Market Commentary – October 2019
Bond yields rise again amid global bond sell-off
Bond yields across the globe rose during October, as investors were concerned over possible bond sales to fund economic stimulus packages. Korean bonds saw their worst monthly fall in three years. Another rate cut from the Federal Reserve, did not stop the 10-year bond yield from edging higher, as Jerome Powell’s comments were widely interpreted to mean that no further cuts were considered likely to be necessary, and the US economic outlook was steady.
Sterling strong ahead of Brexit deadline
Sterling continued to act as a barometer for Brexit sentiment, and, as Prime Minister, Boris Johnson, announced a new deal with the EU, the pound rallied above $1.29, ignoring the fact that the new deal lacked the support to get through the UK Parliament. Hopes that a general election in December will provide the means to break the deadlock over Brexit, meant that sterling rose more-or-less steadily during the month, against both the dollar and other major currencies.
US market buoyant ahead of rate cut
Whilst retail sales dipped off slightly from the previous month, unemployment continued to fall, and inflation remained steady. Against this backdrop, and with investors looking for another rate cut from the Fed, US equities gave another positive return in October. Despite recession fears leading the market lower at the start of October, the fourth quarter has historically been the best quarter for US stocks.
Emerging markets continue to rally
Emerging markets rose in October, outperforming developed markets as a weakening US Dollar and positive news in relation to the ongoing US-Sino Trade War buoyed the asset class. Cyclical sectors, such as Energy and Information Technology were the strongest contributors, while more defensive sectors, such as consumer staples, suffered. Dovishness by the Federal Reserve appears to have taken some steam out of the US Dollar, which is supportive for trade-reliant emerging markets, as well as sovereigns and companies which have borrowed in US Dollars.
Equities around the world mostly gave positive returns during October, with the exception of the UK market, which fell slightly into the close of the month, as it became clear that the Brexit deadline would be extended once again. US equities were buoyed by moderately good economic data, and the expectation of another Fed rate cut. Japanese equities benefited from seemingly positive news on the Sino-US trade war, as did emerging markets, which were also buoyed during the month by a weaker dollar.
Developed European equities were positive in October, with negative returns coming from just a few emerging markets. The corporate earnings season in the EU was overall more positive than expected, despite disappointments from the banks, which were the worst performing sector in the stock market during the month. Irish stocks continued their strong run, as a further Brexit delay seemed to make an acceptable deal more likely.
Sterling saw another strong month in October, as news flow regarding a Brexit agreement seemed increasingly positive. The dollar was commensurately weak against the pound, but also lost ground against other currencies as the impeachment process moved forward, and concerns over a slowing economy led to another rate cut from the Federal Reserve. The euro made progress against the dollar but fell versus sterling.
Across most of the global fixed income landscape, bonds weakened, and yields rose. This was true even for US bonds, despite the Fed rate cut, as Jerome Powell indicated that any future rate cuts would be dependent on the prevailing economic outlook (which he sees as stable). The 10-year US Treasury, remarkably, now yields more than Greek 10-year government debt. European yields remained negative, though they did continue to rally from their lows, as Christine Lagarde, a proponent of fiscal stimulus to jump-start the economies of the EU, takes over from Mario Draghi as President of the ECB in November.
*A Generic bond is a theoretical bond that always has the specified tenor, unlike a Benchmark bond, which is a physical bond, with a decreasing tenor.
Why Currency Hedging is Important
Less than a year ago, Investment Week ran an article warning that the majority of IFAs and wealth managers had failed to hedge their foreign currency exposures, leaving their clients vulnerable to a potentially damaging rally in Sterling (https://www.investmentweek.co.uk/investment-week/news/3066449/warningmisconceptions-currency-hedging-industry-scandal-fca-blind-eye).
Over the period since the 2016 Brexit referendum, and up until July of this year, we have seen Sterling weaken against other world currencies, most notably the US dollar. This has meant that, for the domestic UK investor, unhedged funds investing in foreign markets have seen their absolute returns boosted by the currency conversion. But returns versus the World Index have looked commensurately weaker, since the World Index itself is very heavily weighted towards the dollar – much more so than most UK portfolios, and when quoted in Sterling terms, the Index has therefore appeared much stronger.
This weakening of Sterling, however, is unlikely to be entirely a one-way trip, and already since July we have seen the pound moving mostly higher against the dollar, meaning that unhedged overseas funds have seen their returns diminished in Sterling terms.
Sterling has acted, for the past few years, as the primary barometer of sentiment over Brexit, moving up when there is a high expectation of a deal, and down when those hopes are dashed. With an imminent general election, the only thing that can be confidently predicted about the UK’s exit from the EU is continued uncertainty, at least for the present.
Any economics textbook will describe various ways of forecasting currency movements, based on Purchasing Power Parity (i.e. using inflation rates), relative economic strength (i.e. incoming investment flows) or complex econometric modelling. However, the reality is that currencies can be very volatile, and their movements are very difficult to predict in most circumstances – especially over short periods. Our in-house tools allow us to analyse whether a currency appears cheap or expensive at any point in time and suggests when it is appropriate to hedge the exposure. In the chart below ($ vs £), the blue line segments represent periods when our tools expect the pound to be stronger, and a hedge is recommended, and the green parts of the chart are times when Sterling is expected to be weaker:
This can also be represented purely as a hedging signal, as below, where a hedge should be ‘on’ when the signal has a value of 1:
These indicators help to enhance our process and inform our decision-making, but they also serve to underline the risk involved in currency markets. These charts just show the US dollar, but a typical model portfolio will involve a much wider range of currencies, beyond the main three or four that might immediately spring to mind.
