How will the shrinking pound affect you?
Anyone who's been on a foreign holiday recently will have noticed the pound no longer goes as far as it used to.
Whether you happen to be browsing in a street market in San Francisco, shopping in a plush Parisian boutique or relaxing in a bar on an Australian beach, sterling's continued weakness against most other leading global currencies – due to a combination of economic and political factors – has made it increasingly expensive to buy anything abroad.
It's not just holidaymakers, however, who are feeling the impact of the slump in sterling. The vast majority of us with money in the stockmarket will be affected in one way or another by the UK currency's recent poor reputation in the global financial markets.
In fact, according to Andy Gadd, head of research at Lighthouse Group, even those of us who thought we could avoid potential currency problems by staying at home and only investing in UK-based companies had better start checking the value of our portfolios.
"Few investors appreciate that even with UK-based companies, approximately 40% of the earnings in the FTSE All-Share come from overseas and need to be converted back into sterling," he says.
Charlie Morris, head of absolute return at HSBC Global Asset Management, agrees that this can have a major effect on investments. He suggests there's a sliding scale of currency risk associated with different sorts of investment.
The scale starts with you putting your money in the bank, which comes without any risks attached, unless of course you want to spend your money abroad.
"Then, you can take a bit more risk – although still not any currency risk – with government bond portfolios," Morris explains. "But as soon as you buy equities you are getting involved in commerce, which is entirely different.
"Almost everything you do will involve currency risk, because the vast majority of UK companies have international exposure."
This obviously has an effect on returns. "If the pound falls by a third, stocks in such companies will do very well, partly because their overseas investments will be worth so much more in sterling terms," Morris says.
"Additionally, the fact that the pound goes down will be offset by share prices having to rise by a similar amount. If they didn't, then foreign investors would be getting British-based companies cheap and the market would want to stop that happening."
In contrast, cash on deposit will lose its purchasing power. "If the pound collapses by a third, your deposits in the bank will not buy you much of a foreign holiday next year," he adds.
Whether or not your investments are affected depends entirely which assets your money has been invested in, as Geoff Penrice, a financial adviser at Honister Partners, points out. But of course currency movements add another layer of risk to the whole equation.
"This is one reason why overseas equity funds are considered higher risk than funds investing in UK assets," he explains. "This can work against you or in your favour, but either way it is notoriously difficult to predict."
Most British investors will have a large proportion in sterling-denominated funds, but you should consider having an element of exposure to overseas funds in order to achieve the required amount of diversification.
"Many investors believe emerging markets will outperform the developed economies over the next 10 to 20 years, so will be happy to take extra exposure to currency risk in order to tap into these markets," adds Penrice.
The level of risk also depends on the currency in which a company chooses to pay its dividends. For example, if it pays them in dollars when that currency is particularly strong against the pound, this could mean the amount you receive will be worth considerably less.
Trading in sterling
According to Mark Bodega, marketing director for foreign exchange specialist HiFX, currencies are traded in pairs – so to buy one currency you have to sell another – and rise and fall for a number of reasons. "The movements usually reflect the health of the local economy," he says.
"For example, sterling has been very weak against all its major counterparts over the past 12 months, partly due to the fact the UK has been deep in recession."
Generally, factors that will influence the value of a currency include economic conditions such as inflation, monetary policy, government deficits, the housing market and unemployment; political factors like stability, the form of government and its relationships with other countries; and natural resources, which principally means the possession of large reserves and how they are being exploited.
Stephen Hughes, a director at Foreign Currency Direct, believes sterling was hit particularly badly due to the fact it had been so strong for years. "It was massively overvalued, so when things started to go a little bit wobbly the effect was far greater than for some of the other currencies," he explains.
Subsequently, the policy of quantitative easing adopted by the Bank of England has not exactly helped sterling's cause. As far as the rest of the world is concerned, the fact we have been pumping in billions of pounds illustrates the fragile nature of our economy.
"If we have to release even more money, it will have a pretty negative effect on sterling," Hughes adds. "If we're still trying to repair our currency at a time when France and Germany are announcing they're no longer in recession, this will put us a long way behind."
Economic problems, political uncertainty and further public spending deficits may also swing the balance against sterling. However, it's likely to be the ever-present worries over the housing market that will prove decisive, suggests Hughes.
"Property is the main driver in the UK. If houses are being bought and sold it means people have equity and, therefore, money to spend. Until that happens we really are in a stagnant situation," he says.
Early this year, according to Bodega, sterling started to show signs of life. "From the beginning of 2009, sterling has been gradually recovering, boosted by the prospect of a recovery in the UK economy," he says. "Having reached $1.70 and €1.19, though, the upward trend seems to have run out of momentum since August."
This slowdown is being attributed to uncertainty over the sustainability of the recovery, with economists split on whether the markets will bounce back strongly or yo-yo for a few months before enjoying a longer-term uplift.
Investing in currency
Besides being exposed to currency movements through your investments, you can also invest in currencies themselves – either through buying the actual notes, or more effectively, by buying into a specialist fund run by a full-time investment manager who will study the various markets on a daily basis.
