What position should we take on sterling?

OPM’s Ross Henderson explains why he is recommending a negative stance on sterling.

Since the onset of the credit crisis sterling has steadily declined against most major currencies. Given the political and economic backdrop, it seems unlikely it will stage any meaningful recovery against other leading currencies. Indeed, at OPM Fund Management we see more risks to the downside with further weakness a more likely scenario.

Despite recent GDP figures indicating the UK had officially moved out of recession, the numbers were hardly encouraging with a mere 0.1% rise quarter on quarter. Since then we have seen more negative economic news than positive, with poor retail sales figures and rather grim looking public sector deficit numbers.

Indeed, Mervyn King added to the uncertainty when he admitted to the Treasury Committee that the UK economy was “fragile”. While he understandably refuted suggestions the nation could lose its AAA status, this is not impossible.

Given the fact low or below trend growth rates are likely to remain for some time to come, we do not see any significant rise in interest rates during 2010. Expectations of rate rises will periodically occur, but generally we see the underlying weak condition of the UK economy limiting any upside and this will put further pressure on sterling. If traders decide the euro is more the currency of Germany and France rather than of Greece, then the pressure could switch to sterling. With uncertainty over the election and the possibility of a hung parliament, sterling seems unlikely to gain many friends.

Looking to emerging markets

The decision over which currency among the developed nations one should back is less obvious. At the present time, we are keen to support a number of emerging market currencies, in particular those that were less impacted by the credit crunch.

Some of the commodity-rich countries among the emerging markets continue to have strong domestic consumption and far fewer structural problems than their developed counterparts.

Turning to the US

Given that we expect to see volatility to rise in global markets we do feel there is merit in owning dollar-based assets. Despite the problems in the US, the dollar retains its status as the currency of choice in troubled times. There have already been hints interest rates in the US will rise and we expect rates to do so sooner and faster than in the UK.

The euro is arguably overvalued and concerns over a number of the weaker nations such as Greece and Portugal is hardly an attractive backdrop. Despite this, in the short term, the relative size and strength of the German and French markets may provide support to the currency, particularly if more positive news comes through from the laggard economies.

There are various ways of reflecting a negative stance on sterling within funds and client portfolios. The most obvious way is to invest more in unhedged non-UK assets, although this can sometimes be restricted by the investment mandate or sector restriction. There are, however, other ways of skewing the bias away from sterling based assets.

A number of UK-domiciled funds have recently been launched that allow currency positions to be a major feature. Standard Life GARS and Legal & General DART funds are two that have taken advantage of changes in UCITS rules, although currency may be only one of a number of strategies. Another area gaining support has been emerging market bond funds where both local currency and dollar denominated funds look worthy of consideration.

Overseas opportunities

Within the London Stock Exchange, there is a host of overseas investment opportunities, ranging from foreign companies with listings in London to the large number of companies which derive the majority of their earnings from overseas. While technically this can diversify away from reliance on the UK economy and sterling, it can still leave exposure to general UK market risk and sentiment. A number of quoted companies pay dividends in dollars that again can be a useful way of building up overseas currency.

The recent development of the Exchange Traded Currency (ETC) market has been particularly interesting for multi-asset investors. ETCs can provide long or short passive exposure to currencies in a single trade, without the need for complex trading and futures management. They can be used either to hedge existing positions or to enhance potential returns. While issues such as counterparty risk must be considered, ETCs can be effective in providing a liquid and cost-effective asset that can reflect macro-economic and currency views.

Given the current outlook, it seems sensible to reduce exposure to sterling as the uncertain economic and political outlook is set to be a feature of 2010. A UK investor needs to think globally, not only for stocks and shares, but also currency allocation.