Currency Conundrum

You might read online that the returns of a particular equity market rose or declined by a certain amount over a given period. And you might sometimes notice that these returns do not necessarily match the returns you see in your portfolio. Why is that?

It could be one or more of many potential reasons. One could simply be how ‘market-like’ your portfolio is. Another reason could be fluctuations in currency markets, which can mean that the return investors get from overseas investments can be different to what a local investor gets. 

Currency moves normally come out in the wash

The impact of currency moves for equity investors tend to wash out over the long-term, as second order effects have time to come into play, and therefore they are typically left unhedged. But in the short-term, currency moves can have a pronounced and more direct first order effect. For example, a Brazilian investor in Brazilian equities would have achieved a return of around 5% this year. But a Japanese investor in Brazilian equities would have achieved over 31.5% in returns.

While currency has had a big impact on the returns of the Brazilian equity market, the real story of 2022 has been the US dollar, which has strengthened against most major currencies, including Sterling.

Sterling fell from US$1.35 at the start of the year to a low of around US$1.06 in late September, approximately a 22% decline. Most of this weakness was the result of dollar strength, but the so-called ‘mini-budget’ exacerbated the issue. While Sterling is now back up to around US$1.22 at time of writing, this is still a fall of around 10% YTD.         

Why does this matter? It matters because UK-based investors typically have significant US dollar exposure within their equity allocations. After all, US equities make up make up nearly two-thirds of global equities. What the US dollar does is therefore important, and this year it has been quite beneficial for UK-based investors.

The 10% fall in Sterling relative to the US dollar has cushioned the impact of falling US equity markets for unhedged UK-based investors.

To illustrate, in US dollar terms, the S&P 500 index is down 15% so far this year. But in Sterling terms, the S&P 500 index has fallen less than 6%. Incidentally, this is one of the reasons that many UK investors have seen traditionally defensive, bond-biased portfolios underperforming their ‘riskier’ counterparts this year.

A first order consideration: Could the greenback continue its fall back?

This year the downturn in global growth cycle, high US dollar yields, and weak risk appetite have combined to drive the US dollar higher.

But what happens if US dollar strength subsides, as it has started to do recently? Well, there could be several effects. For example, a weaker dollar would likely negatively impact the earnings of companies that generate a significant proportion of their revenues in US dollars, and vice versa. This is an example of a second order effect. A more direct first order effect is that a weaker dollar would likely present a headwind for US equity returns for unhedged UK investors. If Sterling returned to where it started the year against the US dollar, US equities would have to rise by more than 12% before a Sterling investor would start to make a positive return.

The future path of the US dollar has been one of the most debated topics within the Multi Asset team here in Henley. We have been of the view that the US dollar would strengthen and now that it has done so to such an extent, we are mindful that some of the momentum behind the currency’s strength could start to fade in the short-term.

A potential bottoming out in global growth dynamics, alongside a stabilisation in yields, may provide a better backdrop for risk appetite, and could therefore put pressure on current US dollar valuations.

In relation to Sterling, whilst its longer-term fundamentals continue to remain challenged in our view, more clarity and stability on the policy front could offer some further support for the currency in the medium term. While we are not arguing for structural US dollar weakness (or Sterling strength) we believe there is a potential near-term first order risk to US equity returns. 

A second order consideration: The currency translation effect  

A strengthening of the US dollar may also have second order implications. Different markets can react very differently to how currency moves. Market composition matters.

For example, the UK equity market is not really a reflection of the UK economy because large cap UK stocks generate around 75% of their earnings from overseas sources. By virtue of the translation effect, weakness in sterling – especially relative to the US dollar and the euro – tends to offer a boost to UK equity market earnings. Bad news for the UK economy and sterling can often be good news for UK large cap equities. Further US dollar weakness could therefore be a headwind for UK large caps which so far this year, have been one of the few areas in the market offering some degree of comfort to investors.

Similarly, a weaker US dollar could help other areas of the market to outperform. A prime example would be emerging market equities, which tend to outperform in times of dollar weakness.