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 the thick of the stock market crisis phase of the pandemic, in February and March, the pound fell as low as $1.15. Today it is back above $1.30. Why has the pound recovered and what does it mean for your investments?

The first point to note about the rally in the level of sterling is that is rather surprising. We are now just four months away from the end of the Brexit transition period. If negotiations between the UK and the EU continue to stall, we will leave the European club with no deal. That is widely expected to have a negative impact on the British economy, even if the scale of the hit is disputed.

Leaving the EU could hardly come at a worse time for the UK, battling as it is with one of the biggest economic hits of any developed country. The 20% fall in GDP in the second quarter was the biggest in the G7. The proposed end of the government’s furlough scheme in October makes a return to 1980s levels of unemployment possible, if not probable.

Despite this negative combination of factors, the pound has apparently regained its poise in recent months. In the options market, which is the best guide to future volatility, there is no sign of trouble to come. When you think that we are approaching both a political and economic crunch in the next six months, that is remarkable.

In part, the pound’s resilience is a reflection of investors’ optimism that some kind of a deal will be plucked out of the air at the eleventh hour. This is how European talks tend to get resolved - probably with a couple of all-night sessions just before Christmas from which ministers emerge blinking into an early morning press conference clutching a deal.

But sterling’s strength is also a bit of an illusion. Yes, the pound has risen by about 8% against the dollar in the past three months but against the euro it has hardly budged. To an extent, the exchange rate is about dollar weakness rather than a strong pound.

Foreign exchange markets have been a rollercoaster so far this year for a number of reasons. In the first quarter of the year, the US currency was attractive for four reasons: the pandemic was sweeping through Asia and Europe, and had not yet really affected the western hemisphere; US interest rates were also higher than in the rest of the world at the time, making dollar assets look attractive to investors; the pandemic caused a flight to quality, typically US Treasuries; and many companies, faced with a fall in revenues, were desperate to secure dollar financing to meet their dollar debt obligations.

Since the first quarter, all four of those factors have gone into reverse. The US is now the epicentre of the pandemic; US interest rates are back at rock bottom; recovery in the rest of the world has reduced the safe haven trade; and the Fed has expanded the money supply and credit to the economy, reducing financing worries.

There are longer-term reasons to think the dollar might depreciate from here. America appears to have crossed the Rubicon as far as monetary policy is concerned. The Federal Reserve has massively expanded its balance sheet alongside a big expansion in government spending. US personal incomes have risen at a rapid rate as the government has looked to support the economy. This is a potentially inflationary mix. In combination with the prospect of higher taxes under a Biden Presidency, the reasons for capital inflows to the US are reducing, even as Europe and China look to be more attractive homes for international cash.

So, how should you play these trends as an investor? Exchange rates matter to investors because they can add to or subtract from the underlying investment returns you achieve in overseas markets. They can also influence the competitiveness of a country’s exporters. And they can make it more or less attractive for overseas investors to invest in another country.

The challenge is knowing in advance which way currencies will move. There are so many moving parts that even currency experts are often wrong-footed by foreign exchange movements.

In general, therefore, it probably makes sense to be well-diversified geographically so that different currency moves can offset each other over time. But at the margin, the arguments here suggest that the future direction of the dollar is more likely than not to be slightly downwards and that of the euro (with the region closer than ever before to at least a form of fiscal union) to be upwards.

When combined with the higher valuation of the US market and the relative cheapness of European shares, this argues for a partial shift to this side of the Atlantic. That was the view we took in the most recent Investment Outlook in July and the case still holds today.

Read the latest Investment Outlook here. The next Outlook is scheduled to be published in mid-October.

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. Overseas investments will be affected by movements in currency exchange rates. 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

Diversification; Europe; Markets; North AmericaUK

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