The end of currency a tailwind for UK investors

Currency effects have done a great deal to improve returns for British investors over the last few years. The gross total return on the MSCI World index in US dollars has averaged slightly under 6% per year over the last five years. The return in sterling terms has been slightly over 11% per year. You didn’t even have to invest in markets that have done well in both currency and stockmarket terms – such as the US, which is more than 50% of the MSCI World index – for this to work in your favour. The MSCI Emerging Markets has returned less than 1% per year over the same time in US dollar terms, but more than 5.5% per year in pounds.

The less-happy implication is that if sterling were to recover over the next five years, it would become a drag on international returns. And the pound now looks cheap by historic standards. The Bank for International Settlements calculates real effective exchange rates (see below) back to 1964 for a basket of 27 countries: this shows sterling near historic lows ever since the Brexit referendum in 2016. The only time it was lower was in 2009, during the global financial crisis.

Cheap currencies tend to rise eventually

Forecasting currency movements is an awkward business – there isn’t much evidence that any method works consistently and broadly. That said, some research* suggests that real exchange rates may be a useful predictor of medium-term changes in exchange rates under certain circumstances. They are only helpful when looking at countries that have floating exchange rates (that includes most developed economies, but excludes a lot of emerging markets, which intervene to manage the value of their currencies) and follow an inflation-targeting policy (central banks adjust interest rates to target a set level of inflation, which is what most major economies now do).

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This suggests that sterling is likely to strengthen in the years ahead. That said, there are some caveats. First, sterling’s weakness partly reflects the extreme uncertainty around Brexit, which is not over. Second, it’s not clear that inflation-targeting will remain the dominant approach in the post-Covid-19 era – there might be more focus on stoking growth – and so real exchange rates might adjust through higher inflation instead. Still, given that sterling – and many other currencies – look cheap against the US dollar, there is a decent chance that the dollar will weaken (see below). Hence high US exposure seems unlikely to provide the long-term currency tailwind that it has done for more than a decade.

*Martin Eichenbaum, Benjamin Johannsen and Sergio Rebelo, Monetary policy and the predictability of nominal exchange rates, 2019

Guru watch: Stephen Roach, senior fellow, Yale University

“Scorn has long been heaped on those daring to question the supremacy of the US dollar as the world’s dominant reserve currency,” says Stephen Roach, the former chief economist at Morgan Stanley. But the time is coming when America can no longer count on this “exorbitant privilege”. The result is likely to be a 35% decline in the real effective exchange rate for the greenback.

The seeds of this shift were sown by a persistent shortfall in US domestic savings: in the first quarter of 2020, net national saving was just 1.4% of GDP. This forces the US to draw heavily on surplus savings from abroad to invest and grow – which in turn means it has run a current-account deficit every year since 1982. The Covid-19 crisis will stretch this to breaking point due to “exploding government budget deficits”, forecast to be almost 18% of GDP this year and nearly 10% in 2021. With domestic saving unable to fill the funding gap, the current-account deficit will widen well beyond its record of -6.3% in 2005.

“Reserve currency or not, the dollar will not be spared under these circumstances,” especially as the “painfully visible manifestations of America’s sharply diminished global leadership” are now too bad to ignore. Sceptics will say that “there is no alternative” to the dollar, but they should note that the currency’s share of official foreign-exchange reserves has dropped by more than ten percentage points since 2000. “America’s saving and current-account problems are about to come into play with a vengeance.”

I wish I knew what a real exchange rate was, but I’m too embarrassed to ask

The currency exchange rates that we see and use every day are nominal exchange rates. They tell us what we get if we swap a unit of one currency for another – for example, a pound-dollar exchange rate of $1.25 means that we get 1.25 dollars for every pound. This is all that matters if we are buying something from abroad or sending money internationally. But it doesn’t tells us everything we want to know about the value of different currencies.

For more insight into this, we can use the real exchange rate (RER), which combines the nominal exchange rate with the ratio of the price of goods or services in the two countries. Say that a burger costs $5 in the US, but £3 in the UK. Then the real pound-dollar exchange rate based on burger prices is 1.25×(3÷5)=0.75. This is lower than one, which says the pound is undervalued (the RER will be one if the burger costs the same in both countries once both exchange rates and local prices are taken into account).

In practice, a real exchange rate is calculated by using the price of a basket of goods and services (eg, a consumer price index) not one item. And we consider the trend in the RER index over the long term, rather than at a single point in time. Due to frictions such as trade barriers, transport costs or local taxes and their effect on price, the RER between two countries might persistently be higher (or lower) than one and what really matters is whether it is much higher or lower than usual.

We are often interested in how cheap or expensive a currency is on a global basis. For this, we can consider its effective exchange rate (EER), which is an index that measures the nominal value of a currency against a basket of other currencies (eg, a country’s major trading partners). The real effective exchange rate (REER) is an index calculated in the same way using RERs and provides a measure of a country’s competitiveness. A low REER means its exports should be more competitive on price.