How currency movements can affect your investments

What you’ll learn:

• What makes currencies move.
• How retail investors are exposed to foreign exchange rates.
• How Barclays can help.

Currency movements are always hitting the financial headlines. In the past few months, for example, sterling volatility during Brexit negotiations has been a recurrent theme. Such trends could have a significant impact on the performance of your portfolio – even if, like most investors, you aren’t directly exposed to the currency market. We explain why.

What makes currencies move?

Predicting currency movements is fraught with risk. An economic data release or a surprise political event, which tend to be unpredictable, can cause a currency to slip or jump in the short-term. But in the medium or long term, there are several main drivers of foreign exchange, or forex, market trends.

The main one is the strength of an economy, or the market’s perception of it. A stronger economy generally implies a stronger currency, as confidence in the country’s prospects rises among global investors and they become more inclined to buy assets denominated in that currency.

They will be all the more inclined to do so if interest rates seem likely to rise. Higher rates imply a higher yield on the assets, making them more appealing. A country’s trading relationship with the rest of the world also determines currency movements. Those who export more than they import will typically have strong currencies, boosted by the demand for their goods. 

How retail investors are exposed to forex

Even if you don’t invest in forex, its movements are likely to affect your portfolio. The main way this could happen is if you or your fund manager invest in foreign stock or bond markets. Then any gains or losses made will be offset or enlarged by the shift in currency values.

Assume you put £1,000 in German stocks at the beginning of a year, and during the 12 months the equity market doesn’t move – yet the euro climbs by 20% against the pound. When converted back into sterling at the end of the year, your investments would buy 20% more in sterling.

In this scenario, if you sell you would crystallise a return of 20% on your German stocks, even though they haven’t budged. Similarly, if the euro actually falls by 20% without the stocks moving, you have lost 20% as the euro now buys a fifth less in pounds.

So, when investing in foreign markets the currency movement will increase or decrease the return on the asset itself. A related effect is that if sterling rises, you will be able to buy more foreign currency-denominated investments in the first place, and vice versa.

Even if you only hold UK stocks, you are still indirectly exposed to currency risk. The constituents of the FTSE 100, for instance, make around 70% of their sales abroad¹, so their profits will rise or fall when translated back into sterling in the same way as in the example above concerning German stocks.

Their dividends will also be affected. Dividends have been buoyant in recent months owing to sterling’s slide against the dollar, although the outlook for 2019 is unclear given ongoing Brexit uncertainty and slowing global economic growth².

The earnings effect applies to mid-caps as well as blue chips. In the FTSE 250 the proportion of revenues earned abroad is around 50%³.

As the rise and fall in sterling affects earnings and dividend prospects, it will shift share price valuations and prices.

How Barclays can help

While these currency effects are clear enough in retrospect, they are, like all market movements, extremely hard to predict, and it is difficult to avoid indirect forex exposure. Smaller companies tend to earn most of their money at home – but they are correspondingly riskier and more volatile.

Investors should also bear in mind that despite exchange-rate risk, looking abroad, or at least holding UK companies or funds that invest abroad, will ensure a degree of geographic diversification. Other markets may outperform the UK and may look appealing thanks to cheap valuations and compelling long-term economic prospects.

A diversified portfolio is crucial to long-term investment success, as a spread of assets improves the odds that a fall in one market or asset class can be offset by better performances in others.

Currency risk, then, is not necessarily a good reason to avoid investing overseas or in UK firms with overseas assets. But investors should bear in mind its possible impact and ensure they are comfortable with it before investing their money accordingly.

Remember that all investments can fall as well as rise and you may get back less than you invested. If you’re unsure whether an investment is right for you, you should seek independent financial advice.

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The value of investments can fall as well as rise. You may get back less than you invest. Tax rules can change and their effects on you will depend on your individual circumstances.