Investors spend a lot of time thinking about the return potential from different asset classes. Currency diversification plays into this decision-making process, yet the paradox of choice means that few investors fully consider the downside risk currency can have.
There are many ways an investor can uncover the ‘currency effect’, however one of the most effective methods is to simply look back through history at some of the worst-case scenarios.
Europe is very interesting in this regard and is topical given the recent political instability and concerns about the sustainability of the single currency. Since 1972, we have seen 11 periods where the European equity market fell by more than 10%; of which six fell by more than 20%. The question an investor should consider is whether foreign currency exposure would have a beneficial or detrimental impact and whether a hedging strategy would be helpful to reduce any currency risk.
As can be seen above, we can see the significance of currency shifts on performance. To pick out a few standouts, a Swiss investor would have typically achieved a very different outcome by investing in European equities than an investor from one of the emerging markets. More specifically, the Swiss franc has a tendency to outperform the euro amid European weakness, which creates a drag for Swiss investors that are unhedged, whilst emerging market currencies tend to underperform the euro.
These two examples are not greatly surprising – with the Swiss economy considered one of the most resilient and emerging markets more volatile – however there are a few that may take investors by surprise. The US dollar would be a key candidate in this regard, as the ‘safe haven’ status has not always worked well in stress against European assets and the euro.
We find that the US dollar rallies in just three of the 10 largest market corrections against the euro, meaning it may not always be as effective as many thought as a defensive holding. The Japanese yen and pound sterling are very similar to the US dollar in this sense, rising in four and three of the periods respectively.
To Hedge or Not to Hedge?
Generally, there are three things an investor must consider when making the choice of foreign currency exposure:
Return potential: Are home currency valuations attractive relative to foreign currencies?
Cost of hedging: How much return does an investor forfeit from hedging costs?
Risk: Are there diversification benefits to be achieved by hedging or not?
The first lesson from the analysis above is that currency attribution can be very unpredictable and volatile. For example, the tech wreck in 2000 saw the Japanese yen fall by 27% against the euro, while the 2008 financial crisis saw the yen rally by 32%. Therefore, while the analysis will mean different things to different people, the domicile of an investor will have a direct impact on results.
For example, on face value an Australian, Canadian and emerging market domiciled investor would tend to outperform by holding international equity exposures on an unhedged basis, because their currencies tend to fall in stress, whereas a Swiss investor would do a lot better by hedging their exposures as a rising Swiss franc would otherwise exacerbate the loss.
Investors in the U.K., U.S. and Europe tend to sit in between, but can generally reduce drawdown risk by hedging their exposures.
Sensitivity to Fixed Income
As currency is typically issued and backed by governments, it has similarities to a very short-dated bond. Therefore, a study of currency movements also should be tied into periods where fixed income comes under stress. Given the uncertainty following Brexit, we can demonstrate the major drawdowns to U.K. government bonds and how currencies shift relative to sterling.
We have seen 15 periods since 1972 where Gilts have lost 5% or more but only 3 periods where they have lost more than 10% of their value. While it is worth remembering the gradually declining interest rate environment we have been through, the currency implications could still be important.
Once again, we find that US dollar exposure was not always convincing, with 3 of the 10 periods seeing US dollar weakness. More importantly, the results are very mixed across the board; with 1979 producing very different results to 1972 and 1976.
All else being equal, this may lead a more conservative investor to hedge international fixed income exposures, although one might also want to consider their currency conviction to ensure there is no contradiction.
In sterling terms, the current backdrop looks particularly cheap relative to the US dollar and euro according to our methodology. Therefore, this is supportive of a hedging decision for U.K. investors where possible. To show the complexity behind such analysis though, a U.S. domiciled investor has the opposite issue, where a generally overvalued currency may or may not warrant hedged positioning depending on the market in question and the sensitivity to the total portfolio outcome.
As with most investment decisions, there are no easy answers. However, with stretched valuations among many of the key investment markets, risk becomes particularly important and currency has a unique role to play.
