How do currency moves affect stocks? 💵


This week, the pound hit its lowest level against the dollar since January 2017. There’s already been some chatter about this and it’s likely to be one of the biggest financial stories in the UK for a while. You may also have seen it make a difference to the value of your portfolio.

So what are the reasons behind this and why/how does it impact stock market investments?

Why do currencies move?

The world currency/foreign exchange/FX market is a huge ocean of institutions, investors and consumers trading currencies. Movements in the market reflect the total demand for one currency relative to other currencies.

Currencies only rise or drop relative to other currencies. When people say the pound is weak, they’re speaking in reference to other major currencies. So, for instance, the pound could drop in value relative to dollars, while remaining the same against some other currencies.

There are lots of factors that influence currency movements, including:

  • Whether a currency is inflationary (i.e. loses buying power over time)
  • Central bank interest rates (relative to interest rates in other countries)
  • Consumer demand for spending in that currency
  • Whether a country imports or exports more
  • Simple trading momentum in the short-term
  • Demand for assets and investments priced in that currency

To apply these factors to the recent pound decline: if investors don’t want to buy UK-denominated assets, like property or UK government debt, or invest in the UK, then the demand for pounds goes down.

If consumers and companies don’t want to or can’t import as much from the UK, then the demand for pounds could go down too.

All this means that currency performance can often (but not always) reflect the world’s opinion of a country’s economic future.

In this case, many investors are predicting a dismal scenario in a hard or no-deal Brexit. A scenario like this:

UK assets could be worth less because of slow-down, the loss of the single market and trade disruption. Investment could decline as the UK becomes a less attractive place to do business. It might be harder to export from the UK due to trade barriers, but UK consumers will have to keep spending on imports. UK consumers might have less buying power and fewer people might come into the country to spend pounds. All this would mean there’ll be less demand for UK currency. And grocery shopping will suck.

That’s not necessarily what’ll happen, but these sorts of predictions seem to be the calculation the market is making right now, or at least what they fear.

In theory, currency moves should have a balancing aspect. When currencies weaken because of economic concerns and lack of demand for assets and exports, that makes those assets and exports relatively cheaper, stimulating demand again.

A US investor may not want to buy UK property because of Brexit worries, until it turns out that those very fears have helped weaken the pound and made property significantly cheaper for a buyer with dollars.

The timing of this pendulum effect and the eventual balancing point are difficult to predict and so it’s easy to get this wrong.

How can they affect stock market investments?

Currency fluctuations can have a big impact on stock market investments.

Let’s take a super simple example.

Say you want to buy $150 of US stock as a UK investor. Your British pounds are converted into those dollars at a rate of £100 for $150 (way back in 2015). Now, let’s say the value of the company itself doesn’t move an inch for four years: your shares are still worth $150. Sorry!

But in that time, the pound also declines: you can now exchange $150 for £125. That means your $150 of stock is now worth 25% more pounds than in the past (equally, if the pound rises in this scenario, your $150 investment will be worth less than you paid for it initially).

So even though the underlying value of the investment itself didn’t move at all, the currency move meant that its relative value in pounds made you money. A win, sort of!

In reality, the nature of the impact can be a bit more complicated than whether or not you invest overseas. Companies might be based in a country with a weaker currency but do most of their business overseas, earning income in stronger currencies.

The recent pattern has been that when the pound has performed badly, companies in the FTSE 100, which are large and often operate globally, have tended to see a relative rise in their price in pounds. That’s because a lot of their earnings are in foreign currencies, so their pound share price reflects that income’s growing value in terms of sterling. UK-focused British companies have done less well from this since most of their earnings are in pounds.

Many overseas investments, especially US stocks, have grown even more in pound terms.

This is also true for ETFs and other funds. Even if an ETF is priced in pounds, if the underlying investments are dollar-based assets like the companies of the S&P 500, the ETF’s price in pounds will increase as the dollar appreciates against the pound, all else being equal.

No-one knows for sure what’s going to happen with Brexit. No-one knows exactly what the economic consequences of each Brexit scenario will be either. The value of the pound could continue to slide or it could start to rebound.

