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Currency Considerations: Investing Through the Distortions Motivated by a combination of heavy government debt issuance and aggressive monetary accommodation, investors in the US, Europe and Japan are becoming more interested in the merits of overseas diversification. Certainly, most investors are severely underinvested in markets outside of their home countries. This so-called “home bias” has been measured extensively, and its size has long been a puzzle. Unfamiliarity with international markets is cited as the chief explanation of the seemingly irrational decision to concentrate assets based on geographic proximity. Anecdotally, our experience accords with these findings; investors seem to be put off by the excessive volatility and lack of comfort with exchange rate determination. Indeed, there is a justifiable sense that capital sloshes around the globe from one currency to the next, with little attention being paid to underlying economic fundamentals, such as GDP growth or export/import volumes (Exhibit 1). Nevertheless, the fact remains that greater overseas diversification could enhance the efficiency of portfolio returns—achieving the same returns with less volatility.1 In this paper, we address the big question that investors face when considering overseas investments: should currency risk be hedged, left unhedged or actively managed? As with all important questions, the answer is, “it depends.” We aim to provide a more concrete framework for thinking through investment decisions in currency markets. To Hedge or Not to Hedge The compensation that investors expect for beta, the measure of market risk, is normally thought of as plus-sum: all investors are compensated depending on the amount of market risk they assume. Beta, and its compensation, may rise or Exhibit 1 fall over the course of the business cycle, Global Currency Flows Economic Activity Global Currency Flows Unconnected withUnconnected Economicwith Activity but it is available for all invested; this is 1,100 not the case for currencies. Global FX Trading Volume 1000 Global Nominal GDP 900 Global Export Volume 800 USD (trillions) 700 600 500 400 300 200 100 0 1989 1992 1995 1998 2001 Source: Bank for International Settlements, International Monetary Fund 2004 2007 2010 Currency risk is rightly considered inefficient noise—a major increase in the volatility of returns without a commensurate increase in compensation; in other words, there is beta risk without beta compensation. Consider the hedged versus unhedged returns in US dollars of the Barclays Capital Global Treasury Index over the past two and a half decades. The annual volatility of unhedged returns in US dollars has been more than twice that of hedged returns: 6.8%, compared with 3.3% annualized. Yet, the unhedged investor would only have received a mere © Western Asset Management Company 2011. This publication is the property of Western Asset Management Company and is intended for the sole use of its clients, consultants, and other intended recipients. It should not be forwarded to any other person. Contents herein should be treated as confidential and proprietary information. This material may not be reproduced or used in any form or medium without express written permission. Currency Considerations: Investing Through the Distortions 0.6% in additional compensation for assuming the additional volatility; it follows that the Sharpe Ratio of unhedged indices is generally much lower: 0.45 versus 0.76 in this case (Exhibit 2). Exhibit 2 Developed Market Sovereign Cumulative Returns Developed Market Sovereign Cumulative Returns 6 Index (Dec 1986 = 1) 5 Annual Return 6.7% 7.4% Hedged Unhedged Annual Volatilty 3.3% 6.8% Unhedged 4 Hedged 3 2 1 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 Source: Barclays Capital Exhibit 3 Emerging Market Sovereign Cumulative Returns Emerging Market Sovereign Cumulative Returns 3.5 Index (Dec 2001 = 1) 3.0 Hedged Unhedged Annual Return 5.2% 13.3% 2.5 Annual Volatilty 4.2% 11.5% 2006 2008 2010 It doesn’t pay to take beta risk from currencies—with two important caveats. First, this does not apply to emerging market (EM) currencies, which are on a long-run, secular appreciation trend against most developed market (DM) currencies. A currency appreciates in real (inflationadjusted) terms as productivity rises and as a country’s ability to produce goods and services increases. This is the kind of currency appreciation that results from the development process and parallels the rise in per-capita GDP. Beta risk of EM currencies has been far better compensated over the past decade than it has for DM currencies (Exhibit 3). It appears that this trend will persist, as per-capita GDP in EM countries has continued to converge toward DM country levels at a fairly robust pace. Second, over medium-term intervals— intervals that can last years—DM currencies can significantly depart from fundamental value. This suggests that if an investor has a strong conviction in the Hedged directionality of a DM currency, it may pay to leave currency risk unhedged. Consider the case of British pound sterling, which gradually gained over 40% against the US dollar over a nearly six-year period from 2004 2005 2006 2007 2008 2009 2010 early 2002 through late 2007. Of course, sterling abruptly reversed these gains in the span of six months and returned to early 2002 levels by the end of 2008. This highlights the extreme volatility (beta risk) and the degree of conviction investors must have to leave currency positions unhedged. Ask billionaire George Soros, the “Man who Broke the Bank of England,” and profited enormously in 1992 by taking on extreme currency beta. Unhedged 2.0 1.5 1.0 0.5 2001 Source: JPMorgan 2002 2003 Unhedged currency positions must be followed closely and monitored