Figure 1-5 day Pound Sterling (b) vs United States Dollar Spot (GBP/USD)
After being suppressed in the lead up to the triggering of Article 50, the pound has now climbed to $1.25854(USD). So my prediction is that we are at the start of a bull run on sterling that will see 40% gains in the next five years. Am I talking rubbish? It’s more than possible! However, here’s why I think I’m right.
Firstly the pound is cheap, it’s as low as its ever been against the dollar, barr a few months in late 1984 to early 1985 when it fell to $1.04.
It’s also low against the euro where it’s sitting at €1.15. Higher than 2009 when it dipped to €1.02, but way below the €1.74 of 2000.
Admittedly the value is less clear if we look at the pound’s PPP (purchasing power parity), which compares the value of different countries’ currencies by taking a ‘basket of goods’ approach where its value is adjusted so that £1 buys you the same quantity of goods, regardless of the country you’re in. Oliver Harvey, Deutsche Bank’s macro strategist, thinks that the pound isn’t cheap on a PPP basis. However, Enigma Investments’ Charles Ekins believes it’s undervalued by 24% against the dollar, and 6% against the euro (which he also reckons is undervalued by 21% compared to the dollar). Ekins calculates that a fair PPP value is $1.63. Whilst the price is what the market says it is and not what I think, it appears that $1.40-$1.50 and €1.25-€1.30 is fair.
Secondly, our worst Brexit fears are now priced in. The pound plummeted after the Brexit result and had another pummelling following the Conservative Party conference at the end of last year.
However there was almost no impact when Theresa May announced that Article 50 would be triggered on 29th March. Given what had happened beforehand you may well have expected Armageddon but the markets seem to have accepted that the UK is leaving the EU. Volatility will still be inevitable every time negotiations come to a stand-off but it does seem like all the major bombshells have now been fired.
Thirdly, inflation is raising its head and last week we saw that February’s inflation (as measured by the Office for National Statistics’ Consumer Prices Index – CPI), rose to 2.3% up from 1.8% in January. This increase has pushed inflation over the Bank of England’s 2% target putting an upward pressure on interest rates. Up until now, the bank has resolutely ignored its own inflationary target, refusing to raise interest rates. However, last week Kristin Forbes, US academic and member of the Bank of England Monetary Policy Committee (MPC), did indeed voted for a rise in interest rates. It was the first divergence of opinion amongst the policymakers since July 2016. Obviously it needs five MPC members to force an interest rate rise and with Carney in charge, there is more chance of me winning the lottery, but nonetheless a vote is a vote.
Fourthly, the economy isn’t doing badly and despite all the doom-mongers, it is conceivable that we may see a post-Brexit economic boom. So if our economy continues to fare well once we’re out of the EU – hold on to your enthusiasm and think Switzerland, Norway, etc. who are all performing well – then there’s no reason why the pound and the UK shouldn’t be on the up. Furthermore, we have a number of European elections coming up and whilst Germany has enjoyed economic growth and high employment, bordering France has fared less well and much of southern European is plagued by mass unemployment. It’s not entirely clear how this will pan out, but I’d say there is more cause to worry about the euro than the pound.
Finally, every eight years or so, the pound seems to take an almighty dive that lasts for several months. It happened in 2008; in the ‘dotcom crash’ of 2000; on Black Wednesday in 1992; during the miners’ strike of 1984; and as a result of the IMF Crisis where Labour chancellor, Denis Healey had to appeal to the International Monetary Fund for a £2.3bn bail-out.
After each of those crashes, the pound then rallied over the next few years by roughly 50% in 1976, 80% in 1984, 25% in 1992, 50% in 2000 and 20% in 2008, giving a mean rebound of around 45%. So, as I said it’s not impossible that we could see a 40% rally, after all we hit $1.70 in 2014.
So what does this mean for property? Whilst it’s encouraging that the markets appear to have adjusted to the effects of the Brexit vote, there are still risks facing 2017. However, the gap between property yields and 10-year gilt yields still suggests property is still attractive relative to bonds. Given the general consensus that there should be a 2% risk premium for property over bonds, to compensate investors for the extra risks associated with real estate, including illiquidity, the potential loss of rental income due to tenant defaults and obsolescence, there is enough headroom for interest rates and bond yields to rise before property looks overpriced.
So if the UK economy grows by 2.5% per year for the next few years, the Bank of England should make a gradual rise in interest rates to 2.0-2.5% in order to rein in inflation. This means 10 year gilt yields should rise to 3.5% by 2018. In addition, the improvement in the economy should be sufficient to maintain rental growth at 2-3% per annum. As a result, investors’ rental growth expectations will remain largely unchanged and some of the predicted increase in the 10 year gilt yields would feed through to real estate yields. There are, of course, a number of associated risks. If the Bank of England doesn’t tighten monetary policy and the 10 year gilt yields hover around 2% for several more years, this might create further falls in real estate yields, however it seems unlikely that the Bank of England would suppress interest rates unless the economy falters. My view is that real estate yields look attractive compared to those on offer in other asset classes, such as bonds and are expected to remain so in the medium term. Ultimately, this would support investor appetite and consequently prices for commercial property. Overly optimistic? We’ll see!