'Pounded' - A Cautionary Tale

June 16th 2009

When we were all staring at our crystal balls at the start of the year, anyone who thought the pound would not fall was thought to be unsafe around pointy objects and was not to be made eye contact with under any circumstances. Since then, sterling has risen more than 12% against both the euro and the dollar, and an eye-popping 22% against the Japanese yen. This is making a big hole in returns from overseas investments. The Nikkei may be back over 10,000 for the first time in 8 months, but it needs to be knocking on the door of 11,000 just to be flat for the year in sterling terms. Gold’s 9% rise becomes a 3% fall and the Dow’s level performance translates into a 12% decline.

The pound is also going to make a substantial difference to corporate earnings. Company after company is currently reporting a boost to profits from the previously weak currency; not only are these gains not going to be repeated, they are in real danger of being reversed. This is a problem: the rise in the FTSE means that it is no longer right in the bargain basement, while rising gilt yields and a general fear of inflation mean that that there is little likelihood of the p/e rising – for the market’s gains to be sustainable, they need to be underpinned by higher earnings. If not quite a spanner in the works, the stronger pound is certainly enough to make a nasty knocking noise in the engine.

It does not help also that just over half the market’s total dividends are declared in dollars. This is tremendous when the pound falls, but the swing in the rate since early January is enough to knock dividends down by 6%. To put it another way, making one or two rash assumptions about the banks, every company that is neither a bank nor paying out in dollars needs to raise its dividend by around 10% or else we shall see a second consecutive year of dividend cuts. How many companies can you think of that have increased their dividend by 10% so far this year?

The pound and the housing market have been romantically involved since Moses was a nipper. Like John Sargeant’s tango, it is impossible to know who leads and who follows, but it is a reasonable assumption to think that the rise in the pound is a decent clue that house prices are rising again. At least some house prices are: it is a mille-feuille of a market with a severe shortage of attractive properties for sale nationally, but with a glut of hideous brownfield city centre flats with panoramic views of inner ring roads and stagnant canals. With mortgage rates already rising and reported to be heading even higher yet, it is premature to think that a sustainable recovery is in the bag. In the UK, just as much as in the US, it is very brave indeed to ignore the chances of a big banana skin before the year is out.