UFO Info Week-End

Traders made a killing out of sterling’s abrupt departure from the European exchange rate mechanism in 1992

Traders made a killing out of sterling’s abrupt departure from the European exchange rate mechanism in 1992, for example.Conversely, sterling’s recent strength against the mark has hit British exporters hard, as their goods are priced out of foreign markets.The pound has climbed to dizzy heights in the last year against the German mark and the dollar But dangers lurk. So, if interest rates are higher in the UK than in the US, the pound is likely to rise, and vice versa.But big investors are always looking ahead: they don’t wait until it is obvious to everyone that interest rates in the UK are rising. They aim to predict a rise much earlier, so they can buy the pound before it has become expensive.Financial institutions often manage to make huge amounts of money by betting on future currency movements. Remember 1992 when the government tried to shore up sterling by pushing interest rates sky-high?Why do currency values change? A currency becomes strong when it is in demand It is in demand when it gives investors a good return. If sterling is weak against major currencies, foreign investment returns are magnified and vice versa.Even your mortgage payments could be affected by the pound. If you invest in an international growth unit trust, for example, or a European equity fund, then the value of your investment will be hit by sterling’s fate.Even for those with no direct equity investment to their name, the pension funds they belong to will usually have some overseas investment, and exchange rate fluctuations make themselves felt.

A unit trust may be quoted in sterling, for example, though most of its underlying assets are in foreign currencies. This is particularly the case for millions of small investors.Even if your money is invested within the UK, the pound’s struggles abroad have an impact on shares. For example, many private investors are unaware of indirect holdings by their fund managers in foreign bonds and shares. Trips to France cost a lot less now that a pound buys nearly nine and a half French francs.
Perhaps not surprisingly, few people realise the role such fluctuations can have on their daily lives. “People are aware of [currency changes], but not the potential impact they can have,” says Tim Cockerill, investment director at Whitechurch Securities in Bristol.

We all know holidays abroad become much cheaper when sterling is strong. For most of us, most of the time, foreign currency is an issue to be addressed once or twice a year during a foreign holiday as we painstakingly count out the drachmas or the pesetas to pay for our ice creams. Even if the risk from a Labour government has diminished, the risk of mean reversion remains. And, of course, one bold announcement does not remove the risk that New Labour will be bounced out of its confident stride by the turn of unforeseen events. Still, after last week’s welcome beginnings, nothing has changed my view that gilts remain a sound bet – and who would have thought one could ever have said that with a Labour Chancellor newly installed in Downing Street?. A timely study this week from PDFM, the fund management group, reminded us that the UK stock market has out- performed all other leading stock markets since the dark days of 1975.As Warren Buffett, the legendary American investor, also pointed out this week, the stock market cannot go on producing its current exceptional rates of growth forever.

Because of its poor inflationary record, the returns on gilts have also been inferior under Labour. Such parallels with the past have only limited relevance today, however. After all, we have never before had to deal with a Labour government which is trying so hard to emulate – or, in the case of this week’s monetary policy changes, to outdo – what are traditionally thought of as Tory policies.Before embracing too readily the message that New Labour will be good for investors, don’t forget: (a) that stock markets are already highly valued in historical terms; and (b) that we cannot divorce our fortunes from those of the rest of the world. In nominal terms, the returns on shares might appear to tell a different story, but if you look at real returns (after inflation) the story is clear enough, as my chart shows.

For obvious reasons, industrial shares have tended to do better under Labour in the past than financials, and vice versa under the Tories. It will be a good litmus test of the Government’s professed desire to promote competition.It is true that Labour governments have not traditionally been as good for the stock market as Conservatives ones. How far will Mr Brown move to fill the gap in the public finances by additional taxation on companies? Raising the rate of corporation tax by 2 per cent would raise pounds 2bn and must look a tempting target, given the strong recent rise in industry’s return on capital. And how far will he move to cut the tax privileges of the pension funds by restricting further the advance corporation tax credit on dividends? Either step threatens to put a lid on the scope for the stock market to move ahead.