The assumption I have made for this coursework is that the Investment Manager (IM) has a globally diversified portfolio rather than just running a European or US fund.
An investment manager is a person or organization that makes investments in portfolios of securities on behalf of clients, in accordance with the investment objectives and parameters defined by these clients (Investopedia, no date).
An investment managers’ decisions and considerations when assessing the viability of both European and US stocks will therefore be numerous and unique. Considerations will be influence by the risk profile and objectives of the fund.
Impact of Brexit vote
Following the vote to leave the EU, Insight discussed the potential impact in the months and years ahead to the wider global economy. They stated “there is no roadmap to follow or analogy to invoke as a guide or pattern for how the Brexit vote will reverberate in the months and years to come.” (Insights, 2016).
This suggests UK IM’s are in unchartered territory; no state has ever left the EU before so there are no previous model cases to call upon as opposed to previous financial crisis/events which have been managed through learned experiences.
For example; the recent credit crisis had similarities with the great depression both
- started in the finance sector and spread to the wider economy
- had defaulting financial institutions which were bailed out
- had a bubble which burst
- had banking credit which dried up (Anderson, 2013).
A further example is the recent euro debt crisis with Greece and other counties which had similarities to the Latin American debt crisis of 1982 whereby several countries continually borrowed money whilst their economies were booming, only to end up in crippling debt (Anderson, 2013).
This time it’s different and IM’s need to formulate strategies not undertaken before. The use of tools such at the Value at Risk model, which measures the maximum potential loss expected over a given period are little help. The VAR model uses historical data and is based on normal market conditions. The problem is the unique situation of Brexit wouldn’t qualify as a normal market.
An IM can only therefore work with the information and data currently available to try and minimise risk whilst seeking out opportunity. I will focus on currency risk, correlation and diversification and geopolitical issues for this paper. There are of course many other considerations which is beyond the scope of this paper.
To understand the considerations of an IM, it important to understand the reasons for international investing.
“The case for international diversification of portfolios can be decomposed into two components: firstly, the potential risk reduction benefits of holding international securities and secondly, the potential added foreign exchange risk” (IPTD, no date).
Why buy foreign stock?
Modern Portfolio theory was developed by Markowitz (1952) and suggests that an investor can build a portfolio of multiple assets that will maximise returns for a given level of risk.
If the maximum return, whilst being exposed to the least risk, could be achieved through domestic markets there would be no need for foreign exposure.
In fact, it is argued that international investing is used more to reduce risk than to seek out a higher return.
Goetzmann, Li and Rouwenhorst (2002) state that “one of the most well-known results in finance is the decrease in portfolio risk that occurs with the sequential addition of stocks to a portfolio”.
The single most important consideration when investing in either of these markets is currency risk. As of today (20th October 2016), the Pound has fallen 19% against the dollar and 15% against the Euro (FT, 2016) which makes purchasing stocks in these countries considerably more expensive than pre-Brexit.
Source: Myforexchart (2016)
The consideration is therefore expectation of further opportunity given the current trend downwards in the lead up to invoking Article 50 or threat of a rebound. A rebound would devalue any overseas equity growth whereas a further decline would inflate any gains. As the methodology of Brexit is yet to be determined, the Pound against both the Dollar and Euro continues to experience high volatility.
Shortly after the referendum, the Financial Times asked several experts to forecast the effect on the pound against the dollar. The lowest forecast, given the information at that point was $1.15. As of 20 October 2016, it’s $1.20. (Blitz, McCrum and Mackenzie, 2016).
The difficult decision here is based on the total obdurate lack of uncertainty. The currency will continue to be volatile until a clear direction for exit is determined. This uncertainty is evidenced by HSBC who currently forecast that the pound will fall to $1.10 and parity against the Euro by the end of 2017 (Nag and Graham, 2016), whilst Mnyanda (2016) thinks a hard Brexit has already been priced in and the pound could rally 5%.
Considering these different views, hedging the currencies could be an option. Hedging strategies can help an IM reduce and control currency risk within their portfolio.
In the short term the US economy could be affected by which ever candidate wins the race to the White House and Europe could be affected through the method at which Britain leaves the EU together with a run of forthcoming Europe wide elections.
Schmittmann (2010) examined the benefits of currency hedging for international portfolios. He analysed the exposure in single and multi-country equity and bond portfolios for various investors.
The thorough research looked at various hedging strategies over both short and long time horizons to determine any differential in the need to hedge.
It was concluded that there was little need to hedge for a UK investor buying equities in Germany based on the strong correlation between the GBP/EURO and the both stock markets.
He did however state that “At quarterly horizons, the case for hedging currency risk associated with investments in one foreign country at a time is very strong” (Schmittmann, 2010). Clearly the currency volatility, and double digit devaluation of the pound would back this statement up. A decision to hedge will ultimately be based on the time horizon of investments held.
