A lot has been said about the volatility in currency markets through 2016, and making sense of it in a forward-looking context is dificult. Morningstar remains an advocate for sensible, long-term currency exposures, and identifies the fair value of a currency by undertaking rigorous analysis of what we call ‘multiple deflators’. This means we seek to understand the impact of a currency shift on pricing power and inflation, which can indicate whether the currency could be expected to revert.
However, one of the biggest challenges when understanding currency is risk management. We know currencies are volatile and can shift in dramatic and unpredictable ways in the short-term. This necessitates a requirement for a wider margin of safety and greater scrutiny towards drawdown risk.
Drawdown Risk is a Major Issue for Currency Exposure
Drawdown risk is an essential element to our thinking, as it shapes the risk versus reward dynamic. Stated simply, we want to avoid assets that can fall significantly unless we can expect to be adequately paid for taking that risk.
Ideally, we want to see an environment that exhibits lower risk at times when the currency is cheap and higher risk when it is expensive. However, unlike equities, currency does not always behave so judiciously. What we find is a scenario whereby the ‘average’ drawdown risk is lower during times a currency is cheap but the ‘maximum’ drawdown can remain substantial.
The maximum drawdown risk is a major challenge as we assess the risk versus reward dynamic. It means that on average, buying a cheap currency – such as pound sterling – is likely to produce lower risk and act as a tailwind to returns. However, it also tells us that this is not guaranteed, as the currency can still fall as much as 28% from its already cheap levels.
One reason theorised to explain such a concept is that currencies are the ‘sum of all parts’ to an economy. For example, leaving the European Union could cause a current account crisis in the U.K. which could further implicate imported inflation numbers. Under this type of scenario, most investors are not going to care about the long-term fundamentals and can result in material losses.
A Margin of Safety is of Utmost Importance
This brings us back to our original point about a margin of safety and a long-term focus. If we can hold our nerve and invest with a wide margin of safety, we can ride out any short-term volatility and eventually benefit from the expected price reversion. According to our historical analysis, pound sterling is currently 1.8 standard deviations below fair value since 1982, which gives us confidence that the price of sterling will eventually rally. We will just need to be patient in the meantime.
