When faced with market volatility and alarming headlines, it can be useful to take a new perspective. Simon Bruce gives an upside-down view of currencies and exchange rates.
Sterling’s woes or dollar strength?
Sterling has been falling against the US dollar for some time, but, turning this upside down, the dollar has been strengthening against Sterling.
In fact, due to its status as a ‘safe-haven’ currency and the Fed’s more aggressive rate- raising strategy, which has resulted in more attractive shorter-term yields, the US dollar has strengthened against most major currencies over the past year, attracting global capital. It is also a major energy exporter, which adds extra support.
The DXY index that tracks the dollar against six major currencies stands today at a 20-year high.
As the chart on the below illustrates, Sterling is largely unchanged against the Euro and the Japanese Yen over the past year.
A consequence of the weak pound is importing inflation, as around one third of household consumption is made up of imports, which are now more costly.
From an investor’s perspective, a rising US dollar provides a positive contribution to Sterling-based returns, as US assets are worth more – over 20% more – in the past year. This has helped to shore up portfolio returns for many.
The UK equity market is down only around 3% in the past year, supported by large holdings to sectors such as energy and low holdings to technology. This is combined with the fact that a majority of earnings are from overseas, benefitting to some degree from these exchange rate movements.
No one really knows where Sterling will go from here and over what time frame.
Hedging fixed income assets remains sensible, as this reduces their volatility, and remaining unhedged – that is to say, exposed to currency movements – in equity assets continues to make good sense and will support portfolio values if Sterling falls further.
Inflation and interest rate rises
Rising interest rates are a global phenomenon as the countries grapple with high inflation caused by a rapid growth in the money supply (quantitative easing), supply side issues caused by Covid and the price pressures on energy and food created by Russia’s war in Ukraine.
The fact that the UK Government needs to borrow more, as a consequence of the energy cost support packages and its unfunded tax cuts, is also contributing to rising yields.
But take a look at inflation, central bank interest rates and bond yields in a number of major economies in the chart below.
Date source: Countries’ central banks. Note that inflation for Germany and Italy is the Eurozone inflation rate
It is evident that inflation is universally high. Five-year bond yields are at or near 4% in all but one of these economies and all have risen materially in the past six months.
While that is bad news for mortgage and other borrowers, who have benefited from an extremely low cost of borrowing for many years, it is better news for those holding cash or investing in bonds.
Despite bond price falls as a consequence of yield rises, long-term investors will be better off, over time, from yields at 4% than at near 0%, which we saw 18 months ago.
In the UK, real (after inflation) yields on index-linked gilts are now in positive territory for the first time since 2010. That is good news for investors.
As a consequence, investors’ future liabilities are likely to be more easily funded by their assets.
There is a school of thought, including that of the former chancellor, that the recent support for the supply side of the economy – that is to say, increasing productivity and output – by incentivising companies and entrepreneurs through tax reductions may lead to higher rates of sustainable growth in the future, which will, in turn, help to reduce inflation and allow the Government to bring down debt.
Obviously, this would take time. The markets currently seem unconvinced. In essence, no one knows how this all plays out exactly.
There is no doubt that there will be uncertainty ahead, but investors who own globally diversified portfolios of equities and higher-quality shorter-dated bonds should be well-positioned to weather any possible storms.
Simon Bruce (right) is the chief executive of Cavendish Medical, specialist financial planners helping consultants in private practice and the NHS.
The content of this article is for information only and must not be considered as financial advice. Cavendish Medical always recommends that you seek independent financial advice before making any financial decisions.
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