Since the EU referendum on 23 June 2016, the pound has weakened significantly versus a basket of major currencies. For example, it is down 15% versus the dollar, and by 14% versus the euro. Much of this is due to the increased political risk facing the UK from Brexit, with many investors now more cautious on the UK’s economic outlook.
Following the general election on 8 June 2017, the pound has weakened further versus the dollar and euro. There is scope for further depreciation over the short run, since the outlook for any minority government is relatively uncertain. Even with a potential ‘confidence and supply’ arrangement with the DUP, the Conservatives would have a majority of only two. As such, the longevity of the government is likely to be called into question. While Brexit talks are ongoing, this could lead to a further weakening of the pound in the coming months.
The main effect of a weaker pound looks set to be higher inflation. High-yielding stocks could therefore become increasingly in-demand as investors attempt to generate an income return which beats inflation. With a relatively high yield, low valuation and upbeat growth prospects, Vodafone (LON:VOD) could become more appealing.
As mentioned, the prospects for the UK from a political and economic standpoint have changed dramatically during the course of the last year. Brexit means a high degree of uncertainty over a sustained period. Not only does it equate to lower business and investor confidence during the negotiation period, it also means uncertainty in the months and years following March 2019. That’s when the UK is due to leave the EU, although even that seems to be in some doubt following the election.
If a Conservative minority government is aided on key issues by the DUP, it could survive the full five-year term. However, the chances of that taking place appear to be somewhat unlikely. For starters, the Conservative Party itself has different ideas within its own ranks on key issues such as Brexit. Therefore, even a handful of rebellious MPs could cause bills to be rejected by the House of Commons. Similarly, the DUP may have differing views on Brexit and other issues which mean the Conservatives need to obtain cross-party support for their policies. Given the current political climate, this may prove challenging.
The outcome of a weak government and Brexit negotiations could be even higher political risk than has been experienced in the last year. Therefore, the prospects for the pound seem to be relatively negative, and it could weaken further.
The impact of a weaker pound on inflation
Since the EU referendum a year ago, the rate of CPI inflation has soared from 0.8% to 2.9%. Much of this is because of the weaker pound. Import prices have become more expensive and while retailers in particular have enjoyed some success in absorbing higher input prices, they have started to be passed on to consumers. Therefore, obtaining an inflation-beating income return may become increasingly important and challenging to investors over the medium term.
Since Vodafone yields 5.5% and has been able to increase dividends per share by around 4% per annum during the last five years, its attraction as an income stock remains relatively high.
Since Vodafone yields 5.5% and has been able to increase dividends per share by around 4% per annum during the last five years, its attraction as an income stock remains relatively high. In fact, since the election, the Vodafone share price has risen 3%. This isn’t particularly surprising, since the company is one of the highest-yielding shares in the FTSE 100 and could help investors to maintain a positive inflation-adjusted income over the medium term.
Looking ahead, the rate of inflation is forecast to move higher. Some forecasts predict a rate of as much as 4% by the end of next year, which would mean the FTSE 100 offers a negative real income return at its current price level. Stocks which can comfortably beat inflation when it comes to income return, such as Vodafone, could be able to justify a valuation premium.
Vodafone has also been viewed as a defensive stock in the past. While its expanding product range and increased competition in quad play markets mean it may no longer be a quasi-utility, the company’s geographic diversity and product diversity mean that it may present a degree of protection against a troubled wider economy or even an underperforming wider index.
As well as some defensive characteristics, Vodafone also has strong growth potential which could act as a catalyst on its share price. For example, in the current financial year it is expected to report a rise in EPS of 4%, and next year it is due to record growth of 18% in EPS. This means it has a PEG ratio of 1.4, which for a high-yielding and well-diversified FTSE 100 stock seems to be a very appealing price to pay. Therefore, justifying a higher share price even after a rise of 12% since the start of the year would not be particularly challenging.
The pound has weakened significantly in the last year. The general election result has already led to further depreciation, which could continue over the medium term due to the potential weakness of a minority government. Brexit talks may also lead to greater caution among investors and businesses, which may translate into an even weaker pound.
The effect of this could be positive on demand for Vodafone’s shares, which may lead to a higher share price. Its generous dividend yield may help to protect against higher CPI inflation caused by a weaker pound, while strong growth prospects and a fair valuation suggest a higher share price could be ahead. Further, its diversity could lend itself to above-average defensive qualities, which may appeal during an increasingly uncertain political and macro outlook for the UK.
Therefore, while share prices in general may become increasingly volatile, the long run prospects for Vodafone could be relatively bright. At a time when many investors may be unwilling to adopt a risk-on attitude, it could become an increasingly attractive holding for the long term.