Understanding Currency Risk

If you’ve ever taken a holiday abroad, you’ll be aware that you need to exchange your Pounds for the local currency before you can make a purchase at your destination.  The same is (most generally) true for your investments in stocks, bonds and funds.  You’ll also know that your holiday might appear to be better value from one visit to the next visit; the rate of exchange fluctuates over time and can have a material impact on the cost of your purchase.  Again, the same is true for investments outside of our home market, the UK (in GBP). 

Exchange rates between currencies can fluctuate significantly over time. For example, at the end of January 2015 £1 would have purchased roughly $1.50, whereas at the end of January 2025 £1 would have purchased roughly $1.24. We can see that over the past ten years GBP buys you fewer dollars than it used to. Investors who own assets in different markets will find the value of their investments are impacted by these moves in exchange rates.  Fortunately, there are ways of mitigating and managing exchange rate risk in an investment portfolio. 

Currency hedging is a financial strategy used by investors to protect the value of your assets against these moves in exchange rates. For institutions and fund managers, it involves using financial instruments called derivatives, to effectively “lock in” exchange rates.  This allows a manager to make a decision to invest in a stock, bond, fund or strategy separate from a view on future exchange rates (“FX risk”). 

For example, a UK investor may wish to gain exposure to a US equity strategy but is concerned about the risk of a weaker USD, which, if realised, would reduce the gains from the investment.  Choosing the “GBP hedged” share class removes this currency risk from the decision to invest in US equities. 

We favour hedging in a global investment portfolio for many reasons:

• Reduces risk of unfavourable moves in exchange rates impacting portfolio returns
• Can reduce the volatility (or variability) of returns overall leading to more consistent outcomes
• Allows investors to invest globally without worrying about fluctuation exchange rates

Though there are clear benefits to hedging, there can also be drawbacks.  It’s important to note that hedging can introduce complexity, and a hedged investment may give up potential gains from currency fluctuations, not just avoid losses. The purpose of currency hedging is not to generate returns, but to reduce uncertainty in the investment process and provide more stable, predictable returns by reducing currency risk. This is in line with our overall approach of diversification in general, in asset classes, geography, and in this case, currency.  

Considering both the benefits and drawbacks, we typically aim to hedge some, but not all, of the currency exposure within our investment portfolios, as we look to manage, rather than fully eliminate, investment uncertainty stemming from exchange rate movements. This has the benefit of reducing much of the uncertainty surrounding moves in exchange rates and limiting volatility of returns, without adding unnecessary complexity or cost to the investment process.  

The Noise

• The UK’s unemployment rate held steady at 4.4% in December 2024, below market expectations of a rise by 0.1%. Whilst this figure is reassuring, unemployment could see upwards pressure from the UK’s budget tax rises in employer contributions to National Insurance. Since the UK’s Budget in October 2024, markets have been anticipating job cuts that haven’t materialised yet. A report from The Chartered Institute of Personnel and Development (CIPD) confirms that a quarter of employers plan to cut jobs before April, when this tax rise is implemented in April 2025. 

• ​Japan’s economy expanded 2.8% in the last quarter of 2024. This annualised GDP figure came in significantly above market expectations of 1% and marks the third consecutive quarterly expansion. This growth was mainly buoyed by corporate spending, which rose by 0.5% quarter on quarter. Additionally, net trade contributed positively for the first time in five quarters, with exports continuing to rise despite growing concerns over potential trade tariffs imposed by the US. Economists have now increased their expectations that the Bank of Japan (BoJ) will raise interest rates in 2025. The market reacted well to this data, with the Yen strengthening by 0.3% against the dollar on Monday morning, when this data was released. Continued growth in this region is positive as it supports economic stability and strengthens investor confidence in the region.

• ​The UK’s inflation rate sharply rose to 3% in January 2025, which hit a 10-month high, and exceeded market expectations of 2.8%. The largest contributor to this rise in inflation was airfares, which saw a price increase to 1.7% vs -0.6% the previous month. Prices also increased at a faster pace for education (7.5% vs 5% month on month) due to the new 20% value-added tax on private school fees. The market has now priced in two interest rate cuts for the UK in 2025, lowering borrowing costs for consumers, but has modestly reduced expectations for a March rate cut. 

The Numbers

GBP Performance to 20/02/2025

Source: Bloomberg, data as at 20/02/2025

The Nuance

War and Peace (and Markets): US Foreign Policy and Implications for Investors

The political landscape is shifting, and with that so are market dynamics. The European Union and United States dominate global trade, and tensions between the two powers have risen with President Trump’s recent actions and executive orders in office. Some key political themes that have underscored rising global uncertainty are Trumps’ actions around trade tariffs, dramatic reductions in foreign aid, and contentious talk of the expansion of the U.S.’s borders (such as threatening to acquire Greenland from a NATO ally or claiming Canada as the U.S.’s 51st State). Vice President JD Vance’s speech on the weekend underscored the US’s severance from the relationship the previous administration had with the EU. 

Controversially, the US has initiated peace negotiations directly with Russia on the Ukraine war, bypassing both Ukraine and the EU as negotiating parties, and the Trump administration has made it clear that the US no longer wishes to be the main provider of Europe’s defence going forward. Consequently, the EU announced it will temporarily ease its fiscal rules to allow countries to spend more on their defence and redirect unspent COVID funds to boost investment in military presence in the bloc. 

Hopes that a resolution to Ukraine and Russia might allow energy prices to fall has driven a recent positive shift in investor sentiment in the European equity market.  Further, expectations of increased defence spending in the EU going forward have also improved investor sentiment specifically towards the European defence sector. 

In terms of the effect on government bonds and future borrowing, this boost in defence spending is likely to exacerbate the rise in European countries' long-term borrowing costs. As European countries borrow more to fund higher defence spending, long-term interest rates could be expected to rise.  

As markets adjust to these geopolitical shifts, short-term volatility is to be expected. However, periods of uncertainty often present opportunities for long-term investors. With a diversified approach, portfolios can remain resilient amidst changing market conditions. 

At atomos, we continue to monitor these developments closely, ensuring that our investment positioning reflects both the risks and opportunities in today’s evolving economic and geopolitical landscape – especially with the current dynamic between the US and EU.
 

The Niche

Tulip Mania was one of the first recorded speculative bubbles in history. It took place in the Dutch Republic during the early 17th century. Some tulip bulbs were selling at 10 times the annual income of a skilled labourer!