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Question: I’ve seen that sterling took a hit this week and there’s been a lot of talk of a UK recession, what should I be doing with my investments?
Answer by Chris Rudden, Senior Investment Consultant:
With less than two months to go until the UK’s (already delayed) departure from the European Union, you can’t escape the Brexit noise. How the UK leaves the bloc – if it does – has far reaching consequences for the UK economy and financial markets.
But before we look at a popular strategy for weathering short-term Brexit noise, I think it’s important to understand the basic dynamics of the financial markets, most notably currency, equity and bonds.
Broadly speaking, signs of economic health will strengthen the value of an economy’s currency. Inversely, signs of a weakening economy will make said currency fall in value.
Currency is just like any other product; the more people that want it (the higher the demand), the higher the price those holding it can sell it for. If demand falls, the holder has to drop the price low enough for people to be interested in buying it again.
When the UK economy looks strong, it becomes a more attractive place to invest in for people and companies, and they need to buy pounds to do so.
This only directly affects your overseas investments, though, which benefit from a fall in the pound. Let’s look at an example:
Imagine you bought $100 worth of US stock several months ago for £75. Since then, the pound has fallen in value against the dollar. As the pound is worth less, you can get more for your $100 when you convert it back.
In this example, the same $100 worth of stock is now worth £80 when translated back to pounds. This is a 6.67% increase in your returns, without the stock actually changing in price.
This example gives us a good indication of what could happen to your unhedged overseas investments in the event of a UK recession.
Of course, this dynamic can move in both directions, so most asset managers will put a certain amount of ‘currency hedge’ in place to manage this risk.
Now to UK equity. If a country is heading into a recession, it means that consumers and companies are spending less on products and services, which is likely to cause profit expectations to fall. This is the main reason why domestic shares suffer the most.
This is certainly true for mid and small cap stocks (small- and medium-size companies), as most of their revenue is generated in the UK.
It’s a bit more complicated when it comes to the UK’s largest companies, though. The companies listed on the FTSE 100 generate a lot of their earnings overseas. So when it comes to translating this profit back into the home currency, a weaker pound should automatically boost profit and thus the share price.
When it comes to bonds, it is much more interesting.
It’s widely assumed that there should be a negative correlation between equities and bonds. As described above, equities are underpinned by prospects of economic growth, while bonds act as a safe haven when the economic picture weakens.
An extended period of loose monetary policy and subdued inflation has relaxed the negative correlation between the two asset classes, but we expect this more distinct negative correlation to return.
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There are two main reasons for this, firstly we might see a ‘flight to safety’ if investors sell their stock holdings and buy government bonds in an attempt to protect the value of their money. This higher bond demand will push up the price.
The other factor will be interest rates. It’s widely expected that the Bank of England will be willing to cut interest rates again – much like the Fed has just done – to stimulate a slowing economy.
An interest rate cut is generally good for bond prices.
For example, imagine you buy a £100 government bond that pays you a fixed 3% coupon every year. Interest rates then fall, and newly issued government bonds only offer a 2% coupon.
You still have the government bond you bought for £100 that pays you 3% interest every year. Demand for your government bond rises, taking the price you can sell it for with it.
Simply put, you’d expect bonds to do well if the UK economy weakens. However, the bond market is complex and different types of bonds are affected in different ways. If you have any more specific questions, or would like more information, please get in touch via my contact details below.
So what should you be doing?
At Moneyfarm, we firmly believe that global diversification is an effective and efficient way to manage risk in portfolios.
Investing in UK assets radically increases your exposure to UK risks. It’s highly likely that you already have a large home country bias – you probably work in the UK, own a property in the UK, or you might even have started a UK business. If so, the majority of your assets and income are closely tied to the UK economy.
By spreading your investments across different geographies, you can reduce your exposure to one economy. Then, if the UK struggles over the short-term, you can hope to offset any weakness with gains made in other regions of the world and benefit from foreign exchange movements.
When you diversify your exposure globally, it’s also less likely that you will feel compelled to make rash, knee-jerk reactions to short-term events, instead sticking to your long-term strategy.
If you know what’s going to happen, should you trade to protect the value of your investments? The problem here is timing; no-one knows exactly when moves are going to happen and they often happen very quickly – if managing your investments is not your full-time job, you could miss crucial opportunities.
If you adopt this approach, you need to be right twice. You need to both sell at the right price (high) and buy back at the right price (low).
These are notoriously difficult decisions to get right, not just because it takes a lot of time, skill and experience to identify these opportunities correctly, but because equity markets historically increase over time.
At Moneyfarm, our philosophy is based around long-term, globally diversified investments. Stock markets will fluctuate over the short-term, but riding this uncertainty out usually benefits patient investors. However, we appreciate that not everyone is able to invest for the long term, and financial situations may differ. If you have any questions or are unsure, please get in touch or speak to your independent financial adviser.
Once you’re invested in a portfolio that reflects your financial situation, appetite for risk, financial goals and time frame, avoid any knee-jerk reactions to short-term Brexit noise. Investing is all about patience.
If you’d like to discuss the impact of recent UK events on your investments or your Moneyfarm portfolio, please reach out to me directly. My email address is email@example.com and my direct line is 0203 7456993.
Chris is passionate about blending technology and human expertise to help people make better investment decisions to secure their financial future. With a keen interest in the impact macro economics has on investments, Chris is a Senior Investment Consultant at Moneyfarm and recently completed the CFA Programme, passing all three levels.