Sterling chills out but banks limp on

Whether this week’s more relaxed mood in sterling trading reflects the ‘leave’ campaign losing ground or not, wider markets have certainly become more sure-footed.

‘Implied volatility’ (IV), essentially a market’s future variance according to options pricing, reached fever-pitch just under a fortnight ago.

By Thursday however, IV in pound/dollar trades and against the euro, with ‘strike’ dates 1 month to a year ahead, were 8%-11% lower.

In the 3-month tenor, the sudden deflation in vol. came after the rate last week threatened to match its spike during the 2010 General Election.

A faltering euro after no clear signals from the ECB about its next move at its press conference supported the pound but sterling has been steadying consistently since early in April.

Whilst the cool-down hasn’t completely unwound the run-up in vol. which began in earnest soon after the starting gun was fired for unofficial campaigning in February, we suspect the less fervent currency market conditions are already resonating in UK shares. We note the FTSE 100 set new 2016 highs this week, after several weeks of consolidation. Large and small caps have eased in recent days, but both groups have risen into the black for the year, though retail and UK bank stocks have underperformed.

FTSE UK indices year-to-date comparison chart

Source: Thomson Reuters

Whilst we retain our negative bias on property, non-life insurance, banking, retail, fixed-line telecom and utilities, predicated on actual or perceived currency or political and trade regulation risks, we acknowledge that as the market becomes more sanguine about these risks, their potential negative impact should also be lower.

We highlight Mothercare, second-worst FTSE SmallCap performer over 3 months to date, having lost 38%, Flybe, 30% lower, and Carpetright, Speedyhire, Poundland and Topps Tiles all down around 10% or a little more.

We also note that Next Plc., the UK’s largest clothing retailer by revenues, is the worst FTSE 100 performer (and second-worst in the FTSE 350 only to Restaurant Group). Aviva, Standard Life, Berkeley Group, RBS, Barclays, Lloyds Bank, easyJet, TUI and Thomas Cook, all underperformed wider equities, falling as much as 20% in three months.

Further good-to-strong progress on the upside by top stocks and the wider market are likely as investors pick up themes that were temporarily set aside—for instance the rebound in metals and crude oil prices. Polls giving ‘Ins’ the edge this week, totalled five by Thursday, and together with strengthened odds at bookmakers, these have bolstered the view that the UK is now more likely to vote to ‘remain’.

More time is required to see whether currency volatility deflates further and the market looks past June more clearly. In the meantime, we maintain our reasoning that the smallest sterling and trade regulation-exposed groups may be more vulnerable.