Important information: The value of investments and the income from them, can go down as well as up, so you may get back less than you invest.
Looking this week at the performances in 2021 of UK stocks with high and low exposures to foreign markets, I was somewhat surprised to discover very little difference between the two. The work was done for me by the Cboe Brexit 50/50 indices, which track returns from FTSE 100 stocks ranked by revenues received from the UK.
The UK Brexit High 50 Index comprises the 50 companies that derive the largest proportions of their revenues from the UK; the UK Low Brexit 50 Index accounts for the other half. Since the start of this year, both indices have put in good performances, separated by only half a percentage point1.
So why should domestically focused stocks – like BT, JD Sports and Taylor Wimpey – have performed similarly to foreign earners and multinationals – such as Ashtead, Ferguson and Shell – which are fundamentally very different ?
The answer could be that the Brexit discount applied to UK equities five years ago this week continues to unwind. The stock market is enjoying a positive re-rating overall, as the fog over Britain’s trading future relationship with Europe continues to lift.
It might also simply be a quirk of fate. By chance, investors have judged, at this point in time, the improved prospects of UK focused companies to be about the same as those about to benefit from a reopening of the world economy.
Then there’s the pound, which has been strong so far this year. It will have been depressing the revenues of foreign earners translated back into sterling. Had the pound been a bit weaker, overseas focused stocks might have outpaced their more domestic facing counterparts.
However, and here’s the thing, it’s estimated that around three quarters of the earnings of FTSE 100 companies come from overseas2. That implies we should expect quite a high correlation between the FTSE 100’s highest 50 and lowest 50 foreign exchange earners when faced with significant changes in the value of the pound.
The US Federal Reserve Bank could become a big catalyst to changes in currency values this year. Its carefully orchestrated announcements appear to be converging with market expectations that ultra-low US interest rates may not last for much more than another year or so.
That represents a subtle change from earlier statements consistent with several more years of ultra-low rates and suggests international investors may soon be able to look forward to higher returns from risk free and low risk dollar denominated assets.
That possibility has been reflected in a move upwards in the dollar this month. Against the US currency, the pound has fallen from around 1.42 at the end of May to just below the 1.40 level and, while currency moves are notoriously difficult to forecast with any consistency, there are reasons to believe a bullish move in the dollar may continue3.
As well as indicating that a majority of its policymakers now anticipate US interest rates being increased by 2023 – a year earlier than previously thought – the Fed has raised its growth forecast for the US economy in 2021 by half a percentage point to 7.0%4.
Moreover, after more than a year of rising share prices, it seems unlikely there are still a large number of investors still wedded to the dollar for its safe haven characteristics. The dollar’s significant fall over the second half of 2020 would suggest a flight to the safety of last spring has already been unwound5.
Given that the US economy has entered a strong recovery phase, a stronger dollar should be broadly welcomed. It could be the mechanism by which the rest of the world can tag along, selling more goods and services to US buyers who are effectively richer. America’s near neighbours Canada and Mexico should benefit from that, along with China and significant European exporters to the US such as Germany and Italy.
Faster US growth is a positive for emerging markets, but a stronger dollar far less so. A rising US currency pushes down the prices of commodities priced in dollars, reducing the real incomes of commodity producing nations and their domestic consumers. Other world currencies could also get caught in the crossfire, as investors adjust their positions.
While Brexit Low 50 stocks highlight the difficulties faced by sterling investors aiming to avoid foreign currency risks in the UK, the vexed question of what to do about currency risks when investing overseas remains in search of a definitive answer. Some funds investing in foreign markets offer “hedged” share classes, designed to counteract unfavourable moves in exchange rates.
At points in the past, there has been a strong case to make for Japanese funds hedged against a fall in the value of the yen. Most recently, Prime Minister Shinzo Abe’s reinvigoration of a weak yen policy raised the possibility that foreign investors in Japan would benefit from increased profits from Japan’s carmakers and electronics exporters, only to see their returns diminished by currency falls. The Man GLG Japan Core Alpha Fund – one of three Japanese funds on Fidelity’s Select 50 list – offers a sterling hedged share class.
Sterling global bond funds also tend to hedge their foreign currency risks, to ensure that currencies – which can be far more volatile than bond prices – do not overwhelm their ability to preserve capital and pay a consistent income to investors. The Fidelity Strategic Bond Fund, another Select 50 choice, is a case in point.
However, using financial derivatives to filter out currency risks can often amount to an expensive attempt to avoid what is an inevitable consequence of investing that may, or may not, pay off over time. For that reason, the best approach investors can generally take is to diversify their investments across a number of international markets. That way, the effects of any one currency suffering falls and having an impact on an overall investment return is much reduced.
The Fidelity Select 50 Balanced Fund offers investors a very broad exposure to equity and bond markets and currencies too. This fund invests in 30 or so other funds, mostly taken from Fidelity’s Select 50 list of favourite funds. Alongside a 34% weighting in the UK, this fund currently has large exposures to Europe (20%) the US (24%) Asia (11%) Japan (5%) and smaller positions in Australasia, Canada and Africa.
1 Cboe, 23.06.21
2 FTSE Russell, May 2017
3'6 Bloomberg, 24.06.21
4 Federal Reserve Bank, 16.06.21
5 Link Asset Services Dividend Monitor, Q4 2019
Important information: Investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. Investments in emerging markets can be more volatile than other more developed markets. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. Select 50 is not a personal recommendation to buy or sell a fund. When investing in bonds there is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. The Fidelity Select 50 Balanced Fund and Fidelity Strategic Bond Fund uses financial derivative instruments for investment purposes, which may expose the funds to a higher degree of risk and can cause investments to experience larger than average price fluctuations. The Fidelity Select 50 Balanced Fund investment policy means it invests mainly in units in collective investment schemes. There are just a few fixed limits for the three core elements in the fund. These are 30% to 70% for shares, 20% to 60% for bonds and 0% to 20% for cash. Currency hedging is used to substantially reduce the risk of losses from unfavourable exchange rate movements on holdings in currencies that differ from the dealing currency. Hedging also has the effect of limiting the potential for currency gains to be made. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to a Fidelity adviser or an authorised financial adviser of your choice.
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