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.

In what amounts to something of a surprise move, the pound rose this week to its highest levels against the US dollar since the general election cleared the political air last December. At around 1.33 at the time of writing, the pound now buys more dollars than at any time previously this year1.

The apparent strength of the pound appears to have a lot to do this time with dollar weakness. A weak dollar is symptomatic of improving investor sentiment in markets outside the US, at least, compared with rock bottom confidence earlier this year. Investors are not seeking the safety of dollar assets as they once were.

Heightened volatility in the US stock market this week shows the potential for highly rated technology names to go into retreat. An impending presidential election with a Democratic candidate in poll position and a central bank apparently set to abandon its inflation target – if only temporarily – are other factors currently acting against the dollar.

A week ago, the Federal Reserve Bank confirmed it is prepared to leave interest rates at record lows in order to make up for previous periods of sub-par inflation and stimulate inflation above its long-held 2% target rate2. This landmark shift in policy reduces the appeal of US government bonds, because their future returns adjusted for inflation – or real returns – could be lower as a result.

That’s of critical importance, as investors essentially finance America’s budget deficit by buying US Treasuries, something they will be less likely to do if they expect real returns are going to fall further.

The effects of a weaker dollar are felt way beyond American shores, not least because many foreign companies earn dollars. In the UK, around three quarters of the earnings of the UK’s top 100 listed companies comes from overseas; and around half do for the next 2503.

Big dollar earners like Diageo, GlaxoSmithKline, Unilever and the construction equipment hire firm Ashtead Group are all in the firing line when the dollar weakens. Since around two fifths of British companies pay dividends denominated in dollars, a weak US currency also impacts the sterling value of payouts to investors4.

The current period contrasts markedly with conditions for large companies earlier this year. In the initial stages of the Covid-19 pandemic, investors sought safety in the world’s number-one reserve currency and the pound-dollar rate slipped to around 1.15. That gave a big boost to the earnings of FTSE 100 companies in particular; now that boost has gone.

It’s important to remember though that currency markets can be volatile and conditions can change quickly. A stronger than expected report for US manufacturers on Tuesday lifted the dollar as markets switched to focusing on the prospects for a US economic recovery5. A resolution to ongoing economic stimulus talks in Congress could have a similar effect.

Moreover, the outlook for the UK economy is not without its own challenges. The slow progress of Brexit talks has prompted fresh warnings of a no-deal Brexit at the end of the year, which could constitute a further economic shock. That threat couldn’t come at a worse time. The end of furloughing in October is likely to be followed by a rapid increase in unemployment – decidedly unfavourable for a consumer-led economy already struggling to recover as the pandemic lingers.

This highlights the importance of a difficult decision faced by many investors – whether or not to try to protect an investment portfolio of globally spread investments against currency fluctuations. Some investment funds offer investors a “hedged” share class, which uses financial instruments whose prices move in the opposite direction to the currency of a destination country.

However, while investing this way can remove the ill effects of a currency moving against an investor, it equally prevents participating in favourable currency movements. Given that the outlook for currency markets is always difficult to gauge, hedging might just as easily reduce investment returns as protect them.

Secondly, it always costs money to remove currency risk. Over any particular investment time horizon, there’s no telling whether the cost of hedging would outweigh any foreign currency losses that might arise or not.

Generally, the best approach is to diversify across a number of markets. That will reduce the effects of any one currency suffering falls and having an impact on overall investment returns. Within the UK, foreign currency effects can also be reduced to some extent by investing in smaller as well as larger companies.

The Fidelity Select 50 Balanced Fund provides a one-stop route to a broad markets and currency exposure. This fund invests in 30 or so other funds, mostly taken from Fidelity’s Select 50 list of favourite funds. Alongside a 24% weighting in the UK, this fund currently has large exposures to Europe (17%) the US (25%) Asia (14%) Japan (5%) and smaller positions in Australasia, Canada and Africa.

The JOHCM UK Dynamic Fund is among a number of UK funds on the Select 50 list offering an exposure to small (13%)and medium sized (32%) UK companies6. The LF Majedie UK Equity Fund (10% and 27% respectively) is another7.

Source:

1 Bloomberg, 02.09.20
Federal Reserve Bank, 27.08.20
FTSE Russell, May 2017
Link Asset Services Dividend Monitor Q4 2019
ISM Manufacturing PMI, 02.09.20
JO Hambro Capital Management, 31.07.20
Majedie Asset Management, 31.07.20

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. 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. 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 an authorised financial adviser.

Topics covered

Active Investing; Diversification; North AmericaUK; Volatility

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