"Middle-aged Men and the Urals"

Middle-aged men are like the Urals; everyone knows where they are but nobody wants to go there. In the same way there are question marks over certain highly profitable vehicles of the past year that people just don't want to examine too closely.

Take the UK pound for instance. One of the big surprises of last year was the constant strength of the pound - it certainly took us by surprise. Sterling rose by 10% against the U.S. dollar, +1% against the euro and +12% against the Japanese yen. 1 According to the IMF, the pound became the third most popular currency in the world last year which is surprising considering its diminished stature over the past 40 years.

Inevitably, there are those who expect this situation to reverse itself during the course of this year, and there have been many committed but slightly contorted papers written in the past couple of months that support this view. The mighty Goldman Sachs, for instance, has come out firmly against the pound in recent weeks 2 .

Reversion back to the mean is the lazy man's fund management. It just seems too simple to twist your mind into the position of seeking contrived reasons why the pound should decline in the near-term just so you can say, "Anything that goes up a lot will come down". Certainly, the UK does have its fundamental problems; a budget and current account deficit that makes it look like "the dollar of Europe", to coin a phrase. But the clue to sterling strength actually lies within the arcane mathematics of the current account itself.

We have spent some time taking the current account equation for the UK apart and it is really very revealing. Basically we believe it looks like this;

current account = change in reserves -change in the capital account

The important bit here is the change in the capital account because this can be decomposed into;

change in the capital account = change in direct Investment + change in portfolio investment + change in other investment

You can, as we have, keep on taking this to pieces by separating out the portfolio parts into equities and bonds, but in essence that's all there really is to it. If you are looking for a demand function for sterling over the past seven years, then there isn't a better place to look than the net investment (flow) to the UK resulting from the current account equation. The first illustration shows the rise of inward investment to the UK and the appreciation of the pound against the U.S. dollar for instance.

The relationship is pretty clear; the amount of inward investment (which has been greater than the outward investment) has created demand for the pound which has helped to drive it upwards. By inference, monitoring inward investment should give you a useful guide to the direction of sterling. However, the problem with looking at current account data is that you only get it every three months.

So where should we look for our more timely indicator of money flowing to the UK? If you consider it, you buy a pound of sterling, and no matter what you do with it (put it on deposit, buy a bond or equity), it is going to show up somewhere in the economy in statistics such as the monthly money numbers. To see the truth of this take a look, for instance, at how monthly broad money supply in the UK has exploded in the past couple of years (see second illustration) at the same time as inward investment has increased.

Broad money supply is now growing at the same kind of levels seen in the bad old days of the 1980s (currently about +13% year-on-year with no real signs of it collapsing). However, this time, unlike the 1980s it hasn't shown up as rising high street prices but, instead, as financial asset inflation; government bonds, corporate bonds, houses and, dare I suggest, equities.

For us the issue of the value of sterling is crucial this year for investment success. Our sterling-based investors are looking to recoup their losses because of the rise in sterling last year, whilst our U.S. dollar and euro-based investors are looking for us to get out of a currency that has delivered so much performance in the past year. On that basis alone we will be using money numbers going forwards to gauge our sterling strategy. We are going to the Urals.