Currency condundrums

With the Euro this week hitting parity with the US Dollar, the Yen at a 24-year low and Sterling waning, it is a reminder that exchange rate movements can have a big impact on investment portfolios.

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Jason Hollands
Published: 13 Jul 2022 Updated: 13 Jul 2022

Jason Hollands, Managing Director of Bestinvest, the online investment platform and coaching service, discusses the impact that volatile currrency markets are having on investments:

"While a lot of attention so far this year has focused on volatility in equity, bond and commodity markets, there have been major moves in currency exchange rates too.

"The central story here is that the US Dollar has risen sharply against other major currencies as the US Federal Reserve has embarked on an aggressive programme of interest rate hikes and because the Dollar is the premier global reserve currency it is seen as a relative haven in times of uncertainty.

The Surging US Dollar

"To put the upward march of the US Dollar in context, the Yen has recently hit a 24-year low against it and yesterday the Euro reached parity with the Dollar for the first time in 20 years as the Eurozone struggles with surging energy import prices and risks to gas supplies.

"Believe it or not, it isn’t just Sterling that has had a rough ride of late!

"Since the start of the year, the Euro has depreciated by -11.5% versus the Dollar, Sterling is down -12% and the Yen by -16%.  Meanwhile, if you want evidence of a proper currency crisis, the embattled Turkish Lira is down a whopping -23% versus the Dollar since the start of the year and has halved in value over the last 12-months, so book your flights now!

Exchange rates influence inflation

"Sharp movements in exchange rates won’t just impact how far your cash will – or won’t – go on holiday this year; they also affect the prices of imports and can therefore impact inflation. They will also influence the value of your investments too.

"For example, most major commodities, including oil and gold, are priced in US Dollars and so the effect of high oil prices – with Brent crude rising by 70% over the last year – has been even more pronounced for those paying for oil in British Pounds given the exchange rate movements. This partly explains why fuel prices at the petrol pumps remain eye-wateringly high despite underlying oil prices having pulled back from their peak of $128 a barrel of Brent Crude in early March to just over $100 currently – over this period the US Dollar has strengthened 10.1% versus the British Pound.

Rising Dollar has cushioned global equity losses for UK investors

"One of the most important principles of investing is diversification – spreading your money around. These days most investors take a global approach to investing in order to get exposure to the opportunities that different regions and sectors present, with global equity funds now highly popular. Most global equity funds are, however, very US biased because US companies represent almost 69% of the MSCI World Index.

"Alongside this preference for global investing comes exposure to different currencies too, especially the US Dollar. Since the start of the year, the sharp appreciation in the US Dollar versus other currencies has partially helped cushion the full effect of steep losses on US shares and global equity funds when measured in Sterling. Since the start of the year, the S&P 500 Index has plunged by -19% in capital terms, but for those invested with Sterling, losses would be a less painful -7.9%. When you’re reading about the US bear market and then note that your chosen US fund appears to have held up rather well, don’t assume this is because they’ve necessarily done a great job as currency moves have likely helped out.

"However, currency moves can also go the other way too. The Topix Index of Japanese equities has seemingly held up relatively well during what has been a challenging year, as it is only down by -3.9%. But overlay the weakening of the Yen, UK based investors who bought the Japanese market with Sterling will have experienced double the local currency decline with a loss of -8.4%.

"We would not advocate trying to play the febrile currency markets through your choice of long-term investment funds, but recent currency moves are a reminder that at times exchange rates can have a very big impact and that is certainly the case now.

Should you hedge currency risk?

"While it is certainly wise to be diversified and not over exposed to any one currency – and many investors will have inadvertently become highly exposed to the US Dollar by investing in global funds - over the long run it does make sense for UK based investors to have a reasonable proportion of their investments in Sterling assets if that is where their liabilities and costs sit.

"Some fund managers now also offer versions of their funds that hedge foreign currency exposure back into Sterling, to enable investors to try and neutralise much of the effect of exchange rate movements. These should not be confused with the different share classes offered by many funds these days which are simply priced in different currencies (typically denoted with GBP, USD, EUR at the end) so that they can be sold in different jurisdictions. Nor should they be confused with “hedge funds”, strategies which use a wide tool kit of investment techniques to try and generate positive returns irrespective of whether markets are generally rising or falling.

"Currency hedged versions of funds will typically invest in the same portfolio as the conventional (unhedged) versions most investors are used to. However, they seek to minimise the impact of exchange rate movements by using derivatives – typically currency forwards – to strip out the effect of currency movements. There is usually an additional cost to such funds, which are typically have ongoing fees of around 3 basis points higher than their unhedged siblings. Such funds are often denoted with “Hedged GBP” or “H GBP” at the end and are not always that easy to find.

"Currency hedged funds began to emerge primarily in the Japanese equity sector when recently assassinated former Prime Minister Shinzo Abe returned to office in 2012 and launched his ‘three arrows’ reforms, a key component of which was massive monetary stimulus by the Bank of Japan. This drove down the value of the Yen, but also put Japan back on the radar of many investors, so currency hedged Japanese equity funds started to be launched to enable experienced investors to get exposure to Japanese equities while also trying to neutralise the impact of a weakening Yen.

"While currency hedged funds can play a useful role, many groups do not offer them and they are not widely available on online platforms for retail investors as they are largely aimed at professional investors. If you are going to invest in a currency hedged version of an international fund, because you have a strong view on a currency, don’t forget you will also need to consider switching out of it when your currency view changes.

What now for Sterling?

"A broader consideration now for UK based investors, is where to invest their much-weakened Pounds. The answer could be closer to home. Not only are fundamental UK equity market valuations still at a discount to overall global equities, despite the UK being one of the best performing markets this year with its low exposure to tech stocks and high weighting to ‘value’ sectors, using depreciated British Pounds to purchase more expensively valued US shares is a move that could backfire if Sterling also starts to recover at some point.

"Sterling is currently cheap on purchasing parity measures and so might reasonably be expected to revert towards longer term trend over time. A trigger for a pick-up in Sterling could be a combination of any weakening of US economic data that might persuade the Fed to temper its more recent hawkish tone but also UK-based investors repatriating foreign assets, a fading of current UK political uncertainties or signs that the UK economic outlook won’t be as bad as feared.

Japan: to hedge or not to hedge?

"With the benefit of hindsight, it would have been wise to have hedged Yen exposure back into Sterling (or better still the US Dollar) since the start of the year and this has overall been advantageous over the last decade of very unconventional monetary policy in Japan.

"The plummeting value of the Yen recently has been driven by the Bank of Japan doubling down on its policy of keeping borrowing costs ultra-low (‘yield curve control’) by buying bonds to keep borrowing costs capped at 0.25%, at a time when they are rising elsewhere around the globe. The Bank of Japan’s bond buying frenzy now means it owns half of the entire Japanese government bond market – roughly worth $4 trillion – which looks hard to sustain indefinitely.

"Should you hedge Japanese funds now? Even a modest change in policy – for example, if global inflationary pressures start to nudge inflation higher in Japan – could see the Yen appreciate from currently very depressed levels, and so the case is finely balanced."

About Bestinvest

Bestinvest is a multi-award-winning, digital investment platform and coaching service for people who choose to make their own investment decisions but with the support of tools, insights and qualified professionals. It offers access to thousands of funds, investment trusts, ETFs and shares through a range of account types, including an Individual Savings Account, a Junior ISA for children, a Self-Invested Personal Pension and General Investment Account.

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