What a difference three vaccines, a trade deal, and the imminent eviction of a narcissistic would-be despot can make!
For five years readers have asked us in comments and over email whether they should reduce their exposure to UK assets.
Doing a Brexit will tend to have that effect.
But in the past few weeks we’ve been getting new queries. Readers asking whether – given the stronger UK pound – British investors are taking undue risk by having so much money invested overseas?
Just this week Bob wondered [1] on our Slow & Steady Passive Portfolio update:
I have become increasingly aware recently of the the pound strengthening against the dollar.
Given this portfolio is heavily invested in US equities, would you be concerned about currency risk? (Especially now the immediate impact of Brexit has taken its course…).
Could some of the gains over the past 10 years be attributed to the weakening pound? And would you be concerned about the opposite effect now?
(I haven’t come across any hedged equity funds in my platform, but I believe they do exist elsewhere…)
These are all valid concerns. But should we do anything in response to the answers we come up with?
The short answer: probably not.
Are you George Soros?
Passive investors with a diversified global portfolio [2] signed on for ups and downs on their way to enrichment.
Getting there with the minimum of mishap and hassle means striving not to second guess the market at every turn.
Even active investors should be wary of churning [3] their portfolios on currency speculation. Stock picking skill is rare, and most people who think they have it likely don’t.
And even if you can select outperforming shares, the chances of you also being able to outsmart the highly liquid and capricious currency markets are slim.
With that said, UK shares on their own merits might be worth an extra look if you’re a naughty active sort.
If UK shares were battered by global capital having put UK PLC into the loony bin, then emerging signs of sanity – such our avoiding a no-deal Brexit – could prompt a revaluation.
Then again the trade deal is hardly breaking news. So it may already be in the price.
Why British shares are rallying
Big UK shares have spent years in the doldrums – topped off by London being one of the worst markets in the world for most of 2020.
Our poor performance against the US market was particularly stark:
[4]Source: Nasdaq [5]
Against this backdrop, the recent strength of UK shares is notable.
- In 2021 alone an ETF that tracks the FTSE 100 total return1 [6] is up 5.2%
- In contrast a global tracking ETF2 [7] has delivered just 1.6%
This is after barely a week of trading of course, but it comes on the back of a similar trend in recent months.
Brexit resolution is part of the reason for UK shares moving higher. But there are other factors, too.
Made in Britain
It’s important to understand the UK market is dominated by its largest firms.
Many of these are big, international behemoths in established industries like banking, energy, pharmaceuticals, and mining.
This style of company has been out of fashion for years. They’re typically what we call ‘value’ stocks. As a group they’ve offered little prospect of growth in low return world.
Sectors such as High Street banks and oil companies have faced their own particular headwinds, too.
Even the ‘growthier’ large caps the UK does boast – consumer giants such as Diageo and Unilever – have found the going tough in a global pandemic. Consumers have spent far less time in pubs or even in the supermarkets.
Recently though there have been signs of some of these factors abating.
The Covid vaccines should eventually mean a way out of the global pandemic. With it will come a sharp jump in global economic growth.
Such an economic upturn would be good news for UK giants that can profit from a cyclical recovery, such as energy and mining firms.
Meanwhile the Democratic victory in the US presidential race could also be positive for global growth.
A Biden administration is likely to favour more stimulus, even at the (potential) risk of higher inflation.
That’s good for value shares, too.
The very recent news – overshadowed by this week’s lunatic insurgency in Washington – that the Democrats had won control of the US Senate only reinforces this narrative.
These factors have lately seen yields on US government bonds creep higher. All things equal, higher yields should be good for big financial firms like UK banks.3 [8]
Last month’s trade deal between the UK and the EU shouldn’t be discounted as a factor too, of course.
In fact it has a double whammy benefit.
First and foremost it means the UK avoided a no-deal crash out of the EU, with all the attendant chaos.
Lorry jams at Dover and the Cava running out at Sainsbury’s wouldn’t have mattered too much for our big multinationals. But it would have dinged more domestically-orientated UK stocks.
Perhaps more importantly, the deal signals that the UK is ‘investible’ again.
Without wanting to turn this into a piece about the rights and wrongs of Brexit, it’s undeniable that global financial managers voted with their feet and ditched UK assets in the wake of the Referendum in 2016:
[9]Source: Schroders [10]
The UK-EU trade deal, skimpy as it is, demonstrates the UK hasn’t completely lost the plot.
Remember, global fund managers buying big UK multinationals aren’t professionally much concerned about whether Brexit is good for factory workers in Sunderland, fisherman in Hull, or even bankers in the City.
