Currency movements are always hitting the financial headlines. In the past few months a fall in the US dollar and a recovery in the euro have been recurrent themes; last year, sterling’s slide after the vote to leave the EU was a major talking point. These 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.
The foreign exchange, or forex, market is the biggest in the world, with daily trading volumes of around $5 trillion.1 The New York Stock Exchange, the world’s biggest, turns over around $200 billion a day. The US dollar, the world’s reserve currency, is on one side of 85%2 of currency transactions, and the most commonly traded currency pair is the dollar against the euro.3
The forex market is notoriously volatile, unpredictable and risky, so it is largely the preserve of institutional investors. Large movements in both the short and the long term are common. For instance, in the immediate aftermath of the EU referendum last year, sterling fell by just over 10% against the dollar.4 Its value has ranged from near-parity with the greenback in the mid-1980s to over $2 in 2008.
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 forex 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 abroad5, so their earnings 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. Around a third of UK dividends in the second quarter of 2017 were declared in dollars.6 Dividends have been buoyant in recent months owing to sterling’s slide against the dollar.
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%.7
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. However, you need to bear in mind that past performance is not a reliable indicator or future performance.
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 no 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.