continuously. We assert that, unless one has a strong conviction about directionality, it is better to hedge DM currency risk and reduce the amount of market risk contributed by exchange rates. Those convictions must be supported by clear, empirical evidence of a divergence/convergence in the purchasing power between currencies. At the moment, this type of evidence is abundant only for EM currencies. Western Asset 2 February 2011 Currency Considerations: Investing Through the Distortions An Opportunity We recommend transferring currency risk from the beta platform to the alpha platform, which is the traditional domain of active management.2 Active management, after all, is designed to take advantage of short- to medium-term inefficiencies in the market. This raises a question: are there short- to medium-term inefficiencies in currency markets? We realize how biased it can sound when an active manager argues for the benefits of active management. With that in mind, the remainder of this paper intends to articulate a framework and demonstrate the degree of inefficiencies in the foreign exchange market today, and the scope for active management inherent in that market. Not only are the attributes of beta reversed in currency markets, but so are the attributes of alpha. Alpha (returns in excess of compensation for market risk, as measured by beta) is normally thought of as a zero-sum game: one investor’s gain is another’s loss. While this is the case for most traditional asset classes, it is not the case with currencies. Alpha generation in currency markets is closer to a plus-sum game in which profit-driven investors are compensated by nonprofit-driven participants, such as central banks, sovereign wealth funds and, to a lesser extent, trading companies and tourists. To see this, note that about 70% of exchange rates are managed by governments. Yet the 30% classified as freely floating currencies are not necessarily market-determined either.3 Consider the US dollar, which has been unable to shed its role as the world’s reserve currency despite the collapse of the Bretton Woods arrangement in 1973. Most Asian EM countries and the petro-states manage their currencies against the US dollar in an arrangement that has come to be known as Bretton Woods II (BWII). If the US dollar needs to depreciate, it can only do so against other floating currencies such as the euro, pound sterling or yen. It cannot depreciate against the Chinese renminbi despite China comprising 18% of US international trade, more than that of the entire Euro area.4 This suggests that even floating exchange rates do not always reflect fundamental economic differences. Consider any one of the petro-states: all of their revenues are denominated in US dollars; however, a portion of their spending is denominated in euros. To that extent, they exchange some portion of USD-denominated revenues for euros. In this way, the US dollar depreciates against the euro in a mechanistic sense. Put another way, petro-states’ consumption patterns and wealth levels influence the exchange rate between the US dollar and euro—two freely floating exchange rates—above and beyond fundamental economic differences between the US and Europe. The same dynamic occurs when, say, China decides to marginally adjust the composition of its $3 trillion of currency reserves, redirecting an incremental flow of capital away from US dollars and toward the euro. A case in point: there is not a single model based on economic fundamentals that can explain the behaviour of the euro/US dollar exchange rate. The euro gained nearly 85% against the dollar from its trough in 2001 to its peak in 2008, just before the financial crisis erupted. Yet inflation was similar, and there were no productivity shocks that asymmetrically influenced one economy over the other. The appreciation of the euro against the US dollar, therefore, reflected some sort of misalignment; either the euro was undervalued at the beginning of the period or overvalued at the end of the period, or both. In either case, the cross rate between these two freely floating currencies has been misaligned for most of the euro’s existence (Exhibit 4). Western Asset 3 February 2011 Currency Considerations: Investing Through the Distortions Market Exchange Rate versus Fundamental Valuation Exhibit 4 Market Exchange Rate versus Fundamental Valuation 1.6 Euro/US Dollar Exchange Rate 1.5 1.4 Market Spot 1.3 1.2 1.1 Purchasing Power Parity 1.0 0.9 0.8 Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec 99 00 00 01 01 02 02 03 03 04 04 05 05 06 06 07 07 08 08 09 09 10 10 Source: Bloomberg Exhibit 5 Global Currency Reserves* - a gradual diversification away from the US dollar Global Currency Reserves*—A Gradual Diversification Away From the US Dollar 5,000,000 US Dollars Euros Pounds Sterling Japanese Yen Swiss Francs 4,500,000 4,000,000 USD (millions) 3,500,000 3,000,000 2,500,000 2,000,000 Other Currencies In aggregate, Asian EM countries and the petro-states, among others, have so far amassed USD9 trillion in currency reserves. While data are far from complete, currently the reserves are comprised of roughly 65% US dollars, 28% euros, 4% British pound sterling, 3% Japanese yen and a small amount of Swiss francs.5 As these economies of BWII expand—and they are expanding—they will continue to hoard more and more reserves in order to preserve the status quo of BWII. Accordingly, they will continue to influence the exchange rate among freely floating currencies above and beyond underlying fundamentals, depending on which currencies they decide to hold (Exhibit 5). While beneficial, the BWII arrangement comes with a high and escalating cost. The USD9 trillion of currency reserves has a very low rate of return—negative in some cases—and hinders domestic financial market development. Nevertheless, the central