They want to know that their investments are safe from the prospect – however remote – of anti-capitalistic populist moves, exchange controls, or a currency crisis on the back of economic chaos.
The trade deal took that off the table in practical terms. It also proved the UK establishment hasn’t fatally succumbed to fantasy.
The UK’s legal framework and shareholder protections have long been admired around the world.
With the orderly resolution of Brexit at last, global investors can again buy into companies like Vodafone, HSBC, and Unilever and sleep soundly at night.
Reasons to do nothing
Of course none of this really addresses the concerns of our reader Bob or other UK passive investors [11].
Properly diversified passive investors only have a small allocation to UK assets, reflecting the modest size of the UK market as part of the global whole.
Such investors aren’t worried about how well the FTSE 100 will do, but rather how poorly their world index fund [12] could fare if the pound continues to climb.
This is a very valid short-term concern.
Currency risk [13] is the prospect of your overseas assets losing (or gaining) value as a result of changes in foreign exchange rates.
If the pound strengthens against the US dollar, then all else equal the value of your US funds in sterling will fall.
US shares make up more than half of the world index. And that isn’t the end of the story, as the pound could rise against other currencies, too.
Remember it doesn’t matter what currency your fund is denominated [14] in. Your exposure is to the currency of the underlying assets it holds.
Given everything I said above, it might seem a no-brainer to sell your global shares and load up on British stocks.
However nothing is so easy in investing. Let’s count the reasons why most passive investors are best off doing nothing.
Strategic ignorance The whole point of passive investing is you know you don’t know better than the market. Why do you now think you understand the prospects for the UK pound and stock market better than the combined wisdom of the world’s investors? You probably don’t. Stick with the plan.
Easy come, easy go UK passive investors with global trackers enjoyed a big windfall back in 2016 when the pound devalued on the surprise vote to Leave. If some of that now reverses, well, so what? There will always be wins and losses in a diversified portfolio. It’s unrealistic to hope to only grab the gains.
You already have lots of UK exposure A diversified passive portfolio would usually have a big slug of British assets in the shape of UK government bonds. You may well own your own home in Britain, too. Nearly all of us are paid in pounds. Overseas exposure can arguably be a counterweight [15] to all this.
A strong pound can be bad for British shares Suppose you do dump your global tracker and switch it into one that follows London’s FTSE All-share or FTSE 100. Are you aware that at least 70% of the earnings of UK-listed firms are generated overseas? This means that as the pound rallies, those earnings are worth less. That in turn could cause UK share prices to fall. See? Swings and roundabouts.
We don’t know where the pound will go This is important to reiterate. It may seem obvious that the pound go higher from here, especially against the US dollar. When I used to visit the US a lot for work 20 years ago, I always felt rich. That topped out with the the pound buying more than $2 in 2007! But there’s no law that says we have to revisit those exchange rates. A UK pound bought $5 in the early 1900s. It’s been weakening for more than a century. Even in the short-term, rising yields in the US could support the dollar over a more moribund UK outlook for rates.
The time to switch might have passed The market looks into the future, to the confusion of many. For example rapidly rising share prices after the crash in early 2020 seemed preposterous to some. But the clever market had weighed the evidence and decided Covid wouldn’t cause a depression, especially not with all the money being thrown at it. Similarly the picture for UK assets began to brighten months ago, as the market foresaw a trade deal and liked the look of the vaccines. By the time most investors think about something, it’s already happened.
As always it comes down to this: what do you know better than the market?
Pay your pound of flesh
With all that said, I happen to believe markets are not totally efficient.
There is strong evidence for momentum in share prices, and some evidence that investors are slow to discount all the changes from news events.
The pound could have further to go even on the back of what we already know – and UK shares could continue to do better, too.
One option for passive investors who do decide to meddle would be to hedge out a portion of their overseas exposure using hedged ETF [16] tracker funds. There are various options out there.
You should be doing this already with any overseas fixed income you own. (If you’re not then take a look at this roundup of cheap index trackers [17], which includes some hedged bond ETFs).
Alternatively, if you really, really must you could increase your allocation to UK shares. But don’t go all-in! Switch say 25% of your global fund into a UK tracker, not 100%. (And do remember that you’ve now given yourself the problem of having to decide when to switch back…)
As a naughty active investor [18] I’ll admit to speculating on the back of Brexit, exchange rates, and much else besides. But I was doing this five years ago, too, and I expect to be doing it in another five years’ time.
Do you honestly want to sign up to that? Are you prepared to pay for being wrong?
Most passive investors should just keep on keeping on.
Be glad we’ve avoided the worst that Brexit might have thrown at us, and focus on the long-term big picture, even if UK assets do get their moment in the sun.