How Does Currency Affect Equity Returns?

Concerns about China's currency has contributed to stock market volatility across the region and further afield. What should investors know about the link between currency and returns?

Emma Wall 22 January, 2016 | 12:14AM
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Emma Wall: Hello and welcome to the Morningstar Series 'why Should I Invest With You?'. I'm Emma Wall and I'm joined today by Jason Pidcock, Manager of the Jupiter Asian Income Fund.

Hi, Jason.

Jason Pidcock: Hi, Emma.

Wall: So, there have been a lot of talk in your region of specialty about currencies at the moment. I suppose the first question to ask for investors is how do currencies affect equity markets?

Pidcock: They certainly do affect equity markets especially if you are investing as a sterling based investor. You've got to think about whether sterling will appreciate or depreciate against the currencies you're investing in. We are predominantly investing for sterling investors. So we have to think about the Asian currencies and lot are under pressure at the moment. We're seeing the Chinese currency come back against the U.S. dollar, hasn't actually fallen much against sterling though, but capital flight out of China has been quite strong $108 billion alone in December. And we think there will be more pressure on the Chinese currency because of deflationary pressures in that country, generally.

Wall: So it can't boost gains or exacerbate losses.

Pidcock: Absolutely. Over the last 10 years, there have been periods where sterling gain has been strong because sterling's fallen against these currencies and at other times it's been the other way around. Our view is, we don’t do much hedging, we're just happy to take currency into account when thinking about the equities that we're considering.

Wall: So, then the news of the week, I suppose is that China maybe de-pegging against the dollar. What exactly does that mean and how will that affect returns?

Pidcock: For a long time the Chinese managed their currency against the U.S. dollar, it wasn’t completely pegged, it was like a dirty float, they kept it fairly stable. For a while it was appreciating gradually, but now they've moved to measure their currency against a basket of currencies. So a trade weighted basis they haven’t been open about what that basket is made up of and as the U.S. dollar has appreciated against other currencies particularly emerging market currencies around the world.

So the Chinese currency has fallen back. It hasn’t actually fallen that far. But if this year it falls by let's say more than 6% in U.S. dollar terms then in U.S. dollar terms, there is a reasonable chance you could say that the Chinese economy as a whole will contract. And therefore at a global level, it's not going to contribute to global growth. It's going to be a drag on global growth.

Wall: And although of course China is moving away from the model where it is so reliant on developed market, there is very much a link there. Isn't there?

Pidcock: Absolutely. So China has been sucking in a lot of commodities over the last few years, boosting emerging markets, demand for commodities has fallen back substantially as China's growth rate has slowed. That’s likely to continue with going through the process of seeing the supply response to that, but for many emerging market countries who have their growth rate pulled up by China. They are now seeing flipside. Now many Asian countries are net importers of commodities and will actually benefit from lower commodity prices. In fact all of the countries that we invest in bar Malaysia, are net importers of oil. So the fall in the oil price will help reduce input cost but arguably the oil prices come down because demand generally is low. So often there is a positive correlation between the state of the economies in Asia and the oil price and when one is weak, both are weak.

Wall: I suppose we should talk about the state of the economies in Asia, in particular in China there has been a lot of concern about the fact that China is displaying the lowest growth in sort of 25 years even though actually if you just take the figure on face basis, it looks pretty impressive. The sort of growth that we pray for in a developed world. How risky is the fact that China is slowing down not just to Chinese returns themselves, but also to the whole region. I suppose the scary word is contagion?

Pidcock: I think it is real. I do think there is an over capacity problem in China. So that is causing deflationary effects around the whole world. Whatever the real growth rate is in China, I do think it's lower than it has been and I suspect will continue to go down and as I said earlier, I think in U.S. dollar terms the economy does contract this year which is quite a big deal that’s the first year since 1994 that will have happened.

Many trading companies certainly the mining companies they are feeling the full force of that, less so in the service sector, Chinese tourism growth has continued to be very strong and Chinese tourists are not just going to Hong Kong and Macau, they are going to Southeast Asia, to Australia, Japan and further afield. So there are pockets that are doing well. And China it's an enormous economy by geographic size. So there are some areas, which are really suffering, and some areas not so bad.

Wall: Jason, thank you very much.

Pidcock: Thank you.

Wall: This is Emma Wall from Morningstar. Thank you for watching.

Jupiter Asian Income fund will be launched next month. Jason formerly managed the Newton Asian Income fund

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Emma Wall  is former Senior International Editor for Morningstar