The currency conundrum

The European Central Bank (ECB) is under pressure from eurozone politicians to introduce quantitative easing (QE) to reduce the value of the euro against the dollar. Politicians say a fall of 10 per cent from $1.35 to $1.20-1.25 is needed to help eurozone companies export and tackle low inflation.

But not everyone is convinced a European version of QE would weaken the euro and, in the meantime, the strength of the euro and sterling against the dollar (and emerging market currencies) is having a major impact on investments.

About 16 FTSE 100 companies pay dividends in dollars, so the fall in the dollar has hurt sterling-denominated income funds.

Fadi Zaher, Kleinwort Benson’s head of bonds and currencies, says some global income-seeking investors have been caught off guard, given the speed at which the pound has appreciated against major currencies and has wiped large fractions off dividends paid in the past year.

Philip Lawlor, Smith & Williamson economist, says the problem for investors is gauging how much of their fund exposure is hedged, at what level and for how long.

He says UK-based investors can take out a hedging strategy themselves or hope that companies, for their net exposure, have done some hedging.

But to employ a hedging strategy themselves, fund managers need a high degree of conviction because of the extra costs. That’s because if the currency move does not happen, they will have inferior returns, all things being equal.

“Fund managers need to have a very clear view on currencies and be very explicit about buying the hedged fund classes,” Mr Lawlor explains.

The rise in the euro and sterling has also underscored the benefits of investing locally, with small- and mid-cap funds having outperformed in the past few years, as they have benefited from being more domestically focused than large-cap funds.

The FTSE 100 index has significantly underperformed other global equity benchmarks on a local currency basis. This may be due to 70 per cent of FTSE 100 companies having overseas earnings, compared to 49 per cent overseas exposure for the S&P 500.

Mr Lawlor adds that a strong sterling “could also exacerbate our disinflationary headwinds”.

This would happen where commodities priced in dollars are not going up and the UK ends up importing deflation into a retail environment that is heavily discounting already.

An acceleration in disinflation in the UK would mean that the chance of rate hikes are pushed back and would point to some lowering of growth rates.

However, Mr Lawlor recommends taking a trade-weighted view of sterling, saying that sterling’s current appreciation is not at such an extreme level that it is making UK companies uncompetitive.

“Sterling has risen 12-13 per cent from its low point a couple of years ago, but in terms of its trade weight, sterling is about 15 per cent below where we were in 2008. We would need to see trade-weighted sterling go back above the 2007-08 peak for it to undermine the manufacturing recovery.”

Looking ahead, the actions of the ECB will be key. The euro is overvalued and its appreciation is causing a serious deflationary threat.