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Three sectors to consider if the pound stays strong

Written by: Adam Lewis
Following a prolonged period of weakness after Brexit, sterling has rallied this week after prime minister Theresa May’s decision to call a snap General Election in June. So what types of stocks and sectors should investors be looking at if the rally continues in the run up to polling day?

To date the pound has rallied to around $1.28 versus the dollar and according to AJ Bell’s investment director Russ Mould, movements in the currency markets could well shape short-term stockmarket movements in the run up to June 8.

This is a far cry from June last year, when the value of sterling plummeted after the UK’s unexpected decision to leave the European Union.

“The dominant post-referendum trading theme since last summer has been pound down, stocks up, with overseas plays and dollar earners leading the way and domestic plays lagging,” Mould says.

“If sterling does continue to rally, investors may choose to focus on those sectors that have been neglected since the Brexit vote because of their reliance on the UK economy – namely general retailers, food retailers and the real estate plays.”

Mould says that both the general and food retailers have suffered because the weaker pound has been seen as a contributor to inflation, which has a two-fold negative effect on them.

“First it increases their costs when it comes to importing raw materials and goods from overseas, forcing them to either take a margin hit or raise prices,” he says. “Second, rising inflation crimps consumer spending power, especially if wage increases do not keep pace.”

1. The general retailers

Mould notes that Next, Dunelm and Mothercare are all retailers who have flagged their need to hike prices this year to compensate for increased raw material costs. “So any sustained gains in the pound (still by no means a certainty) could help them both financially and in terms of sentiment toward their share prices,” he says.

Indeed Mould says there is an inverse correlation between the FTSE All-Share General Retailers index and the sterling/dollar cross rate. In other words, the lower the pound the worse the sector does and the higher the pound goes against the dollar the better it does.

2. The food retailers

Mould says a similar pattern can be seen with regard to the UK Food & Drug Retailers sector, where Tesco, Sainsbury and Morrisons are the key quoted players.

“This is not to say long-term issues such as competition from the internet and the battle between bricks and clicks, let alone the challenges to general retailers posed by unhelpful demographics and the concept of ‘peak stuff,’ have gone away,” he says. “But in the short-term the noise created by the currency markets may tempt traders into action and trump long-term considerations.”

3. Real Estate Investment Trusts (REITs) and Real Estate Investment Services

Mould says that both of these sectors took a “drumming” on the back of the referendum result and, unlike the house builders for example, have yet to recapture much of the lost ground.

“If the market decides to start looking for domestic value plays, both areas may therefore come onto traders’ radars, especially as they have already started to run,” he says.

“Besides a focus on the pound (and the prospect that its rally may cool inflation and even further delay any increases in interest rates from the Bank of England) there are three other possible reasons REITs in particular could be starting to make a comeback.”

These three factors are falling bond yields, encouraging transaction activity and attractive valuations.

Mould says: “A fresh plunge in UK government bond yields may be serving to highlight the REITs’ income attractions, as no fewer than nine of them offer a dividend yield of more than 4% for 2017, based on consensus analysts’ forecasts. By contrast, the Bank of England’s reticence over raising interest rates and doubts over the sustainability of the spring surge in inflation have combined to drag the UK 10-year Gilt yield from a February peak above 1.4% back to barely 1.05%.”

Meanwhile he says net asset values (NAVs) have held up well, certainly better than they did last summer. Indeed many REITs are still trading at big discounts to net asset, or book, value which he says suggests they may still be cheap.

He says: “In the 1990-92 recession discounts to NAV reached around 40% but the tax rules were different then – property developers paid 20% tax on asset sales whereas the REIT structure is much more tax-efficient (REITs pay no tax so long as at least 90% of net profit is then distributed as dividends to shareholders).

“As such the current discounts with no tax bill look similar to the depths of the early 1990s recession and so a lot of bad news has already been priced in – even if that bad news in the form of rising vacancies, falling asset values and falling rents has yet to materialise.”

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