Currencies and shares

Investors should not, however, base their strategies on a view of where currencies are heading.

One reason for this is that exchange rate moves are largely unpredictable, as the Swiss National Bank so helpfully reminded us recently.

But there's another reason, pointed out back in 2007 by Lorenzo Cappiello and Roberto de Santis, two European Central Bank economists. To see what they mean, imagine investors expect the US dollar to rise against the euro. Why, then, would anyone want to hold euro-denominated equities rather than dollar-denominated ones when the latter would give us a currency gain? The answer can only be that they expect euro equities to outperform US ones in local currency terms, so that expected losses on the euro are offset by relative gains on equities.

They called this the uncovered return parity theory; expected return differentials on risky assets should compensate us for expected changes in exchange rates. Although this sounds high-falutin', it is really just another phrase for that common sense saying, 'you don't get owt for nowt'. What you lose on currencies, you gain on equities, and vice versa.

So much for theory. What about the facts? These tell us that there is some truth in the idea. My table shows correlations between exchange rates and annual equity returns relative to the UK in local currency terms since 2000. These are mostly positive, and significantly so. This tells us that if a stock market outperforms the UK, its exchange rate is more likely than not to fall against sterling. This is just what uncovered return parity predicts.

However, on the other hand the theory is only partially true. If it were wholly true, then all equity returns in sterling terms would be identical - which has not been the case.

There's a reason for this. Uncovered return parity is a theory about expected returns. But what we see are actual returns. The two differ a lot because surprises are common and inevitable.

In particular, there are two reasons why the theory is imperfect.

One is that relative equity returns are more volatile than exchange rates. For example, since 2000 the average annual change in euro equities relative to the All-Share index (regardless of sign) has been 8.9 percentage points. But the average change n the euro-sterling exchange rate has been only 5.6 percentage points. This tells us that a surprise is more likely to push up equities a lot than it is to depress the currency by an equal amount.

Secondly, some surprises can cause currencies and share prices to move in the same direction. An improvement in a country's growth prospects, for example, would raise both. This might explain why the weakest correlation in my table is for the Canadian dollar. As a commodity producer, Canada is especially vulnerable to surprise changes in growth prospects because of swings in commodity prices - but such swings often cause the stock market and exchange rate to move in the same direction.

Growth shocks, however, are only some of the surprises we might face. Monetary policy surprises, by contrast, often cause a negative correlation between a country's stock market and currency. Looser than expected policy would drive share prices up but the currency down; this is exactly what we've seen in the eurozone recently.

Which brings me to my point. Investors who bet against uncovered return parity by buying the equities of a country whose exchange rate they expect to rise are, in effect, betting that the shocks which generate a positive correlation between the two are more likely than shocks that generate a negative correlation - that growth shocks are more likely than monetary policy shocks.

To know this, however, requires you to know a lot more than the market. This is a mug's game, which is best left to those who play with other people's money. Those of us putting our own money on the line should not buy overseas equities merely because we expect a particular currency to rise.

There is a strong case for investing in overseas equities. You should do so because it is a way of diversifying against UK-specific bad news. You should not do so because you have a view about exchange rates.