In the long run though, a good way to limit your exposure to exchange rate movements is to include non-UK focused stocks as part of your portfolio, such as US stocks, global ETFs and globally-focused UK stocks.


Freetrade does not provide investment advice and individual investors should make their own decisions or seek independent advice. The value of investments can go up as well as down and you may receive back less than your original investment. Tax laws are subject to change and may vary in how they apply depending on the circumstances.

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These are all amazing posts. Would it be possible to put them all in a reference wiki or something, so they’re not lost after a while?

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You definitely have a knack for writing Toby. Love your long posts. Amazing writing as per

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Thanks so much! :smiley:

We do have a wiki here, where you can find more posts like this.

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CNBC has done a number of videos over the past year which I would consider the video form of your posts. Companies are profiled and videos often have a curiosity raising title “How company x took over the world”. I think everyone would agree that the reach of your content in video form would be an order of magnitude higher than written. I think a relatively simple approach of some semi stock photos and footage combined with voiceover is all that is needed. The videos would still look high quality and the value add would be that they are interesting and easy to understand like these posts. I know marketing priorities right now are free shares but I think this space is wide open for you and you could reasonably expect 6 figure view counts. No one could compete with the way you break down and order a topic. Your work is very good but how many new people does it bring. @Viktor

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:pound: :uk: :dollar: :us: :euro: :eu:

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Don’t you hate a strong pound when most of your stocks are USD traded lol :joy:

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I’d say we’re still quite a long way from a strong pound, even after todays pop

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Anyone else holding off on US stocks until the election /Brexit is resolved?

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The problem is the opposite. If you hold US stock you will lose money when the pound rises.

That’s literally what my post says?

Personally I think the pound is peaking at the moment, as the markets have already priced in a Conservative victory. Any election upset would see an immediate fall, while Brexit shennanigans will probably see a rollercoaster ride of falls and rises in the medium to long term.

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Sorry I didn’t understand.
However someone predicts GBP/USD at 1.35 if Boris Johnson wins. It’s not so much, I lost much more (around 7%) previously. I really don’t know what to do. Of course in all the other cases we will return to 1.25 or less.

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I have a googlesheet where I’ve set up stock prices and currency movements - or at least GBP vs. USD, to try to see what correlations there might be between them. You can change the ticker and dates as you like if you want to download a copy.

https://docs.google.com/spreadsheets/d/1i0fjnOdmh89ZBsTWe9onFRHranncpBmBI00UQHy4tEM/edit#gid=0

For those needing a stats refresher, the correlation score (correlation coefficient aka R) tells us a bit about how these two numbers (currency movements vs. share price movements) are moving in relation to each other. The output ranges between -1 and 1. If they move up and down together, this is called a positive correlation, and a score closer to 1 indicates a stronger connection. If their movements don’t appear to be synchronised at all, the score will be closer to 0, indicating no pattern detected. If the numbers move in opposite directions, the score will be closer to -1 and is called a negative correlation.

In addition there is something known as R² (coefficient of determination), which is supposed to indicate how much of the correlation between share prices and currency movements is a result of currency moves rather than anything else that might move the share price. You’ll see this as a score between 0 and 1, which can be interpreted as a percentage.

As some examples:

Companies with high % of non-UK revenues:

Correlation coefficient R Coefficient of determination R²
Ferguson -0.657 0.432
Ashtead -0.659 0.435
Unilever -0.788 0.621
Diageo -0.692 0.479
Compass -0.851 0.724

Companies with high % of UK revenues:

Correlation coefficient R Coefficient of determination R²
Lloyds 0.823 0.677
Autotrader -0.567 0.322
Rightmove -0.655 0.429
Barrett 0.101 0.010
Morrisons -0.646 0.418

All to be taken with a sizeable pinch of salt. And worth checking the spurious correlations website to work out how big you need that pinch to be.

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For US stocks GBP/USD influences directly and completely. If dollar loses 8% against pound we will lose 8% on every US stock.

I thought that if a currency fell, it would make exports cheaper and imports more expensive. And it it went up the opposite happened. So how the business makes it’s money is also a factor?

