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The weak pound has often been a disadvantage to investors, reducing the international value of the UK-oriented investments that tend to dominate British retail portfolios.

But every cloud has a silver lining, not least sterling’s steep drop. A depreciating currency can be a boon, especially for investors with extensive overseas equity holdings.

If someone in the UK had bought American stocks in 1980 they would have benefited from the US’s strong equity performance of 11.1 per cent per year but currency devaluation would have boosted their return to 13.1 per cent when they converted their US stocks back into sterling this year. A pound invested in US stocks in 1980 would be worth £179 in 2022 but a dollar invested in 1980 would be worth “just” $83 today.

It’s not just older savers who have a weakening currency to thank for US stock performance. The sell-off in US equity this year is nowhere near as painful for UK investors. Whereas the S&P 500 is in a bear market in dollars (down by more than 20 per cent) it is not even in a correction (down by more than 10 per cent) for sterling investors. Those who cautiously hedged away currency fluctuations at the start of the year would have lost out and suffered the same losses as US investors.

S&P 500 tracker performance in GBP

Why has sterling weakened so much versus the US dollar? Over the long term, currencies very gradually converge on equal buying power. The Big Mac index maintained by The Economist illustrates this nicely. If a Big Mac costs £3 in London and $5 in New York then a fair exchange rate (based on burger buying parity) would be 1.67 because £3 would convert into $5. If you do the buying power calculation properly, taking into account a basket of equivalent goods and services both sides of the Pond then the fair rate in 2021 came out at 1.44. This estimate, which is based on “Purchasing Power Parity” (PPP), is 30 per cent above the sterling-dollar exchange rate today.

PPP estimates for exchange rates tend to vary slowly as buying power gradually fluctuates with inflation rates and these tend to be similar in developed countries. For example the pound-dollar PPP exchange rate has been in the range 1.38 to 1.46 for the past 30 years while sterling has fluctuated wildly from 1.13 to 2.07 over that period.

Other factors can drive currency over the short term. Interest rates are important, which is why the last time the dollar approached parity with sterling was during US Federal Reserve chair Paul Volcker’s bout with inflation in the early 1980s when the US policy rate was over 19 per cent.

Currencies with higher interest rates tend to appreciate versus those with lower interest rates. Each crisis seems to weaken sterling and it usually fails to regain its previous level after each one. In 2008-2009 during the Global Financial Crisis sterling fell by 30 per cent versus the dollar. Brexit, too, weakened sterling by around 30 per cent. And, just as it seemed that the Brexit weakening was about to be reversed, we have entered another era of dollar strength as the Federal Reserve raised rates more aggressively than other central banks, including the Bank of England. The global sell-off in equities has also been a drag on sterling which falls into the risky currency camp unlike the US dollar which is seen as a safe haven. The coup de grâce recently was the destabilising effects of the British mini-budget.

Some of the factors that have driven sterling down recently will fade away. For example, the Fed’s relatively high policy rate of 3-3.25 per cent will fall while the Bank of England, with bank rate currently at 2.25 per cent, catches up. The UK yield curve is already roughly in line with that of the US with a yield of around 4 per cent on government bonds (gilts) from one year all the way to 30 years.

While politics is unpredictable, it seems likely that the UK government, whatever its composition, will have a greater respect for economic orthodoxy and the current onslaught of crises will abate. Eventually the fear that pervades markets will ebb as equity markets recover. If these factors do subside then many are questioning whether sterling will reverse its losses and start moving back to a value above 1.40 as PPP suggests it should.

If risk appetite does pick up and global stocks resume their usual upward trajectory then UK investors may miss out. That is because many of the factors weakening sterling are also those that are holding back global stock markets. If the two rise together, and given the dominance of US equity which makes up over 60 per cent of global markets, then the blessing of extra return from sterling weakness versus the dollar will transform into a curse.

So should UK investors rush out and currency hedge their stock holdings? This is now fairly easy by switching to sterling-based hedged global and US stock funds. The additional fee for a currency hedge is usually small.

The choice really hinges on whether you think sterling will finally buck the 50-year trend and start to appreciate versus the dollar. If so, it would make sense to hedge against that outcome with sterling hedged funds. Some institutional investors adopt a split approach where, if you are 50 per cent convinced that sterling will strengthen you would hedge half of your global and US stocks and leave the rest unhedged.

Not every platform offers sterling-hedged equity funds: Vanguard UK platform, where I have investments, doesn’t. But investors who can access such options should consider at least partially hedging against potential recovery in a weak currency.

Ramin Nakisa is a co-founder of Pensioncraft

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