Making a point: The US dollar is up 13 percent against the pound since the beginning of the year
Investors have been bombarded in recent weeks with news of a stock market massacre.
The US market, as measured by the S&P500 index, has fallen dramatically by 15 percent this year, while global equities are down 16 percent.
Not good news if you are trying to grow your wealth.
But for UK investors, the outlook isn’t as grim as it might seem at first glance.
That’s because currency fluctuations have taken the sting out of recent market declines.
UK investors tend to hold their portfolio in sterling – and when translated into sterling, the market declines don’t look nearly as bad.
The US dollar has risen 13 percent against the pound since the beginning of the year. As a result, the US market fell by just 6.4 percent this year and global equities by 4.6 percent.
These are still notable declines, but not as damaging to a UK investor’s portfolio as the key figures first suggest.
Currency movements can have huge implications for ordinary investors, but are easily overlooked when planning a strategy. So why are currencies shifting so dramatically, and how should investors react to best protect and grow their wealth?
Why are currencies on the move?
Currency movements usually reflect how major city investors feel about the prospects of one economy relative to another. If global investors think a country has a stable outlook, they are more likely to pump money into the currency to take advantage of its strength.
So if the pound weakens against the dollar, it would be easy to assume investors are losing confidence in the UK economy. But with that you lose sight of the bigger picture, says Jason Hollands of asset manager Evelyn Partners.
“This is not just a story of a weakening pound as a result of the current political uncertainties in the UK, as some have put it short-sighted,” he says. “Instead, it’s more about the strength of the US dollar.”
The proof, says Hollands, is in the movement of other currencies. The pound has remained broadly unchanged against the euro this year and has appreciated against the Japanese yen.
If investors were seriously concerned about the UK economy, the pound would have fallen against a number of currencies, rather than primarily the US dollar.
So why is the US dollar getting so strong?
Global investors have plowed into the US dollar, raising its value.
For decades, the dollar has been viewed as a safe haven in times of market uncertainty. The past few months have proven that this is still the case.
As investors have grown concerned about the global outlook for stocks and bonds, they have retreated to the safety of the US dollar, which is seen as one of the world’s most reliable assets.
Investors are also tempted by the US dollar as the central bank raises interest rates to tackle inflation much faster than others.
In recent days, the Federal Reserve has raised interest rates by another 0.75 percentage point for the second consecutive month. By comparison, other countries have acted much more slowly.
The Bank of England has raised interest rates by just 0.25 percentage point each time, while the European Central Bank has only just made its first rate hikes in 11 years.
Currency investors like it when central banks raise interest rates because it drives up interest rates across the economy, opening up the opportunity to get better returns on cash and bonds.
What do currencies have to do with UK investors?
Foreign investments are priced in different currencies, whether that be US dollars, euros or the Chinese renminbi.
However, most UK investors trade in pounds. So when you use sterling to buy non-UK stocks or bonds, your money is first converted into the currency of the asset you are buying.
When you sell that asset, your money is converted back into pounds. If the exchange rate changes while you hold the non-UK investment, it will affect how much money you make.
This year, currency fluctuations benefited UK investors. For example, if you owned $100 worth of US equities a year ago, it would have converted back to around £73. But today, a $100 investment in US equities would be worth around £84 – a welcome boost for UK investors looking back to convert pound sterling.
Similarly, UK investors buying US stocks today would pay significantly more than they were a year ago. If the pound sterling starts to appreciate against the US dollar, UK investors could lose.
Some professional investors use sophisticated currency hedging tools to minimize the impact of currency movements on their portfolios. However, if you buy common stocks, funds or mutual funds, you are unlikely to buy assets with currency protection, so you are subject to fluctuations.
What should investors do?
Hollands is concerned that British investors buying US stocks are now at serious risk. All is well as the US dollar continues to rise, but if fortunes change, UK investors could be caught out.
He says: ‘While the dollar’s upward march has quietly helped UK-based investors avoid the worst ravages of US and global stock declines, unless you believe the dollar will continue its current gains for a long time, at some point it will a change of fortune in the foreign exchange markets can eat away at profits on overseas positions from here.”
He adds, “That could happen if it’s clear that the Federal Reserve will stop raising interest rates — or even lower it to stimulate the US economy if a recession hits.”
Hollands suggests that this could therefore present an opportunity for UK investors to rebalance their portfolios by cutting some of their global and US positions and pumping the money back into the UK. “The UK has been one of the best performing markets this year, but it remains cheap,” he says.
Brian Byrnes, head of personal finance at the investment app Moneybox, warns investors against strategies to take advantage of currency fluctuations. He thinks they are too difficult to call.
He says: “When we see currency fluctuations affecting our individual savings accounts or pensions, it can be tempting to try to predict and take advantage of these fluctuations or other factors, such as geopolitics or inflation.
“However, the foreign exchange markets are beyond our control and are extremely difficult to predict. The best way right now is to make sure your portfolio is well diversified and not overly exposed to one particular currency, such as the dollar.’
Rachel Winter, partner at stockbroker Killik & Co, agrees that a balanced investment portfolio is essential. That way, you won’t experience the biggest benefits of currency movements, but you won’t experience the worst effects either.
“One of the best ways to mitigate currency risk is to invest in a globally diversified portfolio,” she says. “Currencies fluctuate all the time, some going up and some going down, but many of these moves will cancel each other out to some degree.”
A diversified portfolio means that you spread your investments across different geographies, sectors and asset types. You can do this yourself by building a portfolio of funds, stocks and mutual funds that operate in different areas.
Or you can buy a well-mixed fund, such as a low-cost passively managed global fund that invests in stocks and bonds, or a multi-asset fund.
What if investors mostly hold UK stocks?
Investors in UK companies are also affected by currency movements. Many UK companies – especially large ones – are benefiting from a weaker pound.
Any company that earns a portion of its profits in US dollars but reports it in British pounds is likely to be in pounds.
Winter explains: “Companies that generate income all over the world, but report their profits in pounds, will have benefited from this currency movement, as their overseas earnings will now equal more pounds. Oil companies such as BP and Shell are good examples.’
David Henry, investment manager at portfolio manager Quilter Cheviot, says Diageo is another beneficiary. He says: “Owning brands like Smirnoff, Johnnie Walker and Guinness, it generates about 45 percent of its sales in the US.
Recent currency movements will therefore provide a natural tailwind for the company’s earnings growth.”
Dan Lane, senior analyst at investment platform Freetrade, adds that it is the major UK companies that are most likely to benefit. “Smaller companies are less likely to have an international presence than the big guns,” he says.
The UK’s 100 largest companies derive about 75 percent of their revenues from abroad, while medium-sized companies generate about 50 percent of their turnover abroad – smaller companies an even lower percentage.
This difference in currency exposure is one of the reasons why larger UK companies have outperformed smaller companies so far this year so far.
Shares of the UK’s 100 largest companies have fallen 2.2 percent this year, while the 250 largest have fallen 17 percent since then.
However, as always, investors should be wary of overthinking currency movements in the UK market.
As Quilter’s Henry says, “Our preference is to invest in good companies, no matter where they generate their revenues and especially no matter where they are listed.
“The main factor in the long-term performance of stocks is earnings growth, and the effect of currency movements becomes less significant over time relative to the company’s operating performance.
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