Making a point: The US dollar is up 13 per cent against the pound since the start of the year
Investors have been bombarded by news of a stock market bloodbath in recent weeks.
The US market as measured by the S&P500 index is down a dramatic 15 per cent this year, while global shares have plunged 16 per cent.
Not good news if you are trying to grow your wealth.
But, for UK investors the outlook is not as grizzly as it may first appear.
That is because currency movements have taken the sting out of the recent market falls.
UK investors tend to hold their portfolio in pounds – and when translated into sterling terms, the market falls don’t look nearly so bad.
The US dollar is up 13 per cent against the pound since the start of the year. As a result, when translated into sterling, the US market is down just 6.4 per cent and global shares down 4.6 per cent this year.
These are still notable drops, but not as damaging to a UK investor’s portfolio as the headline 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 tends to reflect how big City investors feel about the prospects of one economy versus another. If global investors think a country has a stable outlook, they are more likely to pump money into its currency to benefit from its strength.
So as the pound weakens against the dollar, it would be easy to assume that investors are losing confidence in the UK economy. However, that loses sight of the bigger picture, says Jason Hollands, of wealth manager Evelyn Partners.
‘This isn’t just a story about a weakening pound due to the current UK political uncertainties, as some myopically portray it,’ he says. ‘Instead, it is more about the strength of the US dollar.’
The evidence, says Hollands, is in the movement of other currencies. The pound is broadly unchanged against the euro this year, and is up against the Japanese yen.
If investors were seriously worried about the UK economy, the pound would have fallen against a number of currencies, rather than predominantly the US dollar.
So why is the US dollar getting so strong?
Global investors have been ploughing into the US dollar, pushing up its value.
For decades, the dollar has been seen as a safe haven in times of market uncertainty. The last few months have proven this still holds.
As investors have grown worried about the global outlook for shares and bonds, they have retreated into the safety of the US dollar, which is viewed as one of the world’s most dependable assets.
Investors are also enticed by the US dollar because its central bank is hiking interest rates to deal with inflation far more quickly than others.
In the past few days, the Federal Reserve hiked rates by another 0.75 percentage points, for the second consecutive month. By comparison, other countries have been much slower to act.
The Bank of England has been raising rates by just 0.25 percentage points at a time, while the European Central Bank has only just implemented its first rate rises in 11 years.
Currency investors like it when central banks raise interest rates because it tends to push up rates throughout an economy, opening the opportunity to make better returns on cash and bonds.
What have currencies got 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 deal in pounds. So, when you use sterling to buy nonUK shares 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 are holding the non-UK investment, that will affect how much money you make.
This year, currency movements have been working in favour of UK investors. For example, if you owned $100 worth of US shares a year ago, this would have converted back to about £73. But today, a $100 investment in US shares would be worth around £84 – a welcome boost for UK investors converting back to sterling.
By the same token, though, UK investors buying US shares today would be paying considerably more than a year ago. If sterling starts to rise against the US dollar, UK investors could lose out.
Some professional investors use sophisticated currency hedging instruments to minimise the impact of currency movements on their portfolios. However, if you are buying ordinary shares, funds or investment trusts, you are unlikely to be buying assets with currency protection so you will be subject to fluctuations.
What should investors do?
Hollands is worried that UK investors buying US shares now face a serious risk. Everything is fine while the US dollar continues to strengthen, but if its fortunes change, UK investors could get caught out.
He says: ‘While the upward march of the dollar has quietly helped UK-based investors avoid the worst ravages of US and global equity declines, unless you believe the dollar will continue its current ascent for a long time to come, at some point a change of fortunes in the currency markets could eat up gains on overseas holdings from here.’
He adds: ‘That might happen when it is clear that the Federal Reserve will stop raising rates – or even cut them to boost the US economy if there is a recession.’
Hollands suggests that now might therefore present an opportunity for UK investors to rebalance their portfolios by trimming some of their global and US holdings and ploughing the money back into the UK. ‘The UK has been one of the best-performing markets this year, but remains cheap,’ he says.
Brian Byrnes, head of personal finance at investing app Moneybox, warns investors against strategising to benefit from currency movements. He believes they are too hard to call.
He says: ‘When we see currency movements like this impacting our Individual Savings Accounts or pensions, it can be tempting to try to predict and profit from these fluctuations or other factors, such as geopolitics or inflation.
‘However, currency markets remain firmly outside our control and are extremely difficult to predict. The best course 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 having a balanced investment portfolio is key. That way, you won’t feel the biggest benefits of currency movements, but you won’t suffer the worst effects either.
‘One of the best ways to limit currency risk is to invest in a globally diversified portfolio,’ she says. ‘Currencies are constantly fluctuating, with some rising and some falling, but many of these movements will to some extent cancel each other out.’
A diversified portfolio means spreading your investments across different geographies, sectors and asset types. You can do this yourself by compiling a portfolio of funds, shares and investment trusts that operate in different areas.
Or, you can buy a fund that holds a good blend, such as a low-cost passively-managed global fund that invests in shares and bonds, or a multi-asset fund.
What if investors hold largely UK shares?
Investors in UK companies are also affected by currency movements. Many UK companies – large ones in particular – are benefiting from a weaker pound.
Any company earning a proportion of its profits in US dollars, but that reports them in sterling is likely to be quids in.
Winter explains: ‘Companies earning revenue all over the world, but reporting their profits in sterling will have benefited from this currency movement, as their overseas earnings will now equate to 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: ‘As the owner of brands including Smirnoff, Johnnie Walker and Guinness, it generates about 45 per cent of its sales in the US.
Recent currency movements will therefore provide a natural tailwind to the company’s earnings growth.’
Dan Lane, senior analyst at investment platform Freetrade, adds that it is large 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 100 biggest UK companies get around 75 per cent of their earnings from outside of the UK, while medium-sized companies generate around 50 per cent of their sales abroad – smaller companies an even lower percentage.
This difference in currency exposure is one of the reasons why larger UK companies are performing so much better so far this year than smaller ones.
Shares in the UK’s 100 biggest companies are down 2.2 per cent this year while the 250 largest after that are down 17 per cent.
However, as ever, investors should be wary of overthinking currency movements in the UK market.
As Quilter’s Henry says: ‘Our preference is to prioritise investing in good companies, regardless of where they generate their sales and particularly regardless of where they are listed.
‘The primary factor in long-term stock performance is earnings growth, and the effect of currency moves diminish in importance over time relative to the operational performance of the business.