UK investors need to be especially mindful of currency when investing in overseas markets, explains Donald Maxwell-Scott.
When assessing the health of an economy, it is useful to look at the strength of the corresponding currency. Some people even view the currency as the share price of that economy.
As we know, the US has been performing strongly, and the dollar has been spurred to highs when compared with many of its developed peers. This is usually because economic strength attracts foreign capital, which must then buy the currency in order to invest. In addition, when economic growth rises, interest rates usually rise too, and that provides a better comparative return for cash.
Many investors often don't think about currency when investing in overseas markets, but UK investors need to be more aware than most people. Following the EU referendum vote result, sterling dramatically weakened against most other currencies, literally overnight.
This had the temporary effect of boosting the stock values of many companies in the FTSE 100, but only because multinational companies derive much of their earnings overseas.
So, when converting their overseas earnings back to a weakened sterling, they were able to do so at a much more favourable rate. Effectively, as the “share price” of the UK economy has fallen, the FTSE 100 has actually risen on the “currency translation effect”- a fortunate quirk owing to the significant overseas content of the FTSE 100.
However, at the other end of the spectrum to sterling is the US dollar, which has gone from strength to strength. Over five years, it is up against the yen, Swiss franc, euro, Canadian dollar and, not surprisingly, sterling.
US earnings season started in earnest yesterday and an indicator of the currency effect was the June announcement by Nike, the shoe and clothing manufacturer, that it had missed earnings estimates for the first time since 2012, according to Bloomberg.
Nike is a good barometer considering its worldwide footprint. Its share price remained robust on the announcement, because it still managed to increase revenue despite missing its earnings estimates. Full-year revenue was up 7%, however, on a currency neutral basis it was up 11%. On a currency neutral basis then, it would have likely hit its earnings estimates, removing the dampening effect of a strong US dollar.
If the Federal Reserve increased rates as initially planned, then this would only make the dollar more expensive when compared with its peers. Many other multinationals based in the US would struggle with an even more resurgent dollar. Given that US president Donald Trump seems to measure his success by the level of the US stockmarket, this would be bad news as he fights for a second term in 2020.
Trump and tax cuts
While Trump is unpredictable, his tax cuts have certainly stimulated the US economy and have benefited companies in the county. Of more certainty is the comparison of the stockmarket performance between Trump and Barack Obama.
On a USD comparison basis, under Donald Trump the S&P 500 has climbed 31.7% since his inauguration on 20 January 2017. Under the tenure of Barack Obama over the same period of his first term the S&P 500 climbed 66.9%.
Of course, this isn’t really comparing like for like; considering the 2008 financial crisis, markets were recovering from huge falls, and benefited from huge amounts of stimulus that were required to keep the global economy afloat.
Nevertheless, of late, the US stockmarket has been impressive, helped by the tax cuts, tech boom, and low interest rates. But currency headwinds could well be the reversal of the cherry on the cake, and it may be time for UK investors to wake up and smell the coffee before any cooling in the US economy occurs.
A simple example illustrates this. At the time of writing (in early July), the GBP/USD exchange rate is around 1.26, so for every £1 you receive $1.26. A £10,000 investment in tech giant Apple (currently trading at around $200 per share) would enable the investor to buy 63 shares valued at $12,600.
If, over the course of the year, the share price in Apple dropped 10%, then the holding would be worth only $11,340. If sterling strengthened against the dollar over the same period - so £1 was worth $1.40 - and the Apple shares were sold and the proceeds converted back into sterling, then it would leave £8,100. Despite the shares falling only 10%, the investor would be sitting on a 19% loss in sterling terms.
Given that the US market is at an all-time high and sterling at multi-year lows, this scenario is not as unlikely as everybody seems to think. A rise in sterling is inevitable at some point as we move forward from the Brexit impasse.
Investors have had a boost from the currency translation effect as sterling has weakened – but what goes up must come down, or in this case, the opposite, which will have a negative effect on returns.
Donald Maxwell-Scott is technical investment manager, Rowan Dartington.