FTSE 100 has underperformed when you remove the currency tailwind

Rahil Ram, a multi-asset analyst at Legal & General Investment Management, says since the Brexit vote the FTSE 100 has underperformed the major stock markets of the other G7 countries when you discount the devaluation of sterling.

It is just over a year since the UK voted to leave the European Union. While life has not changed drastically for most of us, we have seen some significant shifts in UK financial markets.

Most notably, the pound has fallen by around 15 per cent against the US dollar and 13 per cent versus the euro since the referendum. The cheaper pound has mainly benefitted large companies with significant operations abroad. When translated back into sterling, those overseas earnings are now worth more than they were before the big depreciation.

That currency tailwind has been reflected in a total return of over 20 per cent for the blue-chip heavy FTSE 100 index. Does this mean that UK equity markets are celebrating the pending departure from the EU? Not really. When measured in US dollars, the performance of the FTSE 100 has lagged behind the performance of equivalent blue-chip indices in every other G7 country.

Sector winners and losers

A sector breakdown of the FTSE 100 shows that financials and consumer staples have been the two best performing sectors, while telecomms and real estate have been the worst laggards.

Ranking the individual stocks into the top and bottom 10 performers shows the top 10 performers have benefited from deriving most of their revenues from foreign sources (approximately 80 per cent) whereas the opposite is true for the worst 10 performers (approximately 30 per cent).

Ahead of the referendum, the Treasury warned about capital flight and higher interest rates in the event of a vote for Brexit. Instead, the opposite has happened. Gilts have posted positive returns of 6 per cent since last June, due to both the Bank of England’s decision to cut base rates and to extend its programme of quantitative easing. Increased ‘safe haven’ demand resulting from the uncertain economic and political environment in the UK has also been a factor.

In the immediate aftermath of the Brexit vote and the few ensuing months, retail investors reduced their stock market and property exposures, while fixed income and mixed assets saw higher positive flows than usual due to their lower risk and higher diversification properties.

However, since December 2016, equities have been registering strong net inflows again. That has been both driven by, and has contributed to, the strong performance of the stock markets.

cautious outlook for growth

Although we do not anticipate a collapse in the UK economy, we are cautious about the outlook for growth. It is also unwise to extrapolate the performance of the financial markets over last year into the coming twelve months.

The next year sees the UK faced with ongoing (and increasingly difficult) Brexit negotiations, greater political uncertainty, a complex domestic economic environment, with all of this against a fickle global economic backdrop.

The result of the recent snap election is unlikely to shift the momentum of the economy, but the risk is that the increased uncertainty associated with a hung parliament acts as a brake on both investment and consumption. This has kept sterling trading within very narrow ranges lately.

Other factors, like the mixed US economic picture and increasingly strong euro zone data, will also have an impact.

The recent uptick in inflation can mostly be attributed to currency weakness. However, it has still raised alarm among members of the Monetary Policy Committee, with some previously dovish members considering a shift towards tighter policy.

If this materialises, it is likely to adversely affect the country’s prospects given the uncertainty remaining over the UK economic outlook for the foreseeable future.

So-called ‘soft’ and ‘hard’ Brexit have very different implications for growth, inflation and asset prices.

There is very limited visibility on where the negotiations settle but we know that the clock is ticking until the March 2019 deadline for the UK to leave the European Union. Rather than try to look into a Brexit crystal ball, British investors should instead structurally diversify that risk by holding a basket of global assets.

They then need to consider carefully how to treat the associated foreign currency exposure. The case for accepting the foreign currency exposure is tempting given the risk of further idiosyncratic shocks ahead.

However, in our judgement, the case for additional hedging (i.e. neutralising the foreign currency exposure via an offsetting currency transaction) arguably looks even more attractive given that sterling has taken such a battering over the last twelve months.

There are no easy answers in this debate given the uncertainties ahead. But, to only slightly paraphrase Hamlet, “to hedge, or not to hedge, that is the question”.

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