Europe Economy

US Investors Should Fear Tumbling Pound: Citi


A credit downgrade, a plunging currency, stubbornly high inflation and little to no growth aren't optimal conditions for investing. But despite this the U.K.'s FTSE 100 Index has climbed 8 percent so far this year.

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New research by Citigroup has shed light on the growing gap between a weak economy and a bullish stock market in the U.K., but the bank says sterling's tumble could be a warning for overseas investors, particularly those from the U.S.

Sterling fell below the key level of 1.50 against the dollar on Friday. Poor data and a downgrade by credit ratings agency Moody's has led to a 6 percent fall in sterling's value on a trade-weighted basis since January.

(Read More: Moody's United Kingdom Sovereign Downgrade: Yawn)

Analysts predict that the worse-than-expected U.K. manufacturing data on Friday increased the likelihood of further quantitative easing (QE) by the Bank of England this week, which could weaken the pound.

But this could spell good news for domestic investors, according to Citi. Analyzing the last six periods of sterling weakness, the bank says the outcome has been positive for domestic investors, with the average six-month return being 10 percent, after a meaningful sterling fall.

However, there was a warning for overseas investors, including those from the U.S.

"If we look instead at the relative performance of the U.K. to the world in U.S. dollars this positive return picture disappears. Only in the 1970s did the U.K. outperform the world in dollar terms and on average over six months underperformed by 4 percent," it said.

"This underperformance is even greater if we compare the U.K. just to the U.S. On average it underperforms by 10 percent on a 6-month period. Weak sterling is not a benefit for U.S. investors into the U.K."

UK's Great Divide

The analysis by Citi also points to an increasing divergence between the economy in the U.K. and a stock market that has rallied since the start of the year.

"The U.K. equity market is not the U.K. economy. The ongoing consequences of a debt fueled boom deflating are low economic growth, low interest rates and greater chance of more non-standard monetary policy. Further weakness in sterling is a potential by-product," the research team at Citi said in a note on Thursday.

Corporate earnings have recovered to their pre-crisis peaks, Citi said, whereas gross domestic product (GDP), which contracted 0.3 percent in the last quarter - is still around 4 percent below the peak of 2008.

"The major reason for the difference is the exposure of the equity market to the recovery in global economic growth," it said. With Europe and U.S. growth remaining sluggish, economies with exposure to emerging markets are set to outperform. But according to research from Citi and the IMF, only 4 percent of the U.K.'s exports go to emerging markets.

(Read More: Pound Tumbles as UK Heads for Further QE)

But when it comes to the equity market, it's a completely different picture -- with 25 percent of U.K. equity market sales going to emerging markets.

"Clearly the U.K. equity market earnings are not dependent on the U.K. economy," Citi said.

(Read More: Long Haul Ahead for Britain's Struggling Economy)

According to Citi, previous trends during sterling weakness indicate that industrials, consumer services (which includes food and general retail, media and travel and leisure) and telcos have produced consistent outperformance.

Among the stocks that have a decent exposure to both the U.S. and emerging markets are Bunzl, Weir, Spectris, Reed and Compass, Citi said.