banks participating in the BWII arrangement do not aim to maximize risk-adjusted returns of their currency holdings, as we investors do. Their currency interventions are not governed by the profit motive, but by a more comprehensive sense of economic stability. The presence of these large, non-profitdriven participants in the foreign exchange 1,000,000 market implies an oppor tunity for 500,000 profit-driven investors; this is what transforms active currency management 0 into a plus-sum game. Non-prof it1Q 99 1Q 00 1Q 01 1Q 02 1Q 03 1Q 04 1Q 05 1Q 06 1Q 07 1Q 08 1Q 09 1Q 10 driven participants buy and sell curren* Allocated Reserves only. There are an additional $4 trillion in unallocated reserves, the composition of which is not known with certainty. cies, paying little attention to whether Source: IMF COFER database the currencies are over- or undervalued in fundamental terms. Yet, economic fundamentals remain the prevailing anchor, as always. This creates excessive volatility—abrupt realignments after prolonged departures from fundamental value. This excessive volatility is ripe for skilled active managers to exploit in the near- to medium-term. As a profit-driven investor, it is possible to benefit by taking the other side of the trade against non-profit-driven participants and reaping their forfeited profits. 1,500,000 Western Asset 4 February 2011 Currency Considerations: Investing Through the Distortions Concluding Thoughts Today’s global monetary architecture is uncoordinated, undisciplined and unstable. The US dollar no longer qualifies for its reserve currency status, yet there is no substitute framework to take its place. The absence of a consistent global monetary architecture, such as the 19th century gold standard, results in excessive volatility and inefficiencies in the market for foreign exchange. Moreover, BWII is doomed to eventually fail. Any global regime anchored on a single reserve currency sows the seeds of its own destruction. There is a built-in incentive for the BWII economies to hoard US dollars in reserve in order to deter the self-fulfilling speculative attacks that are endemic to a pegged exchange rate regime. Yet, the more US dollars that foreigners hold, the less qualified the US dollar becomes as a reserve currency.6 At some point, the speculative attack (a sudden stop in foreign funding of the US domestic savings deficit) is waged against the over-indebted reserve currency itself. The trigger for collapse is anyone’s guess. We don’t expect a collapse anytime soon, but the amount of US dollars held by foreigners is already staggering, equating to 66% of the total US broad money stock and 40% of US GDP.7 For the reasons outlined above, we believe that the benefits of active currency management are compelling. We like the idea of leaving EM currency risk unhedged. However, we recommend hedging the beta risk from DM currency exposure, and shifting such risk to the alpha platform instead. Here, diversified active management can exploit the plus-sum attributes of an uncoordinated, global monetary architecture. Footnotes This, of course, does not apply to pension funds with the objective of matching liability streams. Such pension funds tend to emphasise domestic fixed-income instruments. 1 It should be noted that active management can be applied to beta, as well. For the sake of this paper, we assume that only alpha is actively managed. 2 Eichengreen, Barry. Globalizing Capital: A History of the International Monetary System. Princeton, NJ: Princeton University Press, 2008. 3 Federal Reserve Board, H.10 Report. 4 IMF COFER database. 5 This dynamic is called the Triffin Dilemma and was first articulated in the 1940s to explain why the 19th century gold standard was disintegrating at that time. 6 Per M2. 7 Past results are not indicative of future investment results. This publication is for informational purposes only and reflects the current opinions of Western Asset Management. Information contained herein is believed to be accurate, but cannot be guaranteed. Opinions represented are not intended as an offer or solicitation with respect to the purchase or sale of any security and are subject to change without notice. Statements in this material should not be considered investment advice. Employees and/or clients of Western Asset Management may have a position in the securities mentioned. This publication has been prepared without taking into account your objectives, financial situation or needs. Before acting on this information, you should consider its appropriateness having regard to your objectives, financial situation or needs. It is your responsibility to be aware of and observe the applicable laws and regulations of your country of residence. Western Asset Management Company Distribuidora de Títulos e Valores Limitada is authorized and regulated by Comissão de Valores Mobiliários and Banco Central do Brasil. Western Asset Management Company Pty Ltd ABN 41 117 767 923 is the holder of the Australian Financial Services Licence 303160. Western Asset Management Company Pte. Ltd. Co. Reg. No. 200007692R is a holder of a Capital Markets Services Licence for fund management and regulated by the Monetary Authority of Singapore. Western Asset Management Company Ltd is a registered financial instruments dealer whose business is investment advisory or agency business, investment management, and Type II Financial Instruments Dealing business with the registration number KLFB (FID) No. 427, and a member of JSIAA (membership number 011-01319). Western Asset Management Company Limited (“WAMCL”) is authorized and regulated by the Financial Services Authority (“FSA”). In the UK this communication is a financial promotion solely intended for professional clients as defined in the FSA Handbook and has been approved by WAMCL. Western Asset 5 February 2011