Makes my brain hurt :face_with_head_bandage:

:eyes:

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That’s pretty cool. Although selecting another stock in the app shows the pink toggle box as completely filled in (only the first stock selected flips between the currency icon ok.), but probably can be fixed quickly.

Hi - just trying to get some advice around the potential effects of currency risk with over exposure to USD. I have read some great insights about this on some threads in this forum but am still not quite fully understanding so hopefully you will be able to shed some light even further.

With the GBP generally low and working under the assumption we have no idea which way it will go in the future I was hoping to get your thoughts on how to reduce this currency risk as I have a high percentage of USD holdings.

Just to quickly outline my current portfolio standings;

65% of my holdings are USD (mainly in ETFs where USD dominates – e.g. S&P 500), whilst only 7% are GBP (the rest all different currencies but I am mainly asking around USD-GBP).

My thoughts around how I might lessen the effects of currency risk are as follows;

I currently have a large holding in VWRL (20%). If I switched this to a GBP hedge version of a similar etf - IWDG, I think this would change my exposure to 53% USD to 26% GBP? Does that sound about right - if so is still too much USD?

I invest monthly, as I am buying regularly - will this negate some of the currency risk as I will in effect be buying at all different times of currency fluctuation (when the dollar is stronger and weaker over time?)

Finally, the area I probably understand least (apologies if I am missing the obvious here), I have read on here around buying ERNU to negate some currency risk as it effectively tracks USD/GBP - how does this work? How does it create a type of USD pot? How does it help with USD exposure? With my current portfolio if the GBP strengths then my holdings will reduce in value - what will happen to the value of ERNU if the GBP strengthens (and why?).

Is this the same concept of USD bonds - for example I have seen VUCP suggested, will this help with exposure to USD (and if so how?) or will it make my exposure to USD worse?

To summarise, say it was accepted that I wanted to achieve some protection to exposure to USD, what would be an approx % of IWDG, or ERNU or VUCP to even out to an ideal level?

Appreciate a lot of questions there but can’t quite get my head around it at the moment!

Thanks in advance!

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Welcome to the Forum!

So first of all buying ERNU is probably not a wise idea. Yes it is only short-term debt with a fee of 0.09% but there are issues with holding bond ETFs. As we saw during the early phase of the crisis it is possible for bond markets to stop functioning and this saw people trying to sell take huge losses on positions due to liquidity issues (nothing to do with the actual quality of the underlying investment).

The concept is that as the bonds are USD denominated you buy them at an FX rate you like and then buy USD shares when you actually want to buy a particular share on the share price alone (not FX as well). However, it also means your holdings are in USD and so you still have FX risk just in bonds not stocks. You can already achieve this without any risk by using a US broker (you can open one online by filling out a W-8BEN form) and using a service like Transferwise to send money at specific rates.

You can see from the above screenshot how bad the dislocation was. There is no alternative to cash except cash. I have seen this suggestion around the Freetrade forum and personally think it is a terrible idea. As it can mean that when you come to pounce on low stock values you are unable to sell without realising a huge loss.

Secondly, IWDG is not the same as VWRL. The VWRL is all of the world stock market whereas IWDG (the only similar hedged alternative available on Freetrade) only covers the developed world and so had a different risk profile. The iShares EM ETF is also unhedged and accumulating (or at least the version on Freetrade is) and so is not really a good swap.

That being said IWDG is an effective option to hedge your risk to major market currencies (i.e. the USD) and then you can buy the Vanguard EM ETF. As EM currencies are far less established and important (or are not free floating) there is less information about their trajectory but one would assume that over the next 20-30 years, as economies like Nigeria, Indonesia and India supplant Western economies, that EM currencies will become more useful and traded and therefore valuable.

Thirdly, yes investing monthly will average out your currency exposure through dollar cost averaging (DCA) but it does not negate your overall exposure. There is no set percentage for USD it is whatever you feel comfortable with but given that the US stock market is about 50-60% of total global value then it does not seem to far off to have what you currently have, or what you would have after switching to IWDG. However, owning ERNU does not even out your currency risk as you are still holding USD denominated bonds and the same goes for VCUP.

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