15th March 2017 at 2:57pm
The fall in the value of sterling since the vote to leave the European Union (EU) in June 2016 has been front-page news. Without a crystal ball it’s hard to say if this trend will continue. However, with the triggering of Article 50 on the near horizon, it’s likely that we’ll see more sterling ups and downs over the coming months.
Most people know that a weak pound against other currencies means more expensive holidays abroad. But did you know that currency movements can also have a big impact on investment returns, especially when markets are highly volatile, as they have been over recent years?
Many investment funds available through ISAs and pensions have overseas currency exposure. In some cases, a lot of a gain or loss can be due to the currency exchange rate, rather than the return of the underlying shares or other assets. So it’s worth making sure you know how much you have invested overseas and whether or not you’ll be exposed to currency movements.
The winners and losers of currency movements
Andrew Milligan, Head of Global Strategy at Standard Life Investments, sums up very clearly the impact of currency movements generally and at the current time:
‘Whenever there is a large change in any currency, whether it’s rising or falling, there are always winners and losers. What’s good for some will inevitably be bad for others. Some businesses will benefit, others will not, for example as exporting becomes easier or more difficult. Some households will find their food costs go up, while others will see their money going further by taking a staycation rather than holidaying overseas.
‘This double-edged sword is already apparent. Stock markets show that the fall in the pound against the US dollar has already boosted profits for many large firms with overseas operations, especially those in the FTSE® 100 Index. For example, FTSE® 100 companies, on average, make 70% of their earnings outside the UK. So many of these stocks could have actually seen a rise in their profits when they converted their overseas earnings back into sterling. However, there are other businesses that will suffer, with many UK high street companies already warning of higher imported costs, say for food or fuel.’
Don’t let the currency tail wag the investment dog
As Andrew mentions, the weak pound has been good news for investments in UK companies which operate abroad. For the same reason, it could be good for investments in international companies. However, you should be careful not to let currency movements dictate your investment decisions, as buying into a currency swing could be a dangerous strategy. Let’s take a look at the impact of currency movements on investments in the recent past.
In 2016, the US stock market (the S&P 500 Index) rose by 12%. But, because of the dollar/pound exchange rate, a sterling investor would have seen this gain rise to over 33%. Be aware though that the opposite can also be true – going back just a few years to 2012 when the pound strengthened against the US dollar, the 16% rise in the US market translated to only 10.9% in sterling terms.
Other currencies can be even more volatile against sterling, the Japanese yen for example. In 2013, the Japanese stock market rose 54% but, due to the strength of the pound, sterling investors benefited from less than half of this return – only 25%. In 2016, this was reversed, with sterling investors seeing a muted 0.3% rise in Japanese equities translating to 23.4% growth. (Source for all performance figures: Financial Express.)
Here are some examples of the value of the pound against the dollar, euro and yen in recent years. As you can see, there have been some quite sharp rises and falls, illustrating the point that the value of currencies can be volatile.
The pound against the US dollar
The pound against the euro
The pound against the yen
Source for all charts: Thomson Reuters Eikon, from 9 March 2012 to 8 March 2017. Past performance is not a reliable indicator of future performance.
What’s next for sterling? Mixed views from the experts
There have been plenty of interesting reports on sterling recently – particularly around how it’s likely to perform as Brexit negotiations begin.
Andrew Milligan offers his views:
‘As we move forward, we wouldn’t expect a huge deal of clarity from the EU’s response and subsequent negotiations until the French and German elections are out of the way. In the meantime, we still expect sterling to be volatile, reacting to a combination of economic developments and political risks, both in the UK and Europe.’
Meanwhile, despite recovering somewhat after hitting its lowest levels post Brexit, some industry experts still consider the pound to be undervalued. Bank of America’s currency team expect to see it fall again in the short term as Brexit approaches, before recovering later in the year. Strategists Athanasios Vamvakidis and Kamal Sharma have stated that ‘the pound looks cheap’. They’ve then gone on to say:
‘We have no doubt that many political hurdles lay ahead for the pound in the years ahead, but we doubt that the markets will be in a perpetual state of panic over every Brexit-related headline.’
Analysts at Deutsche Bank are in agreement with Bank of America that ‘early clarity on a transitional arrangement between the UK and EU’ would be a ‘key stabiliser for the pound’. But they think this deal is unlikely, describing Prime Minster Theresa May’s plan to leave the EU’s single market, as being bad for sterling.
According to The Telegraph, they also warned that there were ‘no fallback options for hard Brexit’ and ‘negotiating multiple free trade deals in parallel with EU talks over a two-year time frame is neither realistic nor good policy.’
As Citywire reported, Deutsche Bank’s co-head of foreign exchange, George Saravelos, said the pound could go as low as $1.05:
‘The Brexit negotiations will soon start and even though intentions are quite positive on both sides we are very concerned about the lack of time to complete a deal in two years, and we worry that negotiations will get stuck around this issue of the payment which the UK has to make to leave the EU, and things will stall quite quickly, that’s why we are so negative on the pound.’
Help protect your returns with a diversified approach
With mixed views on the outlook for the pound, it’s more important than ever to remember that investing is for the long term and no single asset class will provide strong returns or benefit from currency movements in all economic conditions. That’s why it’s always a good idea to invest in a well-diversified portfolio that spreads your money across a variety of investments and geographies to achieve the best balance between risk and return, and to regularly review this.
If you don’t have the time to research and manage your investments then it could be a good idea to delegate these decisions to a fund manager with the expertise and scale to do this for you. They’ll also take into account things like the impact of currency movements on investment returns and check how much you have invested overseas, so you don’t have to.
Some funds will also use a strategy called ‘hedging’ to reduce the impact of currency movements. Basically, this means removing currency movements by using derivatives to bet that a currency will move in the opposite way. Because derivatives are more complex types of investments, it’s a strategy that’s usually best left to professional investors.
The information in this blog or any response to comments should not be regarded as financial advice and is based on our understanding in March 2017.