The pound has been weakening against especially the dollar but also other major currencies for over a decade now. Recent falls have exacerbated that trend and many analysts expect it to continue deep into 2023 and even then the consensus view is that the pound sterling will remain in the doldrums for the foreseeable future.
For investors, a weaker pound can be a negative development but it can also represent opportunities. Hedging an investment portfolio against long term currency dynamics that are almost impossible to predict is sensible risk management. It is also relatively simple to do so.
Source: Yahoo Finance
More active investors might actively target gains by buying and selling assets with currency dynamics in mind.
Here we’ll look at the recent downward trend of pound sterling and the outlook for the next year or two as well as outline how investors can take simple steps to protect their portfolio value from currency movements or capitalise from them.
Pound sterling in decline
Sterling yesterday fell to a two-year low against the dollar and has been been in a multi-year pattern of decline against the world’s reserve currency since 2007. The most recent plunge in the pound against the dollar, down from £1/$1.420 in late May to £1/£1.156 in early September has led to a sell-off of British assets including gilts that could deepen the slide.
The government’s borrowing rates have reached their highest level since 2014 after two-year gilts suffered their worst month since 1986, driving up the cost of borrowing. Yesterday, the Treasury was selling a £2 billion bond maturing in 2046 at a rate of 3.367% cent, its highest interest rate in eight years.
The UK’s financial strength is perceived as being set to weaken with expectations the new Conservative prime minister will be forced into higher borrowing to fund measures to alleviate the cost of living crisis. As a result, markets now expect the Bank of England’s base interest rate to peak at 4.25% next year to offset the inflationary side-effects of more spending.
The Times summarises the market’s attitude towards the pound and UK Ltd with:
“Data this week showed foreign investors sold off a near-record amount of gilts in July worth £16.6 billion, with hedge funds also ramping up bearish bets against UK government debt.”
The pound is also not only falling against the dollar, though it is the currency it has lost most ground to. A leading measure of trade-weighted sterling, which reflects the pound’s value against a basket of other leading currencies, also fell to the lowest in a year.
Kit Juckes, chief foreign exchange strategist at Société Générale, summed up the gloom surrounding the pound with:
“Sterling’s support is waning. The UK economy is in recession, the balance of payments is catastrophic and more or faster rate hikes won’t do much to restore confidence.”
Will the pound sterling weaken further and might it recover in future?
The pound’s weakness against the dollar, a trend first established by the UK’s sluggish recovery from the 2007-09 financial crash, then reinforced by Brexit and the economic impact of the Covid-19 pandemic, has been compounded by the aggressive approach to raising rates being taken by the US Federal Reserve.
Solid recent economic data out of the USA has seen markets price in the Fed raising interest rates by another 0.75% to 3% to 3.25% when it meets later this month. Fed funds futures indicate about a 77% chance of such an increase.
Analysts at Capital Economics have warned that the pound could slip to a record low of $1.05, with higher interest rates unable to support the value of the currency as the dollar surges. That would extend the pound’s losses against the dollar, currently around 14%, to over 22% since the beginning of this year.
A recent research briefing released by Morgan Stanley outlined the expectation of the investment bank’s analysts that the pound will remain under pressure against the dollar until somewhere around the middle of next year. And they don’t expect a strong recovery after that.
The bank’s researchers also don’t think Bank of England interest rate rises will support the pound as they are not expected to meaningfully exceed those of other major central banks and trail the Fed’s. Morgan Stanley analysts believe the only two factors that will significantly influence the relative strength of the pound are the UK economy’s growth prospects and broader investor sentiment.
However, against the euro the pound has been relatively flat for most of the year. It is down a little over 2.5% after the most recent weakening but Europe has its own economic troubles weighing on the single currency. Any bet on the euro against the pound will likely come down to which economy, Brexit Britain or the single market, fares less poorly over the next couple of years and the outlook doesn’t look especially positive for either.
For UK-based investors, it’s the pound’s strength, or lack of it, against the dollar that will almost certainly present the more significant risks and opportunities over the next year or two.
The Australian dollar, heavily influenced by the price of commodities that the Antipodean country is a major exporter of, could also be an interesting currency play when it comes to investment exposure. Its economic growth is expected to hold up relatively well into next year with commodity prices expected to remain heightened.
The yen might also stage some form of recovery after recent weakening.
