How much of the FTSE’s strength is due to currency effects?

Wed 06 Jun 2018

Currencies have historically been extremely volatile, and predicting FX movements is recognised as a very difficult and risky strategy. Exchange rates move on several, often unpredictable, macro-economic factors, including differences in interest rates or inflation, geopolitics or due to government intervention such as capital controls. Many funds have exposure to currency risk from investing in global companies (non-UK domiciled), but also from companies which make their profit overseas. Currency fluctuation therefore leads to a degree of uncertainty for UK investors which can be significant, and therefore it should be a key consideration.

Since the Brexit vote, the Pound has played a large part in investors’ returns on multiple levels. On 24 June 2016, the pound sold off against the USD, slipping from $1.50 to $1.32, falling as low as $1.20 in January of last year. This weakness in Sterling has been a key driver of the imported inflation that the UK is only just starting to see subside, almost two years after the referendum. Inflation can be “demand-pull” or “cost-push.” Demand-pull is seen as “good” inflation, as it comes as a result of rising demand from consumers and therefore increases company profitability and thus their future outlooks. It signals a healthy economy and confident consumers. However, cost-push inflation is that which results from higher input prices for materials used in manufacturing. If demand is inelastic, companies can increase their prices and maintain their profit margins, however if demand doesn’t increase, companies may struggle. Given that the UK experienced cost-push inflation from sterling depreciation, it’s a fair assumption to make that company profitability, and therefore stocks, would suffer.

However, due to the composition of the FTSE 100, UK large caps, which fell sharply after the Brexit vote, have beaten expectations rebounding from below 5,800 to over 7,700 today. The index is heavily weighted towards companies which derive a significant amount of their revenues from overseas (around 70%), which once converted back into Sterling at a weaker rate, are worth more. This inverted relationship has not always been the case. As you can see in the chart below, during the GFC both the GBP and the FTSE actually fell together

Since the initial shock of the referendum, the GBP has slowly started to recover. Concerns over Brexit are fading and the economy has performed better than expected. Additionally, the depreciation of the USD has also helped. However, volatility still persists as and when new macro-economic news and data is released. A few weeks ago the Pound fell sharply against the dollar hitting its lowest levels this year, after weak GDP data informed the Bank of England’s decision to keep rates on hold at 0.5%. According to the Office for National Statistics (ONS), UK GDP growth fell to 0.1% in Q1 2018, marking a five-year low. However, despite the general appreciation of Sterling since October last year, UK equities have also continued their upward trajectory. Which begs the question, are UK investors simply at the mercy of the fluctuating pound, preordained to benefit when the Pound falls?

In an unhedged portfolio international stock and bond returns could be heightened when the pound depreciates, and vice versa when it picks up. However there is also a lot of idiosyncratic, company specific factors that contribute to returns and in some cases are strong enough to offset any currency effects. Additionally, there are several ways to manage currency risk. If managers have a view on currencies, they can incorporate this into their stock picking decisions. Alternatively they can hedge the currency risk using derivatives, so that any future FX movements between the currency used by the investor and that of the underlying fund holdings do not meaningfully affect the performance of the fund. The view on currency may be their own, or that of a dedicated FX analyst (more common at larger fund houses). The downside to hedging is that buying protection can be expensive, especially if you don’t want to lose out on the upside from positive currency effects.

It’s reasonable to believe that ongoing Brexit negotiations will continue to have an effect on sterling. This in turn will lead to persisting effects on UK equities, as the government navigates a very difficult and nuanced situation. However, we believe that if you invest in a well-diversified portfolio for the long term, which has exposure to multiple asset classes and geographies, currency effects should smooth out leaving investors to achieve the right mix between risk and return.