Quantitative strategy
05 September 2022
By Lukas Gehrig, Zurich Switzerland, Quantitative Strategist; Nikola Vasiljevic, Zurich Switzerland, Head of Quantitative Strategy
The role of sterling has changed from the old days as it loses its safe-haven shine, with implications for those invested in it. With unhedged currency exposure contributing to portfolio performance, we analyse the characteristics of the UK currency versus others and which currency hedging strategy might be most appropriate in a sterling investor’s equity portfolio.
News over the last two years has been dominated by a health crisis, sudden drop in economic demand, and Russia’s conflict with Ukraine. In this time, financial markets often treated the world economy as one big entity.
This is changing, as divergent, and soaring, inflation, monetary policy, and the resilience of economic activity becomes more apparent at a local level. For an investor, this is a good chance to reflect on exchange rate risks and opportunities.
The value of a currency is driven by many factors: access to natural resources, political stability, or an economy’s ability to produce sought-after goods, plus several more. Some currencies are considered to be cyclical because their worth relies on goods that are particularly linked with the economic cycle. Others are dubbed “safe-haven” currencies as they remain attractive when the global risk appetite decreases.
Sterling highlights how the role of currencies can change. It used to act as a safe haven for investors. It does not now. To show this point and the effect it can have, we analyse the ability of the UK currency to act as a safe haven against leading currencies over the last three decades.
In analysing the currency’s exchange-rate trends, we applied a well-known concept from economic theory: Uncovered Interest Rate Parity. This postulates that future exchange rate changes are determined by today’s differences in interest rates between currency areas.
We then add a local currency effect (how sterling performed against other currencies, excluding the one being analysed) and a global risk factor, the option-implied volatility index (VIX), or “fear index”, from the Chicago Board Options Exchange.
Our analysis shows that sterling showed safe-haven characteristics against cyclical currencies such as the Australian dollar, generally, and also the Swiss franc, at least until the mid-2000s. The euro and the greenback fared better in turbulent markets during that period. Only the Japanese yen was a clear safe haven for sterling-denominated investors.
However, this changed drastically after 2007: the new triumvirate of safe havens (dollar, yen, and Swiss franc) has proved more resilient to market stress than sterling since then (see chart).
Against the three safe havens, a relative month-on-month increase in the VIX of 1% would currently be accompanied by a sterling depreciation in the range of 0.04% to 0.06%, according to our analysis. Increases of 100% in the fear index are not uncommon in stressed markets, which makes these coefficients meaningful in size.
Pinpointing the reasons for the altered role of sterling in currency markets is difficult. Undoubtedly, Brexit has had an impact, whether through drawing attention to UK-specific issues or by actually lowering forecasters’ expectations of the economy’s prospects.
Knowing that safe-haven characteristics are variable over time, the following conclusions need to be re-evaluated periodically. However, the implications are significant for sterling investors, especially due to the prevalence of USD-denominated assets in global markets.
Our analysis might suggest that sterling investors would be best off not hedging any dollar-, yen- or Swiss franc-denominated foreign equity exposure as appreciation against sterling is likely in stressed markets, thus providing a source of return for a sterling investor.
To investigate this, we computed portfolio returns with three different hedging strategies: in local currencies, unhedged but converted to sterling, and fully hedged to the UK currency.
We then studied the relative performance of a global equity portfolio versus a domestic one for each hedging strategy respectively. We consider an investment horizon of five years, to make the analysis meaningful to the typical longer-term investor.
Our results (see chart) indicate that an unhedged global portfolio generally outperformed one that was purely invested domestically. Before 2014, a currency-hedged global portfolio would have underperformed its domestic peer.
Comparing the relative outperformance of the unhedged and hedged portfolios delivers a clear verdict: UK equity investors would have been almost always better off not hedging currency exposure. For some five-year periods, the outperformance of the unhedged portfolio would have been as large as 4% per annum.
Given the weight of the US market in the global equity portfolio and its safe-haven status, it is little surprise that most of the outperformance of not hedging to sterling comes from the greenback. The following chart displays the breakdown of the currency-conversion effect – or in other words: moving from the local currency line (light blue) in the chart above to the unhedged to GBP line (green).
Our analysis reveals the diversification attractions of a global equity portfolio over a domestically-focused one, and shows that not hedging the currency exposure would have paid off. Have UK investors acted accordingly?
Surveys among institutional investors by pensions consultant Mercer suggest that UK investors have upped non-domestic exposure. In 2013, UK institutions allocated 36% of their equity exposure domestically1, according to the consultant. In the 2019 survey, the latest one, the domestic allocation was reduced to 29%2.
This still represents a considerable home bias when we compare current market capitalisations from MSCI. However, investing 29% domestically is risky at a time when the UK market represents roughly 5% of the global equity portfolio. With past opportunity costs and our subdued outlook for the UK economy relative to other developed markets in mind, further reducing the home allocation would seem beneficial.
Welcome to the latest edition of “Market Perspectives”, the monthly investment strategy update from Barclays Private Bank. With the Russia-Ukraine war raging on, inflation surging, and the risk of recession rearing its ugly head once again, financial markets are grappling with much uncertainty. This month’s report attempts to make sense of it all, providing insight and context behind the major trends at play.