It is therefore of the utmost importance to ensure that clients are not unknowingly exposed to unexpected risks arising from currency gyrations.
Currency movements represent an additional level of volatility added into a fund price, and so some managers choose to remove their currency risk by hedging. However, this type of protection can be expensive.
In order to illustrate this point, consider how we might hedge a foreign investment, if there were no futures markets. Suppose that we, as Sterling investors, want to invest £1m in a US company. We would convert out £1m into dollars and buy shares in the company, but we would be left with exposure to £1m worth of US dollars. The best way to mitigate this would be to take out a loan for the same amount of dollars and convert it into pounds (placing the pounds on deposit). By doing this, we have matched a dollar-based asset with a dollar-based debt, hence cancelling out the currency effect. The cost of the protection would be the cost of the dollar loan (i.e. the US dollar interest rate) minus the interest from the Sterling deposit (i.e. the UK interest rate).
Broadly speaking then, the cost of a currency hedge is the difference between the interest rate on the target currency minus the interest rate on the home currency. In the case of a dollar hedge, this is roughly 1.5%-0.75% = 0.75%. This cost was much higher before the Fed began cutting the target rate back in July this year.
Of course, if we were investing in Europe, and wanted to hedge against movements in the Euro, then the calculation would be much more favourable. With the ECB base rate at 0.00%, and the Sterling rate at 0.75%, the cost of the hedge would be roughly -0.75% – yes, that hedge would actually pay us to do it!
We aim to mitigate currency risks wherever possible in your models. Aside from the obvious solution – investing more in UK funds, this can be achieved in two main ways: by investing in funds that offer a share class that is specifically hedged back into Sterling, or by investing in funds where the manager has discretion to hedge currency exposure, and does so.
The first of these options, to invest in hedged share classes, is most commonly used in the core, where investments are primarily defensive, such as cautious managed funds, fixed income funds and absolute return funds. These types of fund are aimed at the more risk-averse investor and it is therefore natural that a hedged share class will be made available, though this is not always the case. There are also some (but relatively few) satellite funds that offer hedged share classes, such as JPM US Equity Income. Core investors do not want or expect currency risk, and by hedging out the currency risk, we are able to concentrate on generating asset-based returns.
It is important to note the difference between a fund that is traded in Sterling, and one that is actually hedged into Sterling. Many funds are quoted in a range of different currencies, normally US dollars, euros, Sterling, and Swiss francs. They will often have GBP, USD, CHF or EUR in the title of the share class. But this does not imply hedging. In these cases, the underlying holdings of the fund are valued in whatever currency (or currencies) they are normally traded, and then the value is simply converted into Sterling at the prevailing rate. Hence, if Sterling has risen in value versus the fund’s natural currency exposure, the performance when converted into Sterling, will be reduced.
Where a share class is actually hedged, the currency factor is removed, and the return that the investor receives is simply the nominal change in the value of the fund. A hedged share class may sometimes be denoted by GBPH or GBP Hdg, but this is not always the case, and it is important to understand exactly the nature of the investment at the outset.
The second option, investing in funds where the manager exercises discretion in hedging, is more likely to be found in the satellite part of the model. These funds are more difficult to unearth, since the description does not generally give any clues as to the manager’s policy on hedging. We rely upon our detailed due diligence to identify funds like this, which include Neptune Japan Opportunities and Royal London Short Duration Global High Yield Bond Fund. The prospectus for a fund may be vague on this subject, simply stating that the fund manager may invest in derivatives for the purpose of hedging currency risk, but this does not mean that the manager actually does so, and it is only through conversations with the manager that it is possible to get a good understanding of his or her attitude to currency hedging. Some managers are very open about the fact that they regard the currency exposure as an integral part of the investment, whilst others will have a strict policy to hedge out as much currency risk as is practicable.
The overall foreign currency exposure of your models is one of the factors that we look at closely when constructing the portfolios and is one of the many risks against which we seek to insulate your clients.
Disclaimer: The information contained in this report is for illustrative purposes only and should not be construed as a solicitation nor offer, nor recommendation to acquire or dispose of any investment. Specifically the share class used to create the illustrations may not be available on all platforms nor be suitable for individual investors. This report was produced by Independent Strategic Research Limited (ISR) for Affinity Integrated Wealth Management (AIWM) and while AIWM and ISR use reasonable efforts to obtain information from sources which they believe to be reliable, neither AIWM nor ISR make any representation that the information or opinions contained in this report are accurate, reliable or complete. The information and opinions contained in this report are subject to change without notice. Model returns are calculated using the most appropriate share class of the underlying funds, having regard to the illustrative nature of the report, with all income being reinvested. As a result, real portfolio performance may vary from model performance. Where model portfolio histories are shorter than three years, historic model returns are substituted prior to inception date with returns from an ISR performance benchmark. This benchmark is constructed from the average returns of all ISR portfolios with similar risk profiles that existed during that time. The value of investments and the income from them can go down as well as up and past performance is not a guide to the future performance. Affinity Integrated Wealth Management is a trading style of Buryfield Grange Limited, Buryfield Grange Life Planning Limited and Affinity Integrated Wealth Management Ltd. ‘Buryfield Grange Limited’ is authorised and regulated by The Financial Conduct Authority. Not all services provided by Buryfield Grange are regulated by the Financial Conduct Authority. ‘Buryfield Grange Limited’ is registered in England and Wales at Inspire House, 20 Tonbridge Road, Maidstone, Kent, ME16 8RT. Company registration number 4568338. ISR is registered in England and Wales at 34 Southwark Bridge Road, London, SE1 9EU. Company registration number 09061794. Data Providers: Bloomberg L.P. and ISR.
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