Froot (1993), similarly looked at the need to hedge from a UK investors perspective in the US markets and argued that currency hedges are less useful at reducing real return variance at long horizons than they are at short horizons.
Contrary to this is the work of Statman and Fisher (2003), who found that the mean returns and standard deviation of global portfolios with currency hedging were approximately equal to those with unhedged currencies.
Given the assumed IM’s investment time horizon to be medium to long term and not day trading, past evidence suggests no clear advantage of hedging, but again this isn’t a normal market.
Correlation & Diversification
“The primary motive for international diversification has been to take advantage of the low correlation between stocks in different national markets” Goetzmann, Li and Rouwenhorst (2002).
“It is critical to be clear as to exactly why the internationally diversified portfolio opportunity set is of lower expected risk than comparable domestic portfolios. The gains arise directly from the introduction of additional securities and/or portfolios which are of less than perfect correlation with the securities and portfolios within the domestic opportunity set” (IPTD, no date).
It is important to understand a few decades ago it was stated that cross border correlation was low (Grubel, 1968), yet the speed of change in globalisation through information technology and a more connected world, has resulted in more positively correlated stockmarkets between the developed nations.
“The level of correlation between the UK and US market is now so high that the usefulness of independent analysis of the larger-cap UK market indices must now be moot” (Eckett, 2013).
Campbell and Ammer (1993) find that news about future excess returns is the dominating force behind movements in US stock returns, with news about future dividends and real interest rates being less important.
Raddant (2016) noted that following Brexit, the four largest markets were positively correlated.
There are more opportunities for negative correlation in developing European countries which serve local rather than global markets.
Masuduzzaman (2012), argues that there are short and long term relationships between the UK and Germany markets.
Cook (2013) notes the close correlation in the main indices could be explained by medium to large companies being more globally focused and having to rely on international markets. Opportunities for diversification could therefore lie amongst European smaller companies. Typically, this will serve local markets and should therefore not be influenced by political and economic events cross border. The article also highlights that the US, being a larger expanse of land and cultures can shrug of the need to rely on foreign revenues.
If an IM is to invest in the US and European markets, they need to consider stocks which don’t have high correlation to the UK markets in order to gain portfolio diversification.
So how much influence will the UK and its unclear Brexit have on trade in these two regions?
- In 2015 44% of UK exports went to the EU. 53% of imports came from EU (ONS Digital, 2016).
- USA is UK’s single largest export partner 14.5% (Workman, 2016).
- Exports to United Kingdom, in 2014 accounted for 5.0% of total U.S. exports (BEA, 2015).
- Imports from United Kingdom contributed 3.7% of total U.S. imports (BEA, 2015).
The Brexit vote is likely to have much less of an effect on the US market than Europe. A Hard Brexit resulting in loss of access to the single market could impact the GDP of German, France, Spain and Italy more than the US given these figures.
There is a real fear in America that Brexit has wider implications than just a renegotiation of trade deals. Pre-referendum the Federal Reserve acknowledged Brexit as a reason not to increase interest rates. It feared credit issues with central banks potentially having a knock on effect to the US economy.
Worstall (2016) makes an important point however; “if Americans think there will be an impact then an impact there will be as American behaviour itself causes that impact”. The statement taps into the less predictable field of behavioural economics. A decision to invest in Stocks cannot be based solely on data alone and may need to include irrational behaviour.
There have been many papers discussing the effect of the US election on stock markets as discussed in a article by Foster (2016). In summary, there seems to be no clear consistent indication of making an investment decisions based on a presidential outcome. The studies made, all use different parameters leading to differing results. It is therefore less important what the outcome of the election is as to the wider economic issues.
European political issues are a little more complicated. The way in which Britain is allowed to exit the union could affect the stability of the Union itself. “There must be a threat, there must be a risk, there must be a price,” (French PM Mr Hollande; Chassany, 2016). If Britain are given an ‘easy exit’ other countries could follow. Both the French and German elections could be affected through parties promising a Euro-vote referendum in their countries.
An IM’s considerations given the continued uncertainty cannot be based solely on a pre-Brexit model to reduce risk through international modern portfolio theory. In a period of extreme volatility of the GBP against global currencies, it is difficult to look beyond the short-term, but an IM can only invest in these markets with a longer-term view based on the fundamental analysis of individual stock research.
If, as found in various research papers, that the correlation between US, UK and the larger European markets is high, opportunities for large outperformance of domestic markets might be low. If this is the objective of the IM, then smaller European markets, that don’t rely on international trade could be the answer, providing they meet the risk profile of the fund.
It would be prudent to focus more on the currency risk of the portfolio in the current market conditions given the high correlation between these larger developed markets. The geopolitical events in Europe and the US may not be as significant to equity prices as the change in these currencies could be to the GBP.
Has international diversification worked https://www.imf.org/external/np/res/seminars/2003/global/pdf/rouwe.pdf
The real return will need to factor in equity risk, exchange rate risk and inflation (given the important of protecting domestic purchasing power.
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