An independent professional's take on the latest news and trends in global financial markets

Sterling and Equities

By opting out of the euro the UK has saved itself the travails of a Greece or a Spain, which looks like being next in line to feel the full force of the markets’ assault on over-indebted countries. Yet as Dahval Joshi of RAB Capital points out in his latest market commentary, by taking the strain through its currency the UK’s investors are not immune from important shifts in global investors’ attitudes.

This chart from Dahval’s report shows the close correlation between the movement of the London equity market and the value of sterling against the dollar. For the last five years it has been a more or less perfect fit, even though there has been a slight deviation from trend in the last few weeks.

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The globalisation of financial markets has of course been a big factor behind the growing dependence on foreign investors’ views. Twenty years ago, foreign ownership accounted for little more than 10% of either the US or the UK stock market. Today the foreign holding of the US equity market has doubled to 25%, while foreign ownership of the UK equity market has actually quadrupled  to 46%. Big moves into or out of equities have necessarily meant foreigners buying or selling large quantities of pounds.

“Another way to explain the impact of equity flows on sterling” Dahval notes “is to look at the equity market capitalisation to GDP ratio of the UK compared to other major economies. The market capitalisation measures the total value of the equity market, but the amount of domestic savings that are available for investment tends to grow in proportion with GDP. So the greater the market cap to GDP ratio, the greater the dependence on foreign investors. And the UK’s ratio, currently 1.2, has been structurally much higher than other major economies such as the US (0.85), Japan (0.65), Eurozone (0.45), or China (0.4). This explains why the pound is highly vulnerable whenever the equity market sells off”.

Just as pertinent is the fact that more than 50% of UK corporate and Government bonds are now owned outside the UK, roughly twice the ratio that holds in the United States, which means that sterling could be additionally vulnerable if the UK’s perceived debt dependence prompts an adverse reaction in the markets. Devaluation has always been the UK’s stock policy reaction to economic difficulties, but investors are increasingly dependent on foreign investor sentiment. Being out of the euro is a blessing, but that does not remove the need for tough measures to correct the looming fiscal crisis in this country.

Written by Jonathan Davis

February 23, 2010 at 1:09 PM