To hedge or not to hedge

With the dollar down 20% since 2022, hedging looks tempting. But UK debt, housing risks, and BOE policy suggest sterling could be even more vulnerable.

To Hedge or Not to Hedge: Dollar vs Pound for UK Investors

Mike Bell, CFA, Interim Macro Investment Strategist at Elston Consulting

The US dollar has weakened against the pound this year and is now down about 20% since September 2022. For UK based investors, returns on US equities would therefore have been better over the last few years if the dollar had been hedged.

But what about from here?

There are valid reasons to be concerned about the trajectory of US government debt to GDP.  However, those concerns are hardly unique to the US. UK government debt to GDP is also elevated, with the long-term outlook for the fiscal deficit strained by the combination of an ageing population and the NHS and state pension.

So far this century the US has dominated the developed market development and roll out of cloud computing, smart phone operating systems, online shopping, online advertising and online video streaming. The US is now, once again, leading the developed world in terms of technological innovation, this time taking the lead on developing AI. It therefore seems reasonable to expect that the US will grow faster over the next decade than the UK.

Nearer term, while recession risk is rising around the world, the risk of a recession in the UK appears somewhat greater than in the US. Cyclical private sector employment has been contracting in the UK for longer than in the US, with the increase in employer National Insurance contributions and the minimum wage playing a role.

As the economy weakens, the UK treasury is under pressure to raise taxes further at the upcoming budget, which could further increase the risk of a UK recession. In contrast, some fiscal stimulus from the One Big Beautiful Bill could support US growth in early 2026, if a US recession can be avoided between now and then. AI related capex is also boosting US growth much more than in the UK.
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The pound has also historically been particularly vulnerable to slowdowns in the UK housing market, even during the financial crisis when the US housing market struggled too. UK estate agents are reporting fewer new potential buyer enquiries and fewer agreed sales. As a result, a greater proportion of estate agents are also now reporting falls in house prices.

It’s also worth considering that it’s plausible that the UK goes into a recession without the US experiencing one, whereas if the US entered recession, it would likely lead to a recession in the UK too.
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Markets are already pricing in that the Fed will reduce rates to 3%, whereas the Bank of England (BOE) are only priced to reduce rates to 3.5%. If the UK enters recession, the BOE could end up cutting rates by more than is currently priced in. It’s not impossible that UK rates could fall to 2% by the end of next year.

So, with the dollar having already weakened significantly against the pound, it’s not clear that in the near-term sterling strength will continue.

When considering currency hedging one also needs to consider your benchmark. US exposure within most benchmarks is generally unhedged. Therefore, any currency hedging needs to be viewed as an active decision versus benchmark. Irrespective of your view on the outlook for the dollar versus the pound, this consideration should be front of mind when thinking about the sizing of any currency hedges.

Given US equities often make up a substantial proportion of portfolios, hedging the entire currency exposure could easily end up becoming your largest active risk position. So, one should look to match the sizing of any currency hedge to your conviction that the dollar will continue to weaken against the pound, rather than to the size of your US equity position.

For now, our view is that sterling could potentially prove more vulnerable than the dollar and so we look to maintain a neutral currency view relative to benchmark by not hedging the dollar. Our preferred way of hedging the risk of the potential devaluation of the dollar (and other currencies) due to excessive debt burdens, is to own gold rather than to hedge the dollar against sterling.
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With currencies, it’s always key to remember that it’s a relative trade. Sometimes, as now, if one doesn’t count gold as a currency, when considering currency pairs investors can be left simply looking for the best of a bad bunch. Despite the risks to the dollar, we struggle to get excited about the outlook for sterling.