A bullish view on sterling spurred Morgan Stanley strategists to upgrade their view on UK midcap companies on Tuesday.
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A stronger sterling is usually accompanied by underperformance of large-cap UK equities relative to other regions, the broker warned, adding they recommended investors look for exporter shares to sell.
Foreign exchange is having the greatest influence on UK stocks in 20 years, Morgan Stanley said, leaving the latter susceptible to currency swings.
Since the Brexit vote last June, the performance of the FTSE 100 is has highly correlated, inversely, with the sterling's move against the U.S. dollar, as index constituents which derive significant chunks of their revenue offshore saw sharp earnings upgrades.
At the same time, shares of domestic UK companies, whose earnings are in sterling but costs can be offshore, suffered in relative terms.
Morgan Stanley now sees a high probability that this reverses. The firm's FX strategists expect the sterling to rise to $1.28 by the end of this year, and $1.45 by the end of 2018.
Those forecasts prompted the firm to upgrade midcaps to "neutral" from "underweight," and to downgrade their "overweight" stance on UK large-caps to "neutral."
Sectorally, financials and real estate stand to gain most from a stronger currency, the bank said, as their relative performance was most correlated to the exchange rate.
Overweight-rated stocks in the bank's domestic UK basket include AA, Autotrader, Lloyds, Marks & Spencer and Whitbread.
(Reporting by Helen Reid, Editing by Vikram Subhedar)