However, you need to be pretty thick-skinned if you're going to start dabbling in currency investment. There are so many factors that can influence the relative values of currency that it's almost akin to gambling, warns Penrice, although there's the potential to make money if a currency fund is run properly.
An alternative to cash
The prevailing conditions have even persuaded Mark Dampier, head of research at Hargreaves Lansdown, to buy his first-ever currency portfolio – he has chosen Schroder's new Global Managed Currency fund.
"I bought it because it's virtually a cash diversifier," he explains. "I've got a degree of money in cash anyway, and it's obviously earning peanuts at the moment. I've also looked at economies around the world and feel sterling could easily fall further."
The aim of the fund is to invest in a diversified basket of currencies and deliver more attractive returns than those achieved by government bonds. It aims to outperform the Global Currency Index by targeting a return in excess of 3%.
When the fund was launched last June, Robin Stoakley, head of UK retail at Schroders, said the company wanted to offer clients an alternative to cash deposits and government bonds that could deliver a higher yield and the potential for capital gains, while helping them to preserve their global purchasing power.
"Many investors hold assets in cash deposits but, with interest rates as low as they have ever been, these are no longer an attractive option," Stoakley explained.
"Moreover, with inflation expected to rise again in the future, the value of those deposits risks being steadily eroded over time, destroying purchasing power."
The fund has taken the view that many of the most exciting currency opportunities are to be found in the developing world, and so it has been overweight in eastern European currencies such as the Polish zloty, the Czech koruna and the Hungarian forint.
The impact on expats
Arguably more important than its potential impact on stocks and shares, however, is the difference currency movements can make to the lives of Britons living abroad, particularly those who have taken the plunge and decided to retire overseas.
"For example, many expats in France and Spain have found themselves in trouble this year because they are still having their pensions paid in the UK," Dampier explains. "The fall of sterling means their income is worth about 20% less after it has been converted into euros."
So which currencies are likely to do well during the next few years? Bodega at HiFX believes the outcome will be influenced by volatility, a key theme over the past 12 months which looks likely to continue over the coming period.
"However, I still feel sterling is undervalued and e xpect the recent recovery to continue," Bogeda says. "Currencies from countries such as Australia, New Zealand and South Africa, whose economies are based on exporting commodities, are also likely to do well as commodity prices continue to rise."
Five things that could bring the pound down
- A double dip in the economy
- A housing market crash
- Public spending deficits
- Political uncertainty
- Further quantitative easing by the Bank of England
Lower interest rates encourage people to spend, not save. But when interest rates can go no lower and there is a sharp drop in consumer and business spending, a central bank’s only option to stimulate demand is to pump money into the economy directly. This is quantitative easing. The Bank of England purchases assets (usually government bonds, or gilts) from private sector businesses such as insurance companies, banks and pension funds financed by new money the Bank creates electronically (it doesn’t physically print the banknotes). The sellers use the money to switch into other assets, such as shares or corporate bonds or else use it to lend to consumers and businesses, which pushes up demand and stimulates the economy.
The general term for the rate of income from an investment expressed as an annual percentage and based on its current market value. For example, if a corporate bond or gilt originally sold at £100 par value with a coupon of 10% is bought for £100 then the coupon and the yield are the same at 10%, or £10. But if an investor buys the bond for £125, its coupon is still 10% (or £10) and the investor receives £10 but as the investor bought the bond for £125 (not £100) the yield on the investment is 8%.
All investment returns are measured against a benchmark to represent “the market” and an investment that performs better than the benchmark is said to have outperformed the market. An active managed fund will seek to outperform a relevant index through superior selection of investments (unlike a tracker fund which can never outperform the market). Outperform is also an investment analyst’s recommendation, meaning that a specific share is expected to perform better than its peers in the market.
This is more usually a feature of car insurance but it can also crop up in contents, mobile phone and pet insurance policies. An excess is the amount of money you have to pay before the insurance company starts paying out. The excess makes up the first part of a claim, so if your excess is £100 and your claim is for £500, you would pay the first £100 and the insurer the remaining £400. Many online insures let you set your own excess, but the lower the excess, the more expensive the premium will be.
Generic, loosely-defined term for markets in a newly industrialised or Third World country that is in the process of moving from a closed economy to an open market economy while building accountability within the system. The World Bank recognises 28 countries as emerging markets, including Argentina, Brazil, China, Czech Republic, Egypt, India, Israel, Morocco, Russia and Venezuela. Because these countries carry additional political, economic and currency risks, investors in emerging markets should accept volatile returns. There is potential to make large profit at the risk of large losses.
An interchangeable term for shares (UK) or stocks (US). Holders of equity shares in a company are entitled to the earnings and assets of a company after all the prior charges and demands on the company’s capital (chiefly its debts and liabilities) have been settled. To have equity in any asset is to own a piece of it, so holders of shares in a company effectively own a piece proportionate to the number of shares they hold. (See also Shares).
A term applied to raw materials (gold, oil) and foodstuffs (wheat, pork bellies) traded on exchanges throughout the world. Since no one really wants to transport all those heavy materials, what is actually traded are commodities futures contracts or options. These are agreements to buy or sell at an agreed price on a specific date. Because commodity prices are volatile, investing in futures is certainly not for the casual investor.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).