Monthly commentary

My theme this week is the impact of currency fluctuations on portfolio returns. I have been aware of this important factor since I first started learning about investments. I can’t predict currency movements in the short term (a whole industry thrives on playing that game), but I think anyone can assess relative currency risk.

Key principles

Let’s start with some basics. What makes a currency more or less valuable? Here are some of the main reasons:

• Security – how capable is the country issuing the currency of sustaining its relative value? A world superpower in economic (not military) terms with open, efficient and highly liquid markets will get the most respect. The USA, UK, Eurozone or Japan offer what are called the ‘reserve’ currencies. China wants to join that list.
• Politics – is the government behind the currency respected as prudent and unlikely to borrow beyond the country’s means. Such borrowing might come in the form of ‘printing’ money and if there is more of a currency around, its value may well fall. A reserve currency country has more scope to extend its currency base, but not indefinitely
• Interest rates and their anticipated direction (highly significant) – there are always people and corporations and even governments with surplus cash to deposit for short periods, even just overnight. Naturally, that cash gets placed where interest rates are highest and to deposit the cash, you probably need to have it in the relevant currency. So there is demand for currencies issued by countries with higher interest rates on offer. By the way, this fact is the main driver in the price of Bitcoin, which is non-national commodity asset that can be substituted for currency.
• Asset prices in the issuing country – if a country has been having a hard time and is thought to have turned a corner, then richer market players will look to pick up assets of all sorts – shares, whole businesses, properties and so on – at bargain prices. To buy those assets they need local currency, so demand will increase. The opposite applies when the perceived prospects for a country turn negative, or just become muddied, which is why Sterling fell sharply after the Brexit vote.

How does that impact on our investment decisions?

How do fluctuations in currency impact investors, in a direct sense?

Most of the time, we will invest in funds, ETFs or shares priced in the currency of the country in which they are issued. Some funds have “hedged’ share classes, but hedging costs money and it not 100% effective, so has not proved popular with retail investors. So if there is a change in the relative value of the currency in which our investment is issued, the value in our investment report, which is in Sterling, will change, irrespective of any other factor.

Imagine we bought GBP1000 of units in a fund that invested only in the USA. Overnight, the value of the fund’s investments goes up while the US stock market is working by 1%. So our investments should be worth GPB1010 next day. Actually, that will rarely be the case.

If the USD dollar went up 0.5% relative to Sterling, our gain would be 1.5% (GBP1015). If it fell 0.5%, our gain will reduce to 0.5% (GBP1005).

Currency values fluctuate by small amounts daily most of the time, but there are exceptions. Generally, there are trends in relative valuation and sometimes (maybe rarely), one can take a view that there is high probability of one currency going up or down relative to another because one is aware of the impact of the factors detailed above.

For example, it was highly likely that Sterling would depreciate between the date of the Brexit referendum vote and the outcome of negotiations and so there was little currency risk for UK investors buying overseas funds. In fact there was a good case for owning no UK investments at all during that period, because there was no direct currency upside in them.

Note the changes in a currency’s relative value will impact on trade and corporate profits, so there is more to understand on this matter, but that is not something we need to cover here.

Sterling as the Phoenix

Anyone who looks at their portfolio regularly will have noticed weaker performance in terms of valuation numbers from global equity funds over recent weeks. This is mainy because Sterling has been appreciating steadily. The UK Pound Sterling index is a measure against a weighted basket of other currencies and it is up from about 127 to 138 since 6 months ago, nearly 9%. That is quite a headwind for valuations of stocks listed in other currencies.

Why is Sterling going up so steadily? There are multiple reasons which fit in with my criteria above.

The final ‘doing’ of Brexit has reduced political risk, even if there is no economic boom yet. The success of the vaccination programme in the UK has been taken as implying an early re-opening of the British economy.

Interest rates rising is not likely to be a baked in expectation yet, so that is one NOT yet applicable factor. But there may be a growing anticipation of higher inflation, which would be followed by higher interest rates – the data points that way.

I suggest that main reason is that UK assets have become outstandingly cheap and overseas investors, slighly jaded with the big US tech firms and worried about the huge cash flows into non-profitable new ventures listed on the NASDAQ, are thinking about buying some old fashioned ‘value’ businesses that sell stuff all over the world, make profits and pay dividends (and as an aside, may be ripe for takeover). So I guess that an inflow of foreign capital is one driver behind the appreciation of Sterling.

Now if a lot of other people want to buy UK company shares and our profits from overseas investments are being cut back by a possibly long running increase in the value of Sterling, maybe we should be looking close to home if we are keen on getting some assets at good prices with no currency risk?

That has already quite a reversal of tactics for me. But as J M Keynes suggested, when the facts change, you need to change your mind.

I think UK investments, carefully researched with some of the contrarian techniques I have explained before, would be a logical inclusion on any shopping list for those wanting to put money into the market or bank some profits from their momentum led tech funds. And there will be no direct currency risk!