Thinking about the strength of sterling is usually reserved for exchanging currency before a holiday. However, volatile price swings have caused many people to question how a "weak pound" affects their personal wealth and investments.
What is a weak pound?
The pound is said to be weak when its value is low in relation to other currencies. “This means that everything we consume that isn't produced in the UK is more expensive," says David Storm, chief investment officer at RBC Wealth Management in the British Isles and Asia. “And any time we go abroad, it's more costly."
Reasons for a weak pound
So what exactly causes a drop in a currency's value?
Storm points to a number of factors that contribute to a weaker currency, including interest rates and a country's economic stability.
A good example of causal factors contributing to a weak currency is the UK in 2022. Soaring inflation, a cost-of-living crisis, capricious government decision making and an economy that was (and still is) below pre-pandemic levels, all had a negative impact on sterling and saw it sink to a record low against the U.S. dollar in September 2022.
“When you consider the historical performance of sterling against the dollar, it certainly feels as if there has been a prolonged period of weakness," says Storm. “Before the financial crisis in 2007, the pound was worth more than US$2
The decline of sterling 2007-2022
While the impact of a weak pound on travel and consumer goods may be more immediately apparent, how it affects investments and wealth is not as straightforward. Indeed, when looking at the bigger picture, a weak pound can actually work in an investor's favour.
With this in mind, we've highlighted four ways a weak pound might affect your wealth – both positively and negatively.
What a weak pound means for your finances
1. A weak pound doesn't mean the value of all UK investments will fall
It would be easy to leap to the conclusion that a tumbling pound would correlate directly with a fall in UK stock markets, but that isn't necessarily the case. One of the main factors here is the composition of businesses that make up specific markets.
Take, for example, the FTSE 100 and the FTSE 250. In 2022, sterling fell over 10 percent versus the U.S. dollar. During the same period, the FTSE 100, which is dominated by global companies that in aggregate derive around 80 percent of revenues from outside the UK
Conversely, the more domestically-focused FTSE 250 fell almost 20 percent, reflecting the weakening of the UK's economic outlook.
“Sterling's weakness has served as a significant disincentive for many overseas investors – such as U.S. dollar-based investors – to buy UK public-market assets, including UK equities," explains Thomas McGarrity, director, head of equities at RBC Wealth Management in the British Isles.
However, some investors, such as large international corporates and private equity firms seeking acquisitions, can take advantage of a weakened pound by acquiring UK-listed businesses. “A weak pound taken together with cheap UK equity valuations will likely see further opportunistic approaches from both corporates and private equity firms for UK-listed companies," explains McGarrity.
2. Currency volatility reinforces the need for a diverse portfolio
Diversifying your investment portfolio to mitigate market volatility is an established tenet of investment risk management. In the case of a weak pound, this means ensuring geographical diversity and avoiding what is known as "home bias" – the tendency to be overexposed to domestic equities.
Put simply, exposure to a wider range of markets means a decline in one currency can be offset (to a degree) by the stronger performance of others. This practice is designed to help reduce the volatility of your portfolio over time.
“Over the five years to the end of 2022, investing in the FTSE 100 would have given you a total shareholder return, in sterling terms, of around 15 percent," says McGarrity, who is basing his information on the Bloomberg, MSCI World Index. "If you invested in a broad global equity index over the same period, you'd have generated a return of over 50 percent in sterling terms.
So, what's the lesson here?
While investing in the UK market with foreign exposure helps mitigate some of sterling's weakness, an even broader geographic spread can generate larger returns.
3. Dividends can benefit from a weaker pound
When sterling is weak and inflation is high, it's natural to question whether you can sustain your existing lifestyle. But for those who rely on dividends to provide a measure of income, such as retirees, there may be added concern that companies could reduce those dividends as a result of economic stress.
McGarrity reiterates how exposure outside of the UK can help offset this potential downside. “Not only do a large percentage of FTSE 100 companies derive their revenues from outside the UK, around 50 percent will pay their dividends in dollars," he says. "So, a weak pound is good for those dollar dividends, once you factor in the exchange rate."
4. Consider all your potential sterling wealth exposure
While it's understandable to focus on how a weak pound may impact investments, for high net worth individuals who have broader asset bases, currency volatility can have further-reaching implications.
“Take, for example, the business owner of a company that exports goods to the U.S.," says Oliver Saiman, senior director at RBC Wealth Management in the British Isles. “Or the private equity executive who has significant amounts of their net worth in euro-denominated carried interest and co-investment. Currency is going to be an issue in both their professional and personal lives."
Saiman cites the example of a CEO of a UK company planning to list on the NYSE, who is soon to have the majority of his net worth held in U.S. dollar–denominated shares. “When is that flotation planned and what will sterling's position be at that time?" he asks. “This could have a major impact on the individual's currency exposure and ultimately, their overall wealth."
How to react to sterling weakness
With the above considerations in mind, what actions can you take when faced with a weak pound?
For Storm, diversifying investments beyond the UK is critical. “We would definitely recommend taking on more global exposure, simply because it's a broader opportunity set," he says. “The returns from global equity markets are expected to be lower in the coming years, so you'll want to have the broadest opportunity set for the largest chance to generate returns."
Saiman reinforces the need to view investments and wealth holistically in line with your long-term wealth goals. “We advise our clients to consider their overall currency exposure," he says. “And if, due to their professional interests, they do have an enormous weighting to a certain currency, then it's sensible to think about that when constructing an investment portfolio.
"What you want to end up with is an investment portfolio that complements your overall asset base, rather than looking at your personal investments in isolation."
As with any financial decision-making process, the past is no guide to the future and currency movements are extremely hard to predict. As a result, basing investment decisions on exchange rates is very risky, and using the services of an expert wealth manager makes clear sense.
Staying focused on your long-term goals, holding your nerve when markets are volatile and ensuring you have a diversified portfolio that spreads your money across different asset classes and regions (avoiding home bias) can help weather volatility and deliver better risk-adjusted returns.
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