Anyone heading off abroad at the moment will be facing the prospect of the Pound not stretching as far, as Sterling continues to weaken when compared to other global currencies. The implications of a weak Pound go much further than making holidays more expensive as it has a major impact on the UK economic outlook and for investors in UK assets.
Interest rates are key
Whether a currency is strong or weak against a basket of other currencies, and notably the US Dollar depends on a number of factors. The prevailing interest rate, and expected interest rates in the medium term, can help promote a strong currency, as investors will be more keen to hold cash in a currency where interest rates are higher than in a currency with lower interest rates.
The Bank of England, whilst raising interest rates on five occasions since December 2021 are still lagging behind the US and Canada, with the US Base Rate standing at 1.75% and the Canadian Base Rate at 1.50%, compared to 1.25% in the UK. However, the Base Rate is still some way above the Eurozone, where Base Rates are effectively still at zero. Interestingly, the Euro has been just as weak against the Dollar as Sterling, and is close to reaching parity with the US Dollar.
The importance of stability
Financial stability is another important consideration, as investors would, unsurprisingly, be more willing to hold reserves in a country that has sound economic prospects and good governance. It is quite evident the political turmoil and uncertainty we have seen over recent months has impacted on Sterling’s performance. Looking at the longer term, Sterling has been on a broadly downward trajectory against the Dollar ever since the Brexit vote was announced in 2016, and given the uncertainty that was introduced by the vote to leave the EU, again, it is perhaps not a surprise that Sterling has found itself on the backfoot.
Lastly, levels of inflation that exist in the location where reserves are held is also important, as higher levels of inflation can hinder real returns achieved on deposits. Inflation in the UK is also higher than most other developed nations, with the Consumer Price Inflation (CPI) measuring 9.1% in May and standing higher than both the US and Eurozone, at 8.6%.
The higher levels of inflation are, to some extent, not only a disincentive to holding Sterling, but a direct result of Sterling’s weakness. The UK has a negative trade balance, in that it imports significantly more than it exports. Imported goods that are priced in Dollars can potentially cost more when passed on to end consumers, once the Dollar price is converted to Sterling.
The impact on the UK economy
Considering these factors, there is plenty of evidence that confirms why Sterling is under pressure at the current time. But how does this impact on UK businesses, and in turn on the prospects for investors in UK assets?
We have already alluded to the fact that importing goods in Dollars will become more expensive as Sterling weakens. Businesses have a choice whether to absorb these higher costs, at a risk to their margin, or pass on the cost increases, which runs the potential risk that customers may turn to alternatives or simply reduce or stop buying the product altogether. This is the reason why we favour funds that invest in businesses with strong market share, good cash flow and brand loyalty, that can look to pass on increased costs without affecting their market position.
Sterling weakness can provide a positive impact on companies that earn a good proportion of their income from outside of the UK. Within the FTSE100, around three quarters of revenue earned by the largest UK companies are generated overseas, and once these earnings are converted back into Sterling, a falling Pound can amplify the profits of these companies. This effect is less prominent in mid-sized companies, and in particular, far less apparent in smaller companies, that tend to be more domestically focused. For those companies that primarily export their goods, a weak Pound is a barrier to profits, as goods and services priced in Sterling can look more expensive to overseas buyers.
Should investors be concerned about currency risk?
We live in a global economy, and it is only correct that investors should look to hold a diversified investment portfolio, with assets spread across the globe. As we have commented in previous articles, the UK market is relatively tiny compared to the influence of the US, and by simply focusing on UK positions, many of the World’s largest and by definition successful companies will be out of reach. That does, of course, lead to currency risk.
As we have seen over the course of this year, Sterling’s weakness has helped overseas investments held in UK funds. The S&P500 index of leading US shares is down over 17% over the year to date in Dollar terms, but due to Sterling’s weakness, the fall is just 8% when converted back to local currency.
The reverse effect would, of course, be apparent in periods when Sterling strengthens. In these conditions, one option is to blend funds that aim to hedge their portfolio against currency movements.
Where next for Sterling?
The Pound has drifted down a slippery slope this year, due to higher inflation, political upheaval and weak economic prospects. Given our expectations for the coming months, it is difficult to see the position changing significantly in the short term.
If you would like to review your portfolio to consider aspects such as currency risk with one of our experienced advisers, please get in touch here.
The value of investments and the income they produce can fall as well as rise. You may get back less than you invested. Past performance is not a reliable indicator of future performance. Investing in stocks and shares should be regarded as a long term investment and should fit in with your overall attitude to risk and your financial circumstance.