Paul Mumford, a senior fund manager at Cavendish Asset Management, considers the sectors most likely to benefit from a sustained period of sterling weakness.

While the rapid depreciation of sterling is frequently talked about in macroeconomic terms, investors should consider the consequences. And these are not uniformly negative.

The decline in the great British pound has been a major talking point since the start of
the year, with many suggesting that Britain’s economic recovery will be ‘export led’. The theory is that the increased competitiveness of sterling relative to other Western currencies will give UK companies an edge over foreign rivals.

Looking beyond the pessimism
However, put theory – and the optimism of policymakers – to one side, and the reality of a global slump in demand looks far less rosy. Pessimism is growing. Confident discussions about how currency will contribute to a UK recovery have more recently been replaced by concerns that the UK could be much slower to bounce back.

There is now discussion about whether spooked foreign investors are right to spurn sterling, and what this means in terms of our economic health. Where does the ground lie? What, if anything, does the effect of currency mean for investors, and how should they shape their portfolios accordingly?

Put simply, the currency play is yet to begin to have any decisive, meaningful impact on corporate activity. Data from the Office for National Statistics showed that the UK’s trade gap for goods widened to £7.7 billion in January, up from £7.2 billion in December.

The overall gloom was confirmed by recent figures from the CBI regarding the state of
UK manufacturing, which show that output expectations among UK companies are at their weakest since the survey began back in 1975.

But just because UK companies have not yet enjoyed a discernible boost from the weakened pound does not mean they will not do so in the future. Although we are yet to see a meaningful shift towards the buying of UK goods – and our trade gap highlights our continued reliance on imports – this should start to narrow as global economies recover. Indeed, we are already starting to see the effect of currency creep into financial figures. And this often has ramifications for companies and sectors that investors may not have thought would be affected.

Importers feeling the pinch
The retail food sector is a case in point. Many commentators expected the more cyclical fashion sector to struggle in the recession as consumers’ purse strings tightened, while
food is typically seen as much more defensive. However, CPI inflation data shows that the cost of food jumped 12.5 per cent in the year to February, as the food sector sought to pass on ugly cost increases to consumers.

Just like fashion, the food sector is still heavily reliant on imports, and is struggling in the current economic climate. And it will continue to struggle should it have no alternative but to push up costs for the customer. With most UK workers facing pay freezes, and with cheap supermarket rivals springing up to fight it out in the ‘value’ space, price hikes will not be easily sustained. Correspondingly, total retail sales are falling, by 1.9 per cent in February. Customers are simply putting less into their trolleys.

Positive signs
On the other side of the coin, there are certain players who are already benefiting from the fall in sterling, although they are often being given the sleepiest of reappraisals by analysts.

The positive impact of sterling’s fall tends to be two-fold. Firstly, companies with overseas earnings enjoy the simple ‘translation’ effect from the dollar or euro back to the pound, which may help mitigate a decline in volumes. Certain companies, such as the oil majors, even declare dividends in US dollars, which, in itself, may provide an attractive source of income.

Secondly, there are companies that may enjoy strong overseas earnings that are holding up well. The unglamorous Bunzl is one such example. The disposable cutlery and packaging maker has consistently outperformed the FTSE All-Share over the past 12 months, helped by the fact that its principal markets are in North America and Europe.

Don’t ignore the dollar
To disregard the currency effect is foolish, not least in view of the significance of sterling’s decline – down 28 per cent against the dollar before the recent rally – and the level of exposure UK companies have to overseas markets. Roughly 40 per cent of UK company earnings come from businesses that report in dollars, across the services, IT and manufacturing sectors (the latter of which still accounts for 13 per cent of GDP).

While the UK’s recovery is expected to be one of the slowest, it will be helped by other regions’ buying power when global sentiment turns.

So, what does this mean for the investor? Ultimately, the currency play will necessitate much stronger stockpicking skills, to understand which companies are poised to suffer or benefit. The implications may be subtle and require considerable thought.

For example, some companies with strong overseas markets have historically sought to hedge their exposure to a particular region by taking on debt in these markets. This strategy may have been a good one in the boom, when the pound hit heady heights against the dollar, but will now translate badly and could even undermine banking agreements. Meanwhile, certain industrial stocks may look doubly attractive. Some players, like Morgan Crucible, will benefit not only from the battered pound but also from tumbling oil prices.

The benefits of inflation
The other reason not to disregard sterling as a factor in investment decisions is more of a macroeconomic one. A lot has been made of both deflationary and inflationary effects in the past few months, as the trends in the Retail Prices Index (RPI) and the Consumer Prices Index (CPI) have widened sharply. The RPI, which includes mortgage payments and housing costs, is now in negative territory.

The RPI will tick up when lending resumes, and, indeed, recent mortgage approval data is tentatively positive. The CPI will turn down as lower commodities prices set in later in the year, although commodities are set for a sharp rebound when the global economy recovers. But, all in all, the indices will trend upward given time.

When coupled with looser UK monetary policy, this suggests that inflation is the driving force for the UK economy over the medium term. In this scenario, history has shown us that equities tend to provide the best hedge against inflation, where other investment returns are eroded by rising prices. By contrast, companies are able to pass on increased costs to buyers in a strong market, which helps corporate earnings and tends to push up share prices and overall confidence. Moderate inflation tends to be a good thing for investors.

In today’s troubled markets, the need for skilful judgement of companies and sectors, and the effect of specific market factors including currency, is great. Considering the depressed valuations we are seeing in the market, now is the time for investors to get straight on sterling and the long-term outlook for the UK, to lock in tomorrow’s sources of return.