The pound has been strengthening recently against the dollar. Or, more accurately, the dollar has been weakening and losing value against most other major currencies, struggling throughout the second half of 2020 and into 2021.
A continued slide could put British investors in hot water – but also opens up opportunities.
But what’s going on? As the world recovers from the shock of Covid, investors are now putting on a brave face and seeking riskier investments away from the safety-blanket of the US dollar, according to the Telegraph.
This has weakened the dollar – a good thing for Brits buying American stocks, which now cost fewer pounds to buy.
And with a Brexit deal now looking nailed down, this should give the exchange rate of the pound against the dollar some stability.
In this article we’ll be looking at how currency risk has a big impact on your portfolio, what makes a currency get stronger or weaker, and where we see the dollar and the pound going from here.
And we’ll look at what you can do to protect your investments!
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What Makes A Currency Strong Or Weak
#1 – Interest Rates
These used to be a big driver of exchange rates, but are probably having little effect right now, with the modern era of close-to-zero interest rates across all developed nations.
If the US were able to raise interest rates, the dollar would strengthen.
#2 – Economic Health
Institutions and banks tend to move invested money out of economies with a bleak outlook, into healthier ones.
The US is in no worse shape than the UK coming out of coronavirus, so this probably isn’t what’s happening now.
#3 – Currency Itself Is A Speculative Investment Class
Traders buy and sell currencies just like stocks. Brokers trade currency based on how they think it will move in the future, which moves the exchange rate.
#4 – Panic and Confidence
At times of panic – war, political upheaval, or plagues roaming the land – investors flock to what they perceive as safe havens. The US dollar is one of these.
When stock markets crashed in March 2020, the dollar got stronger against other currencies. When the panic passed, money flowed back out into the world.
Also damaging confidence are the current money printing programs in the West, the largest being in America.
The US central bank magics money into existence on a computer and buys bonds and other assets in the open market with it, resulting in more cash in the hands of banks, who lend it out.
Thus, more cash dollars end up floating around the economy. This is in addition to the US’s very generous stimulus cheques that have been conjured up for the majority of workers in America. This seemingly infinite supply of US dollars makes them less valuable, and weaker vs other currencies.
Why Currency Risk Matters
Currency risk is the chance of your investments losing money from moves in exchange rates. The share price of a stock you hold can even go up but you can still end up losing money if the currency swings against you.
Currency risk has a big impact on your portfolio, but many investors will not even recognise it as the cause of their poor performance.
You need to be thinking about currency risk when you plan out your portfolio. Even UK stocks are exposed to currency, with around 75% of revenues generated by FTSE 100 companies coming from outside the UK. That’s almost all revenues being in a currency other than the pound.
When exchange rates move, your stocks will either benefit or take a hit. The effect could be small or enormous, depending on events outside of your control.
A Good Century For UK Investors In US Stocks
This chart shows the declining exchange rate between the pound and the dollar since the 1950s – the pound getting weaker and the dollar stronger:
This puts into some perspective the bounce we’re seeing since June 2020.
That strengthening dollar would have had the following impact on a UK investor investing in America’s S&P500 stock index over that time frame:
We’ve laid this graph out with the S&P500 priced in GBP on the right, being the orange line, and on the left, we’ve taken the exchange rate of 2.8 at the earliest data point – December 1954 – and made sure the axis is 2.8 times higher than the GBP side.
The result is a visualisation to scale of the difference between what US investors would have to pay, vs the ever-increasing price that UK investors had to pay to buy into the S&P500.
Had exchange rates stayed the same as they were in 1954, the GBP line would be equal to the USD line, costing £1,330 instead of more than twice this at £2,750 today.
This means 2 things.
#1 – Expensive To Buy
First, for UK investors buying US stocks at any point in the last 70 years, it was a relatively expensive time to do so.
More recently when the S&P500 crashed in March 2020, at the same time the dollar strengthened against the pound.
This meant UK investors were not buying the bargains they might have thought they were.
The US index fell by 34% between 20th Feb and 23rd Mar 2020 – but, Brits would have been disadvantaged by an 11% fall on the exchange rate buying at this time.
This shows that a stock can be cheap for buyers on one side of the Altantic, but not the other.
