The strengthening of the pound relative to the dollar could undermine the case to allocate money to UK equities, according to BNY Investments.
In a commentary note, senior markets strategist Geoff Yu explained why the prospect of the pound reaching its highest level versus the dollar since 2021 may impact portfolios.
He noted that following a period of matching monetary policy, there is now divergence between the Bank of England and the Federal Reserve. It is being driven by a ‘fundamental difference’ in how the rate setting committees are handling their respective labour markets.
“Sterling’s recent rise can largely be attributed to the divergence in interest rate outlooks,” Yu said. “The Fed cut 50 basis point and will continue to ease up ahead, whereas the Bank of England is proving more cautious about cuts.
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“This shows a fundamental difference in the Monetary Policy Committee and Federal Open Market Committee’s approach to the respective labour markets, and by implication, wage outlook, of the UK and the US.
“In the UK, given the dearth of accurate data due to ongoing response rate issues with the ONS’ labour force survey, the MPC is essentially flying blind but choosing to err on the ‘tight’ side.”
This is leading to pound versus dollar valuations starting to look ‘somewhat excessive’ and has implications for asset allocation decisions.
“The Fed is clear that a hard landing is not the base case for the US economy and the performance of asset markets since points to renewed inflows into local equities and bond markets,” Yu said.
“Furthermore, the weak productivity growth of the UK economy points to more of a stagflationary outcome, which is broadly the market’s consensus on the current outlook.
“This is not conducive for asset allocation and could limit inflows, especially for dollar-based investors who do not find UK pound valuations attractive. Furthermore, the high exposure of the FTSE to overseas earnings also risks downside performance risk and could impact the UK’s financial account as well.”
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