Download Currency Considerations: Investing Through the

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