The strength of the pound sterling has been one of the surprise stories of the last nine months, with data from FE Analytics showing that the currency has appreciated 8 per cent against the dollar since the end of last March and strengthened against the other major currencies as well.
Performance of currencies relative to $ since Mar 2013
Source: FE Analytics
Investors in overseas stocks will have had to see their investments increase by more than a UK alternative to match the returns of the latter.
This raises the questions of whether the phenomenon is likely to continue this year and if so, what investors should do about it. Investors may be tempted to overweight the UK to take advantage of this prevailing tailwind.
Neil Staines (pictured), global macro team head of trading and execution at currency specialist ECU, says that sterling strength is a consequence of relative UK economic strength and is likely to be a feature of 2014 as well, at least in comparison to most parts of the world. “We have been strong advocates of sterling strength for some time now,” he said.
Staines says he expects UK GDP to be 1 per cent in the fourth quarter of 2013, ahead of most expectations, and that the good news will continue this year.
“There have been some people trying to cast doubt on the recovery in the UK and saying it is too reliant on the consumer, and so far there has been a strong consumer-driven rally in the first part of the recovery.”
“However, it is important to compare it across the other regions: there has been a similar amount of deleveraging in the US and the UK and I think that’s important: at a consumer and corporate level, we are in a better position to invest going forward.”
“The eurozone continues to be a worry: we don’t think there’s sufficient momentum or growth to reduce the debt.”
“The case for sterling is specific to where you invest: I think in 2014 you will see further outperformance against the euro and the yen, but not the dollar.”
Staines says that he expects the US data to continue to improve and the Fed to persist with tapering.
He says the UK will be the first country to raise rates – at the end of 2014 – which will give the currency an extra boost. The UK’s extra inflation will demand this action.
However, he warns that when the US does the same, it will do so faster and more aggressively, giving the currency a further boost.
Staines also says that the new management at the Bank of England has shown by its comments that it is more sanguine about sterling strength than Mervyn King, who often warned of its negative effects. It will be keen to use the currency to dampen down inflation, he says.
The stage seems to be set for another good year for the British pound, but investors should be wary of using this as a reason to invest in the UK, according to David Jane, manager of the TM Darwin Multi Asset fund, who warns that this is a high-risk strategy.
While he agrees that UK Government policy has compelled the currency higher, he warns that these movements can easily catch out investors. “If you think about last year, the big surprise to us was the strength of sterling: it was stronger than we thought,” he said. “We ended up hedging our euro and yen exposure, which saved our bacon.”
“The reason [for currency strength] is our Government's policy, although we don’t necessarily see it, because we’re British, Britain seems to be following a very prudent path in comparison to what’s going on in the rest of the world. It seems our policies are preferred by international investors.”
“Do we think it will continue? I think currencies are very difficult,” he added. “We have followed the policy of hedging our European bonds back into sterling and I think that a weak euro will continue against sterling. The tricky one is the dollar.”
“People get very muddled up with currencies. When currencies do well, often equity markets don’t. You are much better off constructing a broadly based portfolio.”
“It’s a much riskier strategy to be invested in just the UK; you are better off in a portfolio diversified by geography.”
Jane notes that sometimes the gains on equity markets can outstrip the losses on currency, which means you could lose money even being in the stronger currency.
“It [sterling strength] would argue for a more UK-based portfolio, but this needn’t be the case. You would have still been better off in foreign equities last year,” he said.
The performance of the major indices underlines this point. Looking at sterling’s recent period of strength, UK investors in the FTSE All Share would have beaten those who had bought Japanese shares, but would have made more money investing in European and US stocks, despite the relative underperformance of the currencies of those regions.
Performance of indices since Mar 2013
Source: FE Analytics
In fact, the manager warns that currency strength can cut both ways, as companies selling abroad will find their products becoming more expensive in their customers’ currencies.
“Strong sterling is bad for British companies as they are so dependent on foreign earnings,” he said.
Besitnvest’s Jason Hollands says that sterling strength could even be a reason to invest abroad. If the pound is stronger, investors will be able to buy more foreign shares for their cash, he explains.
“If you are investing overseas you are getting an extra kicker as a sterling investor as you can buy more,” he said.
“So if Japan for example is the widely tipped hot market for the year where the currency is weak, then it will play to your advantage.”
This is certainly the case in Japan where there are a number of funds that hedge their currency exposure, including those from Morant Wright, GLG and JO Hambro.
This means that they use derivatives to remove the effect of a weakening yen on the portfolio and investors can ignore the fate of the currency.
However, funds that hedge their currency exposure are not available on the other major markets such as Europe, where the consensus is that sterling will dominate.
In these cases, Hollands says there is still an advantage, but it depends on the action of mean-reversion: if you can buy European stocks cheaply and then the currency appreciates, this will work to your benefit.
However, if the currency doesn’t appreciate, you will be caught in a value trap. For this reason, having some comprehension of what the currency you are investing in is likely to do over your time of investment could help maximise your gains.
