Currency Dilemmas

One interesting divergence in equity markets has caught my eye over the last few days. While US equities hit their October lows yesterday (and rebounded sharply), the UK market has stayed a good 15% above its lows from the previous month.

The difference can of course be attributed to the weakness of sterling, which has plummeted in 2008, hitting historic lows of below 1.20 vs. the euro and falling from US$2.10 at the end of last year to $1.48 as I write. So the impact of renewed share market falls has been dampened slightly for UK companies, as their overseas earnings will have gone up in sterling terms.

As I watched another television programme last night on the dire state of the UK housing market, it struck home that the government is left with very little choice than to try and stabilize nominal prices by devaluing the currency. Eventually this will work to put a floor under property prices in sterling terms, but it may be at the cost of a further 20-30% decline in the unit of account. Is £/€ parity really on its way? Skiers across the UK are mourning the cost of pursuing their addiction and next summer we will all have to sit in the rain on the Norfolk or Devon beaches rather than heading for the Med. If Brown and Darling, or the prospect of Cameron and Osborne, make you feel like emigrating – tough, you can no longer afford to.

A blog by Willem Buiter yesterday on the FT website reinforces the point, and goes further in suggesting that the UK might even follow Iceland in adding a sovereign default to the currency and banking crises. He states the preconditions for such a confluence of catastrophes as being: 1) a small country with (2) a large internationally exposed banking sector, (3) a currency that is not a global reserve currency and (4) limited fiscal capacity. All of these apply to the UK.

So what’s the relevance for ETFs? It really isn’t easy for the ETF investor to manage the currency exposure of cross-border investments. While those based in countries with devaluing currencies benefit from having invested overseas, it’s more difficult if one wants to buy assets in a country where the foreign currency might fall compared to your own.

The recent surge in the dollar has caused the US ETF provider WisdomTree to file for currency-hedged versions of some of its international ETFs (reported at Index Universe in July here).

With countries around the world likely to follow each other in rounds of competitive devaluations to try and ease economic pressures, currency volatility seems likely to persist. So wouldn’t it make sense for European ETF providers to join this trend and start to offer currency-hedged ETFs, at least on some of the main benchmark indices in overseas markets, and both ways between, for example, sterling and the euro?

With interest rates in the major currency blocs in low single figures, the cost of hedging is currently quite modest, so this seems like a perfect time to add this type of fund to the investor’s toolbox.

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