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Hard-to-manage risks

Investors should not expect equities to rise if sterling falls because of a no-deal Brexit
August 8, 2019

Would a weak pound caused by a no-deal Brexit be good for equities? Equity investors would be unwise to bet upon this.

History tells us so. There is, on average, only a weak link between sterling’s trade-weighted index and the All-Share index. Since May 1997 the correlation between monthly changes in the two has been minus 0.18. This means that falls in the pound are on average good for equities but only mildly so. They explain only 3 per cent of the variation in monthly changes in share prices, which leaves a lot to be explained by other things instead.

What’s more, this correlation varies a lot, as my chart shows. Each point on the line shows the correlation between monthly changes in sterling and equities over the previous three years. It’s clear that while the correlation between the two has sometimes been strongly negative – such as in the mid-2000s – it has also been slightly positive sometimes. Occasionally, then, falls in sterling have been accompanied by falls in equities: this happened in 2008-09 and in 2015 and indeed in the last few days.

To see why this should be, consider the links between sterling and share prices.

Yes, a weaker pound – if it is expected to persist – raises the sterling value of overseas earnings which should raise sterling-denominated share prices.

But this is not the whole story. Just ask: in what states of the world is sterling likely to be weak?

One is when investors get nervous: because sterling is a riskier currency than other major ones, investors dump it when their appetite for risk diminishes. But, of course, a world of falling appetite for risk is also one in which shares are falling: this is what happened in 2008.

A second possibility, however, is perhaps a greater danger. Exchange rates tend to fall when investors expect weaker economic growth. This is partly because less growth means lower interest rates, but also because if there are fewer transactions in an economy there’ll be less demand for money.

Sterling has fallen recently because markets are unpersuaded by boosterism and believe a no-deal Brexit would be bad for the economy.

This, though, is obviously bad for domestic earnings. It is perhaps, therefore, no coincidence that smaller stocks have underperformed during sterling’s recent dip. It’s also bad news for consumer stocks, insofar as a weaker pound would raise prices and so squeeze real incomes and spending power.

In truth, this is almost certainly even worse news for very small unquoted companies who don’t export, who lack the monopoly power to pass on higher import prices to their customers, and who don’t have the management capacity to cope easily with uncertainty or the need to rejig supply chains. It could be that in harming very small companies a no-deal Brexit would help quoted companies by reducing their competition. But it is dangerous to rely upon this effect.

Net, therefore, while a fall in sterling would – other things being equal – perhaps be good for multinational companies with big overseas earnings (who in fact make up the bulk of the All-Share index) it isn’t so good for equities in general.

Whether this means we should shift our equity portfolios accordingly is, however, another matter. There’s still huge uncertainty about what sort of Brexit we’ll get, and little of use can be said about this. It’s possible, therefore, that sterling would rise if the risk of no-deal recedes, especially if market attention shifts towards the sterling-supportive effect of a looser fiscal policy. As Bank of England governor Mark Carney said last week, if we get some form of Brexit deal, “sterling would probably appreciate".

If this happens, big multinationals would underperform smaller stocks.

Some risks, therefore, are just hard to manage.