What does the strong pound mean for my investments?

THE pound has come a long way since its nadir in 2022, in the immediate aftermath of the Truss government’s mini Budget. From around 1.07 versus the dollar last September to 1.24 today, the 14% revival in sterling over the past seven months has been impressive¹.

Changes in Britain’s political scene aren’t wholly behind this move. In fact, they might have had little more than a marginal effect. The euro has performed almost as well against the dollar as sterling, adding around 11% over the same period².

So the real story has been one of dollar weakness more than anything else. Markets are betting on interest rates coming down in the US either later this year or in 2024 and sooner than in the UK, making dollar assets less attractive on a relative basis.

The latest data suggest the US consumer is, at last, starting to roll over in the face of elevated inflation and high borrowing costs. Retail sales have been patchy since January, with falls of 0.7% in both February and March more than counterbalancing a 0.4% rise last month³.

With domestic private consumption accounting for more than two thirds of America’s economic output, there’s only so far the Fed can realistically go in pressing down on inflation. Downbeat sales forecasts from Home Depot and Target last week seem to confirm weakening consumer trends.

Meanwhile, inflation in the UK is proving more persistent than almost anyone thought, so rates could stay high a while longer over here. With food prices still on the rise, we still have some way to go to meet the prime minister’s target of halving the annual inflation rate by the end of this year. That’s even with the simple maths of high base effects in 2022 on his side.

With the summer fast approaching, holidaymakers may well be taking exchange rates into consideration when deciding between Europe and America as a destination. Currencies though also have an impact on the value of our investments.

Whether you own shares in a UK company drawing most of its earnings from the US – Ashtead or Ferguson, for example – or a fund investing in Europe or emerging markets, currency movements are likely to be a factor in how your investments perform.

The UK stock market is famously exposed to overseas earnings – more than 75% in the case of the FTSE 100 and around a half for the FTSE 250 – so foreign currency movements too⁴. It’s one of the reasons why stock market returns often seem to diverge from the performance of the UK economy. Buying British often actually means buying global.

Even UK businesses selling goods mainly to UK customers – take B&M European Value Retail and Next for example – have a foreign currency exposure, since they source a substantial proportion of their goods from overseas. For them, a strong pound is generally a good thing.

One of the consequences of this is that UK investors have the opportunity to allocate some of their money overseas, with only a limited increase in currency risk compared to investing in UK companies alone. 

In exchange for that marginal increase in currency risk, areas underrepresented in the UK become available – for example, US, Japanese or Chinese technology, or basic resources and precious metals in developing countries.

That highlights another aspect to the debate about currency risk. Investing in almost anything involves risks of some kind or another, including the one that’s impossible to have any influence over – market sentiment.

Volatile swings in the prices of shares in global mega-companies like Apple, Meta and Tesla over the past year in the absence of any significant changes in underlying fundamentals suggest that currency considerations ought not to be the main area of focus.

You might decide to invest more overseas when the pound is strong compared to when it is weak. Notionally, you get more underlying assets for your money.

However, thinking like this can amount to trying to time currency markets, which is a notoriously difficult pursuit. Like attempting to time stock markets, this can be a source of investment mistakes that add nothing to your longer term returns.

Back in the 1990s, one idea was to hedge the Japanese investments held by sterling investors back into pounds. The idea arose as Japan increasingly moved to a policy of weakening its currency in order to counteract deflation and boost the competitiveness of its legions of manufacturing exporters.

So some investment houses launched sterling hedged share classes for their Japanese funds. However, while this may have worked initially, the benefits proved short lived.

The pound-yen exchange rate has been relatively stable ever since the mid 1990s. At the start of this century, one pound would have bought around 172 yen, not much different from the 170 yen you would get today⁵. Yet long term investors in hedged share classes will have had to stump up hedging costs for all the years in between with no commensurate reward.

The biggest determinant of returns over the past 30 years has been the quality of fund manager. Successful funds such as the Baillie Gifford Japanese Fund – a Select 50 fund – have provided investors with attractive returns over the long term through having skilled managers able to identify and invest in the best companies Japan has to offer⁶.

Moreover, for most investors, currency risks should be seen as a fact of life. They’re certainly worth monitoring and taking account of, but not really to the extent that they fundamentally alter an investment strategy.

Maintaining a diverse exposure to asset classes, geographies and currencies too – so managing risk rather than trying to avoid it altogether – remains the best route to achieving attractive long term returns with acceptable levels of volatility.

The Fidelity Select 50 Balanced Fund – which invests around 80% of its assets in Select 50 funds – works this way. While this fund benefits from a unique makeup, it has at least one thing in common with most other globally invested funds – no currency hedges.

Source:

¹ Bloomberg, 19.05.23

² Bloomberg, 19.05.23

³ US Census Bureau, 16.05.23

⁴ FTSE Russell, May 2017

⁵ Bank of England, 18.05.23

Important information: Investors should note that the views expressed may no longer be current and may have already been acted upon. 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. The Fidelity Select 50 Balanced Fund invests in overseas markets so the value of investments can be affected by changes in currency exchange rates. This fund uses financial derivative instruments for investment purposes, which may expose the fund to a higher degree of risk and can cause investments to experience larger than average price fluctuations. 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. 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. 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. 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 one of Fidelity’s advisers or an authorised financial adviser of your choice.