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Why the exchange rate matters to investors?

November 2017


Tags: Investing Strategies

Since the Brexit vote last June, you will probably have noticed your pounds don't buy as many euros and dollars at the Bureau du Change before you head off on holiday. The cost of household stalwarts like Marmite has gone up in supermarkets and the price of filling your car with petrol has also increased.

This reflects a fall in sterling against other major currencies in the wake of that shock result in the referendum on membership of the European Union. Companies listed on the stock market have been also affected by these moves in the currency markets and this has implications for your investments in stocks and funds.

 

What is forex and why does it matter?

Foreign exchange, or 'forex', is the world's largest financial market in terms of daily trading volumes – according to the Bank for International Settlements, the average daily turnover stood at $5.1 trillion as of April 2016. 

Interest rates have a significant impact on the future trading direction of currencies, as they represent how much the holder of a currency gets in yield. High-yielding currencies tend to perform better than low-yielding ones. Increased demand for a country’s products and services will also lead to greater demand for its currency. 

 

Currency hedging

Some companies, particularly if they operate in countries where the currency regularly experiences volatility, will ‘hedge’ their exposure. This involves taking out a financial instrument with a bank which can help eliminate or lessen the impact of currency on revenue and profits. 

Currencies trade in pairs. So, for example, on the eve of the Brexit result, one pound sterling was worth $1.49 but at the time of writing it is only worth $1.26.

This helps explain why the UK’s flagship FTSE 100 share index hit a new record level after the Brexit vote. The constituents of the FTSE 100 derive around 70% of their earnings from outside the UK. If sterling falls in value against the currencies in these overseas markets, then the earnings are worth more when translated back into pounds and pence. This is known as a ‘translational’ effect. 

Other London-listed companies in the mid-cap FTSE 250, which have more of a domestic focus, are not faring as well as their larger counterparts.

Source: SharePad, 22 June 2017

Therefore, a fund or exchange traded fund with exposure to large caps is likely to perform better if sterling is weak and vice versa.

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Transactional effect

The other way a company or group of companies can benefit or lose out from changes in exchange rates is through a ‘transactional’ effect. In the last 12 months, a UK-based firm with a greater proportion of its revenue in overseas currencies than costs would have seen the value of overseas sales increased in sterling terms, while its costs increased less quickly. This would have boosted reported profit margins and earnings. 

The reverse can also be true if a big chunk of a company’s costs come from outside the UK. Tesco (TSCO) and consumer goods giant Unilever (ULVR) were at loggerheads last October, as Unilever looked to increase the wholesale price of brands such as Hellman’s mayonnaise, Lipton tea and Flora in the face of opposition from the supermarket.   

If the wholesale price of a product increases, then consumer-facing businesses such as Tesco face the choice of passing higher costs on to their customers and seeing them go elsewhere or absorbing the costs themselves and facing pressure on profit margins as a result. 

The impact from currency movements can be significant, historically Rolls Royce has noted that every one cent movement in the average exchange rate between the US dollar and UK pound will affect underlying revenue and profit on an annual basis by £15m and £2.5m respectively. 

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Constant currency

If currencies are volatile it makes sense to focus on constant currency numbers when examining company accounts to measure the true health of a business. Most companies will present these numbers in their interim and preliminary results.

Currency movements tend to iron themselves out over time, so you should never expect one year’s exceptional forex-led uplift in earnings to be repeated year in, year out. 

A long-term investor should instead keep tabs on a company’s historic track record of earnings and cash flow and its future growth prospects.

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Selftrade does not provide investment advice. This article is the authors view and is not the view or opinion of Selftrade and Selftrade accepts no liability for any loss caused as a result of the use of this information. The opinions expressed are those of the author at the time of writing and should not be interpreted as investment advice.

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