How to manage risk amid weak sterling

This article is part of
The Guide: Passive Investing

How to manage risk amid weak sterling
 Sterling rallied against the US dollar following the announcement of an early UK general election

Sterling has been buffeted by sizeable headwinds over the past year, most notably the vote to exit the EU and the subsequent decision by the Conservative party to hold a general election in June.

From a starting point of 1.49 versus the US dollar and 1.31 against the euro on the day of the EU referendum last summer, the pound has been on a rollercoaster ride against both currencies amid fierce debate about the implications of Brexit.

The vote sent sterling plunging to its lowest level against the US dollar since the 1980s, and left it at a multi-year low against the euro.

But recently the UK currency has recovered modestly – albeit still well below pre-Brexit levels – following prime minister Theresa May’s announcement of an election, which will take place in just one month. 

The move drove the pound up to its highest level versus the US dollar for more than six months, above 1.28, and it also provided a boost against the euro.

With sterling likely to remain volatile during both the general election and the prolonged exit from the EU, passive investors must carefully consider how to manage their currency risk, with several threats to returns from overseas equity markets.

To hedge or not to hedge?

Investors who have exposure to markets such as the US or Japan have seen a positive impact from sterling’s sharp decline versus both the dollar and the yen since last June.

Given US equities comprise more than 60 per cent of a standard MSCI World Developed Markets benchmark, those focused on global equities have also benefited, and for many this means sterling’s plunge has been beneficial so far.

The same has been true for those investing in unhedged Japanese equity products, and to a lesser extent European ones, with the pound still sharply below pre-Brexit levels versus the euro.

The danger now is whether that currency story has run its course. On the balance of risks, and considering the election and the stability it may bring to the UK, it looks more likely that sterling could either remain at current levels, or rally further.

Broadly speaking a retreat to levels seen in the immediate aftermath of the referendum seems very unlikely, barring some unforeseen catastrophe for the UK.

Therefore, there is an argument that sterling investors should consider hedged share classes for their overseas exposure to protect against further currency gains.

Of all the regions this remains particularly relevant for Europe, where the falls in the pound could be mirrored by the euro if its own ongoing political issues flair up.

The region is beset by instability, and has multiple upcoming elections to contend with. It remains at risk of euro currency weakness, which would harm returns for UK-based investors who remain unhedged.

However, it comes down to an individual investor’s view. If investors are bearish on the outlook for the pound, then investing in overseas equity markets without hedging could yield positive returns if sterling was to continue to deteriorate.