I wrote recently that conventional economics points to sterling rising – a view with which some of you disagree. This poses the question: what hangs upon this debate? From the point of view of UK stock selection, history suggests the answer is: surprisingly little.
One reason for this is that correlations between FTSE sectors and moves in sterling’s trade-weighted index are low. If we consider monthly changes since 2001, most sectors have negative correlations with sterling, but these are small. The strongest is only minus 0.28, for travel and leisure.
To put this another way, a one standard deviation move in sterling is associated with only a quarter standard deviation move for even the most sterling-sensitive sectors such as oil, travel and telecoms.
The same holds true if we control for moves in the All-Share index. On this measure, most sectors have a statistically insignificant link to sterling: these include miners and chemicals, which might surprise you. Exceptions to these include oils, pharmaceuticals and telecoms, all of which suffer slightly when sterling rises. This is as you’d expect, given that such sectors are big overseas earners. But the effect here is small; a 1 per cent rise in sterling, controlling for the All-Share index, is associated with a less than half per cent fall in these sectors.
| Sectors responses to 1% change in sterling | |
| Oil & gas | -0.33 |
| Pharmaceuticals | -0.31 |
| Travel & leisure | -0.38 |
| Telecoms | -0.47 |
| Banks | 0.41 |
| General financials | 0.44 |
| Controls for changes in All-share index | |
| Based on monthly changes since Jan 2001 | |
Beneficiaries from a strong pound are banks and financials. This might be because rises in sterling have sometimes been a sign of increased appetite for risk among global investors, an increase that isn’t fully reflected in the All-Share index; sterling is a riskier asset than most currencies, and so is sensitive to variations in appetite for risk. Again, though, the effect here is small: a 1 per cent rise in sterling is associated with a less than half per cent average rise in banks.
One reason for such low sensitivities might be that moves in sterling are usually too small for investors to bother with, especially as they are often subsequently reversed. They contain lots of noise and little signal, so should be ignored.
To test this hypothesis, I looked only at months in which sterling moved a lot – by 3 per cent or more. There have been 15 such months since 2001.
These data, however, tell us much the same story. In these 15 months each percentage point move in sterling has been accompanied on average by moves of less than 1 per cent in the opposite direction for most shares – even those such as chemicals, oils, miners and pharmaceuticals, which you’d expect to be sensitive to sterling. These are small effects.
One reason for this is simply that sterling can move for many different reasons: because investors believe it has become misvalued; or because they revise their expectations for UK growth or interest rates; or because they change their view of the eurozone economy; or because appetite for risk changes. These developments would have different implications for shares. This is why economists say you should never reason from a price change: what matters is why the price has changed.
This also explains the share price moves around the time of the vote to leave the EU last year. Sterling’s fall then was accompanied by falls in retail stocks and rises in globalised stocks such as miners and oils. But these moves weren’t solely due to sterling. They were driven in part too by the belief that Brexit would depress UK economic growth - a belief that was obviously bad for domestic stocks.
For me, the message of this is simple. You shouldn’t base you stock selection on a view of where sterling is going. Not only is there a good chance that your view will be wrong, but even if it’s correct shares might not respond very much to your call.
This isn’t to say that investors should ignore the currency market completely. If you’re hoping to retire overseas or to buy a holiday home, you should hold some of the currency you intend to use simply as a hedge against a fall in the pound that would increase your future cost of living. Investing overseas can also protect us from local inflation or market underperformance. And there’s a case for holding foreign currency as protection against falling house prices; sterling has tended to fall when house prices fall.
For stock selection purposes, however, the foreign exchange market doesn’t matter much. This is good news: it reduces the number of things we have to think about.