Source: Bloomberg/Morgan Stanley/Pound Sterling Live
How a weak pound affects your investments
In total, the pound has lost 14% against the dollar this year, which translates into a 14% adjusted return for UK-based investors who hold dollar-denominated assets like Wall Street-listed stocks. If these losses extend over coming months, as some analysts expect, holding dollar-denominated assets will prove even more lucrative for pound-denominated investors.
How does the pound weakening against the dollar deliver currency-adjusted returns for investors in dollar-denominated assets outside of the dividends or non-adjusted capital growth?
If a UK-based investor bought into a dollar-denominated asset, for example shares in Apple, when the pound was worth $1.35 at the start of the year, a single share, worth $182.01, would have cost £134.82. If the investor sold that share, theoretically trading at the same dollar price, they would get back £158.27. The Apple share price has since dropped to $157.96 which currently translates to £137.36 for a small gain in adjusted terms. That’s despite the fact the share price has seen its dollar value fall by around 13% this year. A USA-based investor selling an Apple share bought in January would realise a loss of 13% on their cash balance. A UK-based investor would realise a gain of 1.88%, minus currency conversion fees.
Pound-denominated stocks listed in London that earn a significant amount of their revenues in other currencies, especially the dollar, can also similarly benefit from a weaker pound. When dollar-denominated revenues are converted back into pound sterling, they are more than they would have been if the pound had been stronger, boosting the bottom line.
That’s why the FTSE 100, which includes many big multinational companies like miners, oil and gas companies and international consumer goods groups, has usually historically risen when the pound weakens. However, the equation can be a complex one as overall investor sentiment around the UK can counterbalance the positive impact of currency movements for FTSE 100 companies. Over the last several days of August, when the pound was weakening, the FTSE 100 also fell.
Should you invest for a weak pound?
Currency dynamics, the strength of the world’s major currencies, are notoriously hard to predict with a long term horizon. Within a range, economists can be relatively confident the U.S. economy will outperform the UK economy for growth over the next couple of years. Over 10-20 years it’s a lot harder due to so many unknown factors.
For example, when the pound first dropped against the dollar in the wake of the international financial crisis, nobody was aware Brexit was on the horizon. The start of what could have been a new strengthening of the pound against the dollar in 2013/14 suddenly gave way to a new bear trend when the Brexit referendum was announced by David Cameron’s government. It was then of course subsequently reinforced by the shock result of that referendum for the UK to vote to leave the single market.
While most have their opinion on how Brexit Britain will fare economically over the next 10-20 years, nobody knows. If things go well, the pound could well strengthen again in the future. It could also weaken further.
The lack of reliability of long term currency movement forecasts means investors would be unwise to build an investment portfolio heavily slanted towards taking advantage of a stronger or weaker pound. But it is wise to balance a portfolio’s currency exposure in a way that is designed to neutralise long term dynamics by hedging different scenarios against each other.
That may sound complicated but all it really means is making sure an investment portfolio has exposure to a range of different currencies and not just pound sterling. Or even dollar, euro, AUS or yen-denominated assets.
More experienced investors who take a hands-on approach to their investments might consider more actively shifting currency exposure in their portfolio to try to capitalise on trends like the pound weakening against the dollar now. They would simply buy more dollar-denominated assets before cycling back into those denominated in other currencies when they felt the current trend had played out.
For most investors, such an active approach may not suit. However, more general currency movement hedging doesn’t have to be complicated.
How to hedge against currency movements
Whether you invest directly yourself, through a workplace pension, or both, you should be able to relatively simply hedge the future pound-denominated value of your investments against trends such as a weakening pound. Most investors hold the majority of their investments through funds, which might be actively managed or passive index trackers.
If you are investing through a workplace pension scheme, or in the process of selecting one, you should have several choices available to you. Some of those may be very UK-centric and invest only or predominantly in pound-denominated assets like the FTSE 100 index or an actively managed selection of London-listed shares.
Most will have a more international flavour and exposure to a range of developed markets, especially the USA. Simply make sure you choose a workplace pension fund that offers diversified currency exposure to assets denominated in different currencies.
If you are investing directly through a SIPP, ISA or private pension through a general fund, you should take the same approach. And if you more actively create your own portfolio through a combination of active and passive funds and individual shares, simply make sure your choices spread currency risk.
If you are willing to take on more risk and bet the pound remains weak against the dollar, you could target more dollar-denominated assets like Nasdaq or S&P 500 tracker funds or actively managed funds invested in the U.S. market.
