Nothing is as constant as change
Heraclitus is of course correct, but perhaps should have appended “or uncertainty” to his proclamation.
In a year already marred by global equity and bond market falls, many UK investors will find the recent drop in the Pound a source of concern. The UK is a relatively open economy and many businesses based in the UK sell products and services outside the UK. Imports and exports are a big part of our economy and sometimes we import inflation along with goods.
£1 would have bought you US$1.17 on 12th September but only US$1.07 today at the time of writing, 26th September. The rate was 1.38, less than a year ago on 19th October 2021 (-22%). The appeal of stay-at-home holidays grows as does that London shopping trip for non UK residents.
For politicians a weak currency might be the least painful of difficult options. For investors the challenges are often not so clear.
Firstly, does the investor really understand their current currency exposures? Many just add up the value of their securities listed in the UK market or priced in GBP, but we know many UK listed firms have significant overseas P&L and Balance Sheet exposures. The resultant currency risks are actively managed by individual companies using derivatives, further muddying the true currency exposure.
Secondly, given the difficulty in measuring currency precisely, how should we attribute a portfolio manager’s performance between skill or the vagaries of the foreign exchange market? Again, sophisticated analysis can be undertaken, but is susceptible to questions of time frame and comparative benchmarks.
Uncertainty, whether it be related to equity, bond or currency, is always with us. But sometimes we are more aware of risks. As we have observed before, having set and agreed your risk profile, the volatility of markets provides the opportunity for re-balancing. Significant market volatility could change your underlying asset allocation further from your agreed policy than you might expect. During a bear market, the less risky assets (cash and bonds) should not fall as much as the riskier (equities). An untended portfolio will experience a reduction in its risk profile as the allocation to less risky assets grows as a percentage of the overall portfolio.
For many long-term investors, the appropriate risk budget will not have changed, and they should therefore re-balance to their pre-bear market strategic target. Generally risky assets will recover to new highs (even if this takes a long time) and the re-balancing will improve aggregate portfolio returns for those who are willing to look beyond current market volatility. The process should be iterative: If risk assets fall further, additional re-balancing should be considered.
Investors should regularly discuss re-balancing of their portfolio with their investment manager(s). And this conversation should include currency exposures, which are a key component of a strategic policy, like asset allocation. Understanding your manager’s approach to managing currency is as important as their approach to asset allocation if you want to avoid surprises.
If you find it hard to understand your real currency exposure, please do discuss with a friend at ARC.
If you'd like to speak to Grant about anything in this month's CIO notes. then please contact him on the details below