Surviving the Coming Currency War
Coverage of the 2013 Global Investment Conference
BY Luc de la Durantaye | December 4, 2013
Rising currency tensions around the world will impact any portfolio with international equity exposure. This is because its total return comes from both the currency return and the local index. Contrary to common perception, the return on the basket of currencies embedded in international equities doesn’t sum to zero. In fact, over the last 20 years, it has been greater than +1.0% on an annualized basis — and, over the last 10, it’s been -0.95%.
To put this in context, the median value added of a global equity manager for those time periods has been 1.65% and 0.68%, respectively. The performance of the currency basket is just as significant as the alpha provided by global equity managers. And yet, we suspect investors are much more likely to focus on the selection of the global equity managers than they are on determining a strategy to manage the currency exposure.
On a shorter-term basis, the basket of currencies can be quite volatile, with swings in excess of +/- 20% on a rolling three-year basis. In addition, the ideal hedging approach varies from fully hedged to totally unhedged, depending on the time period. In short, the return impact of currencies can be large and there is no straightforward strategy for managing this risk.
This is particularly problematic right now, as investors face the mounting challenge of currency devaluations resulting from central bank policy — devaluations that could escalate into a full currency war.
This would be highly detrimental to global economic growth. World trade is vital for economic growth, and trade would certainly be disrupted if currency movements were suddenly viewed as “manipulation” worthy of retaliation via trade tariffs. Prior to the global financial crisis, most major economies treated foreign currency movements with benign neglect since they could use conventional monetary or fiscal policies to offset the currency depreciation effect of a trading partner. In the wake of the global financial crisis, the ability of many central banks and governments to adjust to adverse currency movements has been greatly diminished as they reach the zero bound in interest rates.
At the same time, in a slower economic growth environment, it has become more pressing for every country to defend its export markets, as the export “pie” is not growing as quickly.
As the economic environment remains challenging, we will continue to experience increasing currency tensions. Whether they remain skirmishes or turn into outright war remains to be seen.
Changes in the current economic environment could lead to major currency movements, thereby increasing opportunities for active currency management. In China, historical policies have created economic imbalances with low domestic consumption and high capital investment as a share of gross domestic product (GDP). China also faces excessive foreign-exchange intervention leading to a large trade surplus and high foreign-exchange reserves. This situation cannot be sustained; China must rebalance its economy and that means continuing yuan appreciation is likely.
In Japan, the country’s debt-to-GDP ratio is much higher than in other developed economies. With domestic savings shrinking as the population ages, Japan’s ability to continue funding its debt domestically is limited, putting downward pressure on the yen. By contrast, the Canadian dollar sits on middle ground in terms of fundamental drivers of currency attractiveness. In this environment, uniform and static hedging of foreign currencies is not optimal for the Canadian investor.
In this environment, returns from foreign currency can be as significant as those from active equities, so investors should make sure they give equal attention to both. Plan sponsors, in particular, must manage currencies more actively because they will continue to play a greater role in how monetary policy around the world is determined.
Luc de la Durantaye is first vice-president, global asset allocation and currency management, CIBC Global Asset Management