When an American YouTuber tells you that a stock is cheap, they mean it’s cheap for Americans!
A foreign currency like the Great British Pound will not be on their radar! Ignore them, and just watch Money Unshackled instead!
#2 – Currency Gains
Secondly, UK investors holding US stocks over the last 70 years would have ridden a wave of currency gains.
In fact, UK investors into the US would have received a double dose of growth over this timeframe.
The US’s S&P500 has outperformed all other major world stock markets since 1990 – beating some, like the UK, by a country mile.
So, owning US stocks would have given you better investments, and growth from the currency movements.
But the exchange rate could have moved the other way, like it looks to be doing now, at least in the short-term.
Impact On Investments If The Dollar Continues To Get Weaker
UK investors could take this opportunity to top up their American holdings before and if the dollar recovers.
For us globalists who already own a wide range of stocks from all countries, not just the US, our non-US stocks may be blown upwards on favourable headwinds as other investors pull money out of the US and store it elsewhere.
This by the way, is our actual portfolio equity split, more info on which can be found here.
If you’ve ignored us and built a portfolio solely of UK stocks, your small cap stocks may now perform better from a solely currency perspective, as they have less US exposure.
But as we’ve shown, large caps who make a lot of their earnings overseas in dollars are less likely to benefit.
Impact On Investments If The Dollar Returns To Strength
The most obvious way to restore confidence in the dollar and send it back to strength would be if the US central bank stopped their folly of printing money without limit.
But that is like asking a scorpion not to sting you – as much as it might try not to, at the end of the day, it’s all it knows how to do.
Obviously, central bankers think money printing is necessary, but other experts like Ray Dalio say they’re just kicking a problem down the road. It might be better to take the pain and get it over with.
If the dollar does return to strength, which it probably will eventually because America is such a powerful economy, then you may have wanted to use this time to buy US stocks while they were on sale – relatively speaking.
Should You Fear Currency Risk?
Your time horizon matters. Short-term exchange rate fluctuations can be violent – as we saw around Brexit.
But long-term investors may have much less to worry about – many economists believe that currencies reach equilibrium over time and therefore exchange rate fluctuations tend to balance out.
And we’ve shown how UK investors would have missed out on American growth if they’d worried too much about the increasing buy price.
However, we know from looking at the last 70 years in Fig.1 that a directional trend can become engrained, so let’s now look at your options for reducing or eliminating currency risk.
#1 – Avoid
Just buy UK investments. Hopefully you see the pitfalls in limiting yourself to one market though, and this would not be our preferred way to run a portfolio.
And we’ve shown that avoiding currency risk in the UK market is almost impossible, dependant as it is on the Financial and Energy sectors, both hugely impacted by the US dollar.
#2 – Diversify
Instead of investing in one foreign country, invest in all of them. By owning assets in all currencies, global equities will naturally hedge each other as rising currencies are offset by falling ones.
This method gets our vote.
#3 – Currency-Hedged ETFs
This can be a very cheap and straightforward way to remove currency risk.
Currency-hedged ETFs offset the effects of exchange rates on returns, cancelling out any losses from falling overseas currencies.
Sadly, it also cancels out any win you might have taken from rising overseas currencies too.
As indeed would have happened if you’d chosen to hedge the S&P500 over the last 10 years, instead of accepting the risk and taking the much higher unhedged gains.
Currency Hedged ETFs will usually have the word “Hedged” in their title.
So which way is the dollar going? The US has said it will keep injecting at least $120bn of credit per month until “substantial further progress has been made” in the recovery – by which it means both full employment, and inflation over 2%.
When this will be is anyone’s guess, and until then the dollar will presumably continue to weaken.
Economist Jim Rickards, bestselling author of The Death of Money, estimates this is 5 years away, which could mean $7trn more money printing still to come.
Wealth manager Iboss said: “We expect the dollar will continue to weaken … because the American government and central bank will continue pumping money into the market to help the economy.”
Another wealth manager Seven Investment Management said the dollar could weaken against the pound in the longer term, regardless of Brexit, and with the rollout of Covid vaccines, money might continue to flow out of safe haven currencies like the dollar.
So it looks like a weak dollar, and bargain prices in the US market, may be around for a while yet.
How do you manage currency risk in your portfolio? Let us know in the comments below.