don't usually do so very much. It also tells us that falls in sterling are rarely accompanied by an aversion to UK assets generally; if this were the case, we'd see gilt yields rise as sterling falls, but this happens in only a minority of cases.
I suspect the majority of history will repeat itself. The likeliest cause of a weak pound would be disappointing UK growth or looser monetary policy, perhaps in the form of more quantitative easing, either of which would be good for gilts. And it's unlikely that the pound's fall would add so much to inflation as to greatly trouble the market.
You might think the best thing you can do if you expect sterling to fall would be to hold gold, simply because its price in sterling should rise as the pound falls against the US dollar.
History suggests you're generally right. The correlation between annual changes in sterling's trade-weighted index and in the sterling price of gold since 1991 has been minus 0.62. Falls in sterling such as in 1992-93 and in 2008 have usually seen gold do well in sterling terms.
The message, then, seems clear. If you expect sterling to fall, you should be wary of UK equities, should hold more gold, and be more or less content to hold some gilts.
Except for one thing. It's unwise to base asset allocations upon a forecast of exchange rates, simply because these are fundamentally unpredictable, at least at time horizons of the few months which most people think important for asset allocation. Of course, if you look at the UK economy you can see lots of good reasons to expect sterling to fall. But if you look at the euro, Japanese or US economies there are rather fewer reasons to expect it to do so.
Yes, a fall in sterling is a risk - one which you might want to protect yourself against by holding more gold or foreign currency. But you shouldn't bet everything upon it happening.
