Sterling strikes back

In the run-up to to the EU referendum on 23 June 2016 – and in the months that followed – uncertainty gripped the UK market and overseas capital took flight. This led to the value of the sterling plummeting by an eye-watering 7.63% against the US dollar overnight¹.

The value of the pound relative to the dollar continued to fall and, by the middle of October, sterling had fallen by 17.15%² – a drop which was exacerbated by Theresa May’s announcement that she would trigger Article 50 by the end of March 2017. This sparked fears of a hard Brexit and led to the currency freefall, which meant the pound was within touching distance of reaching its lowest level since 1985.

This then bolstered the performance of the FTSE 100 index, as many UK blue-chip companies derive their earnings from overseas – they therefore incurred costs in cheaply-valued sterling and received revenue in US dollars.

Fast forward to today and currency valuations look very different. Research from RWC shows that, in 2017, the US dollar fell by 10.7%, which is the currency’s worst year since 2005³. The investment service company said this was likely to be the result of downside inflationary surprises in the country over the course of the year.

Because of dollar weakness, sterling is now up 12.84% on a relative basis over the last 12 months⁴. In fact, it is largely back to where it was before its June 2016 nosedive.

What does this mean for my portfolio?

Watching currency fluctuations and tying them into the macro backdrop is all well and good, but what does the sterling bounce-back actually mean for UK investors?

From an underlying stock perspective, how you position yourself largely depends on whether you believe the dollar weakness relative to sterling is temporary.

For instance, if you think sterling only looks strong because of a temporary blip in the dollar, now may present itself as an opportunity to buy into funds with an overseas tilt. This means that, if the dollar recovers, they will benefit from an added uplift. Funds we like which have significant overseas revenue exposure include Threadneedle UK Extended Alpha and TB Evenlode Income.

For those who believe the weakness of the dollar relative to the pound is more of a long-term fixture, equity income exposure needs to be monitored carefully. Before the EU referendum, dividend cover across the FTSE 100 companies looked rocky. When sterling fell, however, this bolstered the balance sheets of many firms and therefore helped them with their dividend payments.

Of course, if the dollar remains weak from here, this will impact companies’ bottom lines and – once again – bring their dividend sustainability into question.

The best way to combat this is to use funds with solid long-term track records of paying income. A good example is the City of London Investment Trust which has increased its dividend pay-outs for 51 years⁵.

Alternatively, Rathbone Income has managed to increase its dividend during 23 out of the last 24 years⁶.

At the risk of sounding like a broken record, diversification in today’s environment is key. Widening both your equity income diversification and your underlying revenue exposure is never a bad thing and, given the recent currency swings, could certainly help to protect your portfolio from any nasty surprises.

¹Source: FE Analytics. Total return in US dollar terms. Correct from 23 June 2016 to 24 June 2016

²Source: FE Analytics. Total return in US dollar terms. Correct from 23 June 2016 to 31 December 2016

³Source: RWC http://www.rwcdr.co.uk/Docs/18.01_RWC_Emerging_&_Frontier_Markets_-_Q4_17_Investor_Letter.pdf

⁴Source: FE Analytics. Total return in US dollar terms. Correct over one year to 31 January 2018.

⁵Source: The AIC. https://www.theaic.co.uk/sites/default/files/hidden-files/AICDividendheroesJan18.pdf

⁶Source: Rathbones. https://www.rutm.com/downloads/fund-related/investing-for-income-11-2016_100845_en-gb.pdf?isTracked=1