Third time lucky

And so, we enter the era of the third new Prime Minister and Chancellor in as many months. Messrs Sunak and Hunt inherit the unenviable task of trying to clean up the shambles of Liz Truss’ mini-budget and the government paralysis that came about from the infighting amongst the Conservative Party. The red-tops seem split between euphoria at having what seems like a competent and fiscally astute pair at the top and those who claim the austerity that certain departments will have to undergo are all of Sunak’s making during his time as Chancellor. The latter view seems a little unfair given that his profligacy saved the livelihoods of a large percentage of the population during what was surely a textbook Black Swan event, however, the time of the government being prepared to bail-out everyone and everything has passed and a much overdue return to self-sufficiency now awaits those companies that only survived on life support.

But what of Sterling, that seemed headed for parity against the Dollar post Kwasi Kwarteng’s mis-placed attempt to kickstart the economy?

The correction in bond yields and the value of Sterling against most major currencies has been almost as dramatic as the fall as the market came to realise that the days of Prime Minster Truss were numbered, and Sterling versus the Dollar is now above where it was prior to the mini budget. The jury may still be out as to whether this is just a relief rally or a fundamental bottom, but we believe that despite the dire economic data coming out of the UK, there are some good reasons why we may well have passed the floor.

For bond yields to reduce and the value of Sterling to appreciate international investors have to believe in the prospect of an orderly functioning market without the Bank of England having to step in with extraordinary measures and a credible fiscal policy from the centre. The mini budget may have accelerated a trend, but as the chart above shows, bond yield and the value of Sterling had both been trending in their respective directions for almost a year.

Bond yields at 3.5% are high for those who have only entered the market in the past 13 years, however the 1%-2% range which those entering the market since the Financial Crisis have become accustomed to are the abnormal, not the current rate, and inflation is not the culprit, but the artificial market produced by Central Banks continuing with Quantitative Easing for longer than was probably necessary. Prior to the Financial Crisis 3.5% would have been seen as a particularly low bond yield and still below the prior low of 3.9% registered in 2003, and by way of comparison on Black Wednesday in 1992 when Sterling faced another existential threat post the withdrawal from the European Exchange Rate Mechanism, yields were running at 9.3%.

For Sterling, almost reaching parity is exceptionally rare, as between the Second World War and the Financial Crisis the previous low was 1.6% in 1985. The exchange rate against the Dollar needs to be considered in combination with the Dollar against other major currencies (DXY) index which has appreciated by over 20% since July. The rate of appreciation is almost unprecedented, and while it can be argued that the US economy remains stronger than most other nations as the global economy starts to contract under the weight of inflation, and geopolitical tensions, there are strong arguments to be had that perhaps the exchange rate is a combination of UK malaise and Dollar overvaluation. Unfortunately, while geopolitical threats exist, baring the US falling into a deep recession, the Dollar is likely to remain strong as it remains its perception as a safe haven currency. The issue of being regarded is a haven currency is one those of us who are UK nationals but based in Switzerland are only too aware of, in this Fund Manager’s lifetime alone the Swiss Franc has appreciated by almost 400%.

One biproduct of Sterling being undervalued is that UK companies, of which many can be considered world class, trade at a generationally large discount to their multinational peers; it would be surprising if overseas companies, private equity and investors are not running their slide rulers over the UK and considering the opportunity. To date, the economic and political uncertainty has led to UK equities being shunned in the most part by these sources of capital, but everything has a price, and we would not be surprised if in the coming months M&A in the UK may start to gather momentum.

If activity capital markets pick up in a significant way, it is highly likely that UK equity markets will start to recover and in turn so to will consumer sentiment. While we recognise the impact of inflationary factors such as energy costs that have led to a cost-of-living crisis in the UK, we believe that the previous administrations were in a large part responsible for the historically low consumer and investor sentiment in the UK.

UK investors have benefited from the strength of the Dollar over recent times, and most global funds are overweight the US in country of listing basis. While we do not disagree that most world-class quality companies can be found in the US, the strength of the Dollar is starting to have a noticeable impact on the Free Cash Flow of those multinationals with significant overseas earnings and perhaps now is the time to increase exposure to UK corporates and Sterling.