the danger of doing nothing

This article is part of the guide to Currency Issues available here.

Key Takeaways

  • The impact of currency exposures on international investments can be large in both return and risk terms. History is filled with examples of large negative impacts from unmanaged currencies.
  • “Doing Nothing” is the highest risk option.
  • Currencies add risk to an international portfolio with no additional expected return. In no other asset class would an unrewarded risk be left unmanaged.

 

ARGUMENT 1

“It is a zero-sum game and it all comes out in the wash”

Given that every currency transaction involves a currency pair with a buyer of one and a seller of the other, the holder of the currency that appreciates has an equal and opposite gain to the holder of the currency that depreciates. The sum of the gain and loss is zero hence, currencies are by definition a “zero-sum game”. Further, since currencies exhibit cyclical behaviour it is sometimes claimed that the long-term return impact is bound to be close to zero and therefore the impact can be ignored as “it comes out in the wash”. Let’s examine the evidence.

RETURN IMPACT OF THE “DO NOTHING” APPROACH

We have seen that the currency market is by definition a zero-sum game and that currencies exhibit cyclical tendencies. It follows that the long-term expected return of a given currency pair should be close to zero. Indeed, over the last 50 years, while there is clear evidence of cyclicality in the US dollar’s movements versus foreign currencies and a secular downtrend in the dollar’s Trade Weighted value, the net long term average change is relatively small. However, the magnitude of the movements in the shorter cycles, even spanning multi-year time frames, has been very large as shown in the chart and table below. For individual currencies versus the US dollar, the size of these moves has been even greater.

 

Major US Dollar Moves

Major US Dollar Moves

Unless an investor genuinely has a multi-decade horizon, currency movements over five to ten-year horizons will have a significant impact on the value of international portfolios and cannot be ignored.

Given the downward trend in the US dollar versus its major trading partners over the long term, it cannot be argued that “it all comes out in the wash” because it rarely reverts to the same level. Furthermore, while the US dollar has oscillated between both expensive and cheap valuations during these cycles, the movements are so large that the impact is significant for international portfolios on a multi-year time frame.

 

ARGUMENT 2

“If you like the international asset, you should also like the currency”

The idea here is that if, say, a foreign equity market is believed to be an attractive investment opportunity, the expected high return on capital in the equity market will drive capital inflows which will also lead to an appreciation of the underlying currency.

If this were true, then there would be no need to manage or hedge the currency exposure as leaving the currency exposure unhedged would result in the best return outcome as both the asset and the currency appreciate in unison.

However, the empirical evidence does not support this theory and the theory itself is flawed.

EXAMPLE: Japanese equities and the Japanese yen.

The correlation between the Nikkei 225 Index and the Japanese yen has been frequently negative and often significantly so. This means that when the equity market has been strong, the Japanese yen has been weak and so the currency loss has reduced the return from the investment into Japanese equities in US dollar terms.

Correlation of the Japanese Yen and Japanese equities

Source: Millennium Global and Bloomberg, 1992 to 2019. Sourced on 31 March 2020

Correlation euro-german equities

Source: Millennium Global and Bloomberg, 1992 to 2019. Sourced on 31 March 2020

 

In fact, there is a very good reason why there is often a negative correlation between an equity market and the associated currency.

When a currency depreciates, exporting companies get a boost as their products become cheaper to sell in overseas markets and sales volumes go up accordingly. Alternatively, they can raise their prices in the domestic currency while keeping prices constant in foreign currency and expand their profit margins. Either way, corporate profits get a boost.

Hence, it is often the case that there is a causal link between an equity market valuation and the currency market valuation as a weaker currency provides a pricing advantage to exporting firms. Japan is a relevant case study as the Japanese equity market has a large proportion of exporting oriented firms.

This is where the “Do Nothing” approach can be a poor choice as gains from foreign equity market appreciation can be offset by currency depreciation.