So Brexit happened, and people are worried that the U.K. will fall apart.
Sonja Marten, chief currency strategist at DZ Bank AG in Frankfurt, told Bloomberg News recently that the pound is “where people are taking their Brexit fears.” If that’s true, then there’s a lot of fear going around. The pound has tumbled 18 percent versus the dollar since the Brexit vote on June 23 through Thursday.
Those Brexit fears may yet be realized, of course -- particularly since the U.K.’s departure from the EU remains to be negotiated -- but I think things have gone surprisingly well since the vote. The MSCI United Kingdom Index has returned 12 percent in local currency since June 23 through Wednesday (including dividends). That’s a far cry from the short-term pain predicted by the IMF, OECD and many analysts.
The post-Brexit success of U.K. stocks, however, is cold comfort to many U.S. investors who stood by U.K. companies. That’s because many U.S. investors don’t hedge the foreign currency exposure that comes with buying foreign stocks, which means that an investment in U.K. stocks is also an investment in the pound. (Discussing the relative merits of currency hedging is for another day, but here’s a good overview.)
When those investments in U.K. stocks are converted back into dollars, U.S. investors are finding that a declining pound is taking a massive bite out of their U.K. bets. That same MSCI United Kingdom Index that returned 12 percent in local currency since June 23 has returned a negative 7.8 percent in dollars over the same period – a difference of nearly 20 percent in just four months.
For U.S. investors, in other words, Brexiteers’ fears have already been realized. Go ahead, scream.
Even over longer periods, the currency risk lurking in foreign investing is greater than investors may realize. Consider that the MSCI United Kingdom Index returned 11.1 percent annually in local currency from January 1970 through September of this year (the longest period for which data is available), whereas the Index returned 9.6 percent annually in dollars over the same period. Here again, currency is the culprit. The pound declined by 1.3 percent annually versus the dollar during that period, which accounts for nearly the entire difference.
That difference between the return in local currency and the return in dollars may not sound like much, but over those 47 years the local currency return turns out to be twice the payoff. A $10,000 investment in the local currency would have mushroomed into $1.35 million, whereas that same investment in dollars would have yielded just $730,000.
But before you run out to hedge all of your U.K. stocks, some historical perspective might be useful.
The pound’s average daily closing price since 1971 (the longest period for which data is available) has been $1.75, with a standard deviation of $0.31. That implies that yesterday’s close of $1.23 should be exceedingly rare, and in fact the pound has traded below $1.25 on only two occasions since 1971: during the five trading days since Friday’s flash crash and during most of the nine-month period from September 1984 to May 1985.
The data also implies that there’s a greater probability of the pound rising than falling from its current level (in geek speak, the pound is 1.7 standard deviations from its historical mean).
The last time the pound hung at its current level, returns were far better in dollars than in local currency. The forward ten-year returns for the MSCI United Kingdom Index averaged 17.6 percent annually in dollars in the period from September 1984 to May 1985, whereas those same returns averaged just 14.3 percent annually in local currency during that period.
Here too, the pound’s fortunes accounted for nearly the entire difference. The pound appreciated against the dollar during those ten-year periods by an average of 2.9 percent annually.
Sure, the pound may hang around its current level for a while, or it may weaken further before it reverses course. But to me the pound’s history doesn’t say hedge U.K. stocks; it says go buy those fancy Northampton shoes while they’re on sale.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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Nir Kaissar in Washington at firstname.lastname@example.org
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