The first, which has received a bit more attention recently, is the decline in Sterling against the Dollar and the second is the relative strength of UK equities. To an extent, these stories are related, so it is worth a quick look at what has been going on in UK equities sectors and then looking at how moves in currency exchange rates feed through into UK equities’ performance.
Since the start of the year, the FTSE 100 index has fallen by around 3% (chart 1). In the US, the S&P 500 is down 19% and the tech heavy NASDAQ is down 28%; in Europe the major indices are down between 16% and 20%. What factors are responsible for the significant outperformance of UK equities this year, especially at a time when UK economic performance has not been better than its competitors?
The influence of sector dynamics
A quick look at the constituents companies offers a partial clue as to what is driving this. The top 10 constituents of the FTSE 100, which account for 50% of the total index, contain two oil and gas firms (BP and Shell), two mining companies (Glencore and Rio Tinto) and two pharmaceutical companies (AstraZeneca and GSK). The remaining firms are Diageo, British American Tobacco, Unilever and HSBC. Oil and mining firms have performed exceptionally well this year as commodity prices have risen, whilst BAT, AstraZeneca, GSK and Diageo are from historically defensive sectors which typically perform better in troubled markets. Banks have also benefited from the effect of significantly higher interest rates we have seen this year (chart 2).
By contrast, the top 5 holdings in the S&P 500 are Apple, Microsoft, Amazon, Tesla and Alphabet - all of which are technology stocks that have, in general, performed poorly this year. The sectoral split across the index also reveals the difference in the two indices. The S&P500’s top sector is IT which constitutes 28% of the index, and is one of the poorest performing sectors this year - the FTSE 100 has only 1% exposure to the sector.
The role of interest rates
However, this is really only a partial explanation. We believe this is also connected to one of the other big themes we have seen play out this year, namely rapidly rising long-term interest rates. High growth sectors like IT typically pay few dividends. Investors accept this, in the expectation the company will grow and pay higher dividends eventually. However the further into the future those dividends are expected to be paid, the more sensitive they are to interest rate increases (this is a similar effect to what happens with pension liabilities).
The impact of interest rates on dividends
This can be seen by a very simple model over 10 years. Assume there are two firms and that the value of each firm is the net present value of expected future dividends. 
Firm 1 is an old economy firm that pays dividends of $3 each year for 10 years. Firm 2 is a tech firm that will pay no dividends for 5 years and then pays $2 in year 6 increasing by $2 per year until it pays $10 in year 10.
Both firms therefore pay $30 in dividends over 10 years but at different times. If interest rates rise from 1% to 3% this has a disproportionate effect on the value of the tech firm. As can be seen in chart (3) where the value of the yearly dividend falls by much more between the red lines than the blue lines. Indeed the full impact is that the old economy (Firm 1) falls by 10% and the tech firm by 16%, purely due to how they are impacted by higher interest rates.
Dollar strength rather than Sterling weakness?
As mentioned in the introduction there is one other large factor at play, that has also been making the news for other reasons, and that is the depreciation of Sterling (chart 4). To be clear, the depreciation of Sterling is more a “dollar strength” story than about “weak sterling”; against the euro, Sterling has actually strengthened over the last year. However for companies that make large amounts of their profits in dollars, such as those selling commodities denominated in dollars, the strength of the dollar is positive as it increases the value of those profits when converted into pounds. Around 70% of the profits of FTSE 100 firms come in the form of foreign currency; as such, when sterling declines, it tends to boost the value of UK equities.
The ‘so what’ here is an active lesson in the value of diversification. For many years UK equities underperformed and were out of fashion, however the ‘value’ nature of UK equities has meant they have held up better in the current environment. Whilst this is not necessarily an argument for holding more UK equities, it is an argument to always be aware of the old adage that ‘diversification is the only free lunch in finance’.
Source, Kempen July 2022
 In theory the value of an equity is equal to the net present value of its future dividends. An investor would not pay more for something than they are expected to receive in return. If dividends remain stable but interest rates increase, the value of those dividends in todays money decreases reducing the value of equity.
About the author:
Robert Scammell is a senior portfolio manager responsible for developing Kempen’s LDI proposition for UK clients, sitting on both our UK Asset Allocation Committee and UK LDI Committee.