Over the past few years, Brexit was often the usual suspect for any sterling weakness. It may have played such a role again earlier this year, but we believe the currency has mainly been driven by its more traditional risk factors.
We often say sterling acts as a risk-on currency, for a number of structural reasons. The UK is a large global financial centre and it runs a large structural gross foreign asset position. Losses on financial markets, as a consequence, typically do not bode well for the pound.
As a net asset owner, a bull market is better than a bear market, while the City thrives on more financial activity. Unfortunately, COVID-19 has dampened activity and triggered weakness in markets, broadly speaking.
We believe currency weakness can be quite useful in the context of a global multi-asset portfolio.
When you buy a foreign asset, you receive the foreign currency exposure too. Long-term expected returns on currencies are close to zero, as exchange rates are relative prices and the uncovered interest rate parity theory, which suggests that differences in interest rates will equal the relative change in FX rates over the same period, generally holds.
However, this does introduce extra short-term volatility. Within a portfolio context, some of that extra volatility can be helpful, as it diversifies other risks in the portfolio.
The degree of diversification depends on the base currency of the investor. For example, for a sterling-based investor, holding US stocks un-hedged through March meant a loss on the stocks in US dollars terms – but a smaller loss when translated into sterling. For a dollar-based investor, it is actually the other way around, where the weakness in their UK stock holdings would be compounded by the loss in sterling.
So, some currencies can act as a shield for investors in risk-off periods, such as the greenback, while others boost the returns on foreign assets in good times, or make the situation worse in bad times, as we saw with sterling this year.
To hedge or not to hedge?
Drawing all of this together, some foreign currency exposure can be beneficial, but too much and it will start dominating portfolio outcomes.
What is ultimately required, in our view, is a balancing act that depends on the base currency. We hedge a substantial part of the foreign currency exposure in our global multi-asset portfolios via currency forwards and/or futures, but for the reasons outlined above, not all of it.