How to make the most of the currency effect

How to make the most of the currency effect

Most people feel comfortable investing in equities, but perhaps less confident about investing in currencies. What is often overlooked is the extent to which currencies impact equity markets and how important it is to understand these currency and equity interactions when investing in UK equities, international stocks or global funds.

Events last summer provided investors with a perfect example of how currencies affect equity markets. Instead of a collapse in UK markets after the EU referendum, the FTSE 100 (UKX) rose strongly as the global profits of Britain’s largest companies, when exchanged back into pounds, ballooned on the weaker pound, causing share prices to rise. However, UK-focused companies lagged significantly behind their global counterparts.

A report from KPMG at the end of 2016 showed that their KPMG Non-UK 50 index, which represents the 50 largest UK companies with over 70% of their revenue derived from abroad, gained 20% in the six months following the EU referendum – compared to a fall of 6% in the KPMG UK 50 fund, which includes the 50 biggest UK companies where at least 70% of their revenue comes from the UK.

The UK companies which benefitted most strongly from the weak pound were clearly those that earned most of their revenues overseas. These included sectors such as mining and oil & gas, closely followed by defence and aerospace companies, with healthcare companies not far behind.

Shire (SHP) earns 96% of its revenue overseas, with 70% of its revenue coming from the US. HSBC (HSBA), which represents 7.4% of the FTSE 100, earns most of its revenue in Asia.

UK-focused companies lagged much further behind, caught out by both a weaker currency and the prospect of a slowing UK economy.

These included Capita (CPI), which earns 70% of its revenue in the UK. It recently dropped out of the FTSE 100 due to a fall of 30.8% over the past year. Compared to the FTSE 100 growth of 9.3%, this is a net underperformance of 40.1%.

Another company that earns 72% of its revenue in the UK is Intu Properties (INTU). It has seen its share price fall 17.5% over the past year, underperforming the FTSE 100 by 26.8%.

Of course, it is not just currencies that move markets. The mining sector benefited hugely from increased Chinese demand and the initial Trump trade, while the pharma sector has been on a roller-coaster ride thanks to Trump’s repeated efforts to repeal Obamacare.

Nonetheless, the relative performance of UK versus globally focused stocks does confirm that currency movements certainly have an impact.

Investing in US stocks

While it is relatively easy for UK equity investors to work out which UK stocks they should be buying depending on their view of sterling versus the dollar, there is a wide range of options for investors choosing international stocks and funds too.

Take a hypothetical example of share ABC to see just how much investor returns are enhanced if the currency moves in your favour. On top of rising equity valuations, investors could also be rewarded by currency appreciation in those cases where equity market performance is positively correlated with currency movement.

Stock ABC – sterling falls
  Purchase Sale Return
Share Price $100 $120 20%
Currency £:$ $1.50 $1.20 25%
Cost/Value £66.67 £100 50%

The example above shows an investor buying $100 of Stock ABC when the exchange rate is $1.50 to the pound. This would cost our investor £66.67.

Our investor chooses to sell when the share price has risen 20%. However, at this point the dollar has rallied from $1.50 to the pound to just $1.20, an appreciation of 25%.

The investor therefore benefits from the compound gains of 20% on the share and 25% on the currency, giving her an overall gain of 50%. This clearly shows how UK investors can benefit from buying US stocks if the dollar is going to strengthen relative to the pound.

What this example also shows is how important it is to invest in those companies where share performance is positively correlated with a rising dollar, so investors need to look beyond just the currency and work out what type of US companies are likely to benefit the most.

If the dollar is strengthening because of an improving US economy, this typically favours US companies that import raw materials or intermediate goods and sell their products mainly in the local market. Examples include Home Depot (HD), which earns 89% of its revenue in the US and is also likely to benefit from less expensive imports, reducing its costs.

Another example would be Wells Fargo (WFC), which unlike most US banks earns 95% of its revenue in the US, making it a very attractive option, with the added benefit that as monetary conditions start to normalise, rising interest rates should boost the profitability of banks.

A strong dollar is potentially less of a benefit for big multinational US companies, which earn most of their revenue overseas, including Apple (AAPL), Intel (INTC) and McDonalds (MCD). Here, the appreciating currency will reduce the dollar value of these overseas profits.

UK investors need to be much more selective about buying overseas stocks if the currency of their shareholding is depreciating. The example below shows that the same underlying 20% equity return for stock ABC has been wiped out entirely by the strength of sterling.

Stock ABC – sterling strength
  Purchase Sale Return
Share Price $100 $120 20%
Currency £:$ $1.50 $1.80 -16.7%
Cost/Value £66.67 £66.67 0%

What about investing in funds?

Fund investors also have the option to take a view on currencies in most markets by choosing between normal ‘unhedged’ funds and equivalent funds which are ‘hedged’ against currency moves.

This is not the same as a hedge fund, but instead is where a fund manager strips out their exposure to the currency and leaves you with just the underlying equity return (plus or minus the costs of hedging).

Numerous managers offer both hedged and unhedged versions of some of their more popular overseas funds, including Schroders, JPMorgan and Legg Mason among others.

As per our previous example of Stock ABC, there are times when you absolutely want to be in the ‘normal’ unhedged version of a US fund, such as in the aftermath of the Brexit result.

However, if you believe that sterling is going to strengthen, as it has done recently, then the hedged fund version will deliver better returns.

Throughout the three years 2014-2016, sterling was progressively falling in value, delivering enhanced returns for investors in US stocks who were also taking on the currency risk.

In contrast, the recovery in the pound so far this year means that the hedged versions of these funds have outperformed, as the performance table above shows.

So, investors who have a view on sterling have plenty of options available in order to make additional returns.

If you believe sterling is going to fall and the dollar rise, then you could invest in international stocks which are listed in the UK, especially those whose earnings are principally US based.

Investing in these stocks will deliver additional currency benefits as sterling falls. Fund investors will want to have the benefit of the currency exposure, making the normal version of the fund more attractive.

However, if you believe sterling is going to strengthen, then UK-focused stocks are a better bet and you need to be careful about selecting international stocks.

Fund investors in this case would be better off choosing the hedged version of the fund, as they will still benefit from the equity market return, without being negatively affected by the rise in sterling.

We may not want to be currency traders, but the increasing impact that currency markets have on stockmarket returns cannot be understated. Having a currency view, whatever type of investor you are, is more essential now than ever.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

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