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Should investors respond to the strengthening UK pound?

The yen has been weakening against the UK pound (click to enlarge)

The yen has been weakening against the UK pound (click to enlarge)

(Source: Google Finance)

When I wrote about currency risks and opportunities for investors in January, I mentioned I was going to leave my holdings in Japan untouched, rather than cashing in on the Japanese yen’s strength by converting my Nikkei tracker funds back into UK pounds.

At the end of March, however, I changed my tune and swapped half of those holdings into a UK FTSE 100 tracker.

Why? Well, it’s not because I think private investors can predict short-term currency movements with any great confidence. I know I can’t predict short-term currency shifts. Indeed I swapped a little late, looking at the graph.

What I do believe in, however, is reversion to the mean.

I think the yen’s strength in late 2008 was down to a combination of fear and the unwinding of international currency trades.

Certainly the yen’s strength wasn’t because of a booming Japanese economy; the world’s second largest has been creamed, thanks to a collapse in exports.

Recently, however, the Nikkei has rallied, and the yen has started weakening against the UK pound. With the relative performance of my Japanese holdings one of the few bright spots in my portfolio recently thanks to yen strength, I decided not to push my luck.

One difficulty with making this decision is that the Nikkei and the yen have quite a neat relationship, in that a weaker yen is good for Japanese exporters, which means the market may well rise faster than the UK FTSE 100 if the yen falls further.

And Japanese stocks look cheap, after decades of under-performance. By only trading half my holding, I’ve tried to hedge my bets.

A minor factor in my switching half the funds into the UK was that my Nikkei index holdings are held in an ISA. The Japanese market is notoriously low yield, rendering the tax-free status of dividends held in an ISA rather moot.

I’d prefer to have the dividend-paying FTSE 100 tracker in my ISA (albeit simply reinvesting the income automatically into more shares) and in time move towards holding the low yield Japanese tracker outside the ISA allowance.

My ISA provider enables such switching to be done for free, provided it’s a switch between index trackers held in the same account – quite a valuable little perk, although you do have to guard against over-trading (not least because of all the tedious paperwork you get mailed every time!)

What about the pound versus the dollar?

My exposure to the dollar via U.S.-focused funds was less than my Japanese holdings, prior to the switch at least. (It’s now about equal).

Much of my exposure is via technology funds/trackers, which have performed well since I bought them, and which I’m still pretty bullish about. (Technology companies are exposed to the recession, but they generally have lots of cash and are on pretty low ratings by historical standards).

For these holdings, tinkering because of a twitch in the UK/US exchange rate would feel more like tinkering.

That said, there is plenty of scope for the pound to rally versus the dollar, reducing the sterling value of direct holdings in the U.S.:

Not unprecented, but the US Dollar clearly spiked versus sterling (click to enlarge)

The US dollar clearly spiked up versus sterling (click to enlarge)

(Source: Google Finance)

If I had say 20% or more of my portfolio in dollars, then as a UK investor I’d have thought about lightening that load by now. A move back to $2:£1 would result in a drop of 25% in the UK pound value of U.S. holdings.

If you’re a U.S. investor, conversely, you might want to buy some UK blue chips like BP, Vodafone or Warren Buffett favorite Tesco while you can still get more pounds for your dollars. All three companies look cheap to me, and are yielding 3-7% in dividends. (No guarantees of course that the pound will keep strengthening, but it certainly doesn’t look a bad time to buy from a U.S. perspective).

Another impact of a strengthening pound versus the dollar will though be a drop in sterling terms in profits for many of the big UK companies who report in dollars, such as BP and HSBC. This will also have a knock on effect for the FTSE 100.

In my possibly over-bullish view, such shares aren’t exactly expensive at current levels, and personally I’m happy to leave my holdings in those shares alone. It will be pretty ironic if my FTSE 100 tracker allocation created by switching over from Japan is held back because of a strengthening pound against the dollar!

Such are the difficulties of keeping currencies in mind when investing, and why I think it’s only practically relevant from a diversification and broad movement perspective.

Please do read my previous articles about currency risk and currencies, investing and diversification if this is a new consideration for you.

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