UK equities, global diversification and currency risk

There’s a long held view that UK equities provide global exposure so there’s no need to worry about global diversification and no need to worry about currency risk. At one level there’s an element of truth to the premise that the UK equity market provides global exposure, and in the table below we set out the source of sales for companies in major indices:

Regional sales, % of total	FTSE 100	Euro Stoxx 50	S&P 500
Europe	23%	46%	6%
UK	21%	15%	1%
North America	22%	15%	67%
GEM	16%	16%	8%
Others	18%	9%	17%
Total	100%	100%	100%

The data reveal that only a fifth of UK FTSE 100 company sales are now from the UK, and indeed 48.4% of the FTSE100 now report in US dollars with 0.7% reporting in Euros and therefore only 50.8% reporting in sterling. So we can’t ignore currency and ‘UK’ assets will have plenty of currency ‘risk’ even if it’s not recognised by some investors. Then there are arguments that currencies add noise but don’t exhibit direction. Of course if they’re only noisy it’d be smart to hedge them if the hedge is cost free and the noise would be a source of incremental risk but not expected return – but it’s also smart to think through whether currencies may exhibit more direction from time to time.

For example, between 2008 and 2012, the dollar mainly traded as a risk on/risk off indicator, displaying a strong negative correlation with the equity market. However, over the past six months, this correlation has broken down, with the dollar strengthening as equity markets moved higher (and weakening during the recent sell-off). There are now good reasons to wonder if the dollar trade-weighted index is in a structural bull market reflecting the decent expected growth, with the NAHB survey, one of the best lead indicators of the US housing, at a 7-year high, pointing to a rise in residential investment as a percentage GDP from the current 2.7% of GDP to around 4.5% of GDP. US households appear to have de-levered, with leverage now below trend (relative to both assets) and corporate sector balance sheets are in a sound state, and banks are lending again both to the corporate sector and households, with pent-up demand, reflecting the average age of the capital stock and auto fleet being at an all-time high. What’s more, the dollar is cheap in terms of purchasing power parity, standing some 3% below fair value against the euro. Meanwhile, the current account deficit in the US is now just 2.9% of GDP, down from nearly 6% in 2006 and the US has a significant structural advantage in  shale gas and oil fracking that underpins currency competitiveness (indeed, the BDI estimates that by 2020, US electricity costs will be half those of Europe). As for policy, the Fed seems to be preparing for an exit from easy monetary policy, while the ECB and the BoE have recently moved in the opposite direction, assuring investors that implied short rates expectations are too pessimistic (MPC in the UK) or that rates would stay low for an ‘extended period’ (ECB). This opens the potential for structurally higher rates in the US relative to those in the UK and Euroland.

In contrast, we may now see further downside for the Australian dollar, which has already fallen by around 11% since mid-April, but remains around 40% above its 2008 low on a trade-weighted basis. Australia may face a sharper than expected slowdown in GDP, is an international debtor, and is heavily exposed to slowing Chinese growth, whilst facing a poor outlook for domestic demand growth.

Determination of the optimal currency exposure and risk management approach and position in an investment portfolio are important, complex and specialist challenges – and we seek and take specific ongoing advice on currency exposure and risk participation, reflecting the need to avoid unwanted and unwarranted risks, and the reality that currency risks are unavoidable in the modern world and can be significant.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla