Download Going Global Why understanding currency diversification within a

Going Global
Why understanding currency diversification within
a global portfolio is important for U.S.-based investors
Arnerich Massena & Associates, Inc.
December 2007
Contributors:
Tony Arnerich
Jillian Perkins
Travis J. Pruit, CFA
M. Lynn Spruill
© 2007 Arnerich Massena & Associates, Inc. All rights reserved.
This material is for the general information of clients of Arnerich Massena & Associates, Inc. It does not constitute
a personal recommendation or take into account the particular investment objectives, financial situations, or needs
of individual clients. Past performance does not guarantee future results. This material is based on information that
we consider reliable, but we do not represent that it is accurate or complete, and it should not be relied on as such.
Opinions expressed are our current opinions as of the date appearing on this material. This material may not be
sold or printed for distribution without the express written permission of Arnerich Massena & Associates, Inc.
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Going Global
Why understanding currency diversification within a global portfolio is important for U.S.-based investors
Table of Contents
Globalization: the impact on investors
• Preparing for a global perspective
• What is currency diversification?
Sidebars:
• A brief history of currency
• BrettonWoods and beyond
• Where are we now?
The world’s major currencies
• The U.S. dollar and other reserve currencies
• Currencies of the Broad Dollar Index
• Emerging markets growth
• Fixed or pegged currencies
What makes a strong currency?
• Economic growth and export demand
• Fiscal and monetary policy
• Trade weights
Current trends in international currencies
• The growth of the euro
• China: will its undervalued currency be allowed to appreciate?
• Currency developments in the Middle East
• Pressures on the dollar
Diversification beyond dollars
• The world is your oyster
• Recommendations and conclusions
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Going Global
Why understanding currency diversification within a global portfolio is important for U.S.-based investors
Globalization: the impact on investors
The term “globalization” has been tossed about in fields from politics to agriculture. But globalization is not just a
catchy word; it is a real phenomenon, with significant impact on the world of investing.We believe that the changing
global environment demands a different approach to investing to accomplish our goal as investment consultants
of preserving and growing the purchasing power of our clients’ portfolios. Globalization has created two major
reasons for increasing the diversification of an investment portfolio outside of the United States, particularly in
terms of diversifying currency, that are crucial for investors to consider now. First is the increase in international
trade and growth. As free trade expands and trade protections are eased, markets outside of the United States
are experiencing rapid growth, and this growth is accessible in an unprecedented way to American investors.
The second reason is that the United States dollar is under unique pressures at this time. As the United States has
been a world superpower, the dollar has been a “super-currency,” being held as the foremost international reserve
currency, acting as the currency of choice for trading commodities like oil and gold, and acting as a stability peg
for other countries’ currencies. But the rise of the euro, changes in the oil market, the United States’ troublesome
debt, and the declining value of the dollar suggest that America and the American dollar are seeing a shift in their
position in the world marketplace. Even with strong returns in U.S. equities, the inflationary effects of a declining
dollar erode the purchasing power of earnings; retaining that purchasing power may require that we venture into
the world of global investing.
We believe that investors are just beginning to recognize the opportunities available in the international community
and that to date, the potential depth of diversification across asset classes and currencies has often been overlooked.
It is our goal to help investors think not in terms of having an international allocation in their portfolios, but in terms
of creating a global portfolio. In this paper, we will begin by providing some historical background; understanding
the history of major currencies will lend a context for understanding the state of major currencies today. We
MSCI World Index Country Weights1
In 1972, shortly after the inception of the
MSCIWorld Index (a stock index that measures
developed market equity performance), the
United States made up 67.5% of the index’s
country weightings. Today (as of December
2006), the U.S. represents only 48.7% of the
MSCIWorld Index1.This is one indicator that
the shift away from an American-dominated
world economy and to a global marketplace
is well underway.
1972
Canada
4.4%
2006
Other
2.8%
Canada
3.5%
Japan
8.9%
Other
4.1%
Japan
10.8%
Europe
16.4%
United States
67.5%
United States
48.7%
Europe
32.9%
Source: Lazard Investment Management, Inc.
1
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Going Global
Why understanding currency diversification within a global portfolio is important for U.S.-based investors
will then discuss potential ways to add a level of diversification to your
portfolio through investing in different types of foreign securities such as
foreign bonds, global corporations, and a wider variety of international
asset classes.
Preparing for a global perspective
Representation is the term used in behavioral economics to define
human beings’ tendency to represent the future with the present. In
other words, we think things will always be the same and act accordingly.
Change, however, happens regardless of how much we psychologically
seek permanence. The sidebars, A brief history of currency and BrettonWoods
and beyond, highlight some of the major shifts in world and economic
power; these shifts are strong reminders that change and upheaval are
consistent and recurrent themes of history.
As today’s world economy shifts, it will take a proactive approach to
overcome our natural inclinations to both see the world as unchanging and
to be most comfortable investing close to home. This home bias applies
to citizens of any country; comfort and patriotism inhibit investment
too far abroad. But it may be particularly strong in Americans, who are
accustomed to enjoying the elevated status of having dominated as world
leader for nearly a century. As an economic and military superpower,
both our credit and currency hold particular sway over the international
economic environment. However, there are definite signs that the winds
of change have arrived and to adapt, we will likely need to look past the
dollar for diversification.
What is currency diversification?
Currency diversification for our purposes simply means buying assets
denominated in foreign currencies. Those different assets represent
different markets and countries and are purchased in an effort to
experience different growth dynamics; spread the risk of currency
depreciation, at home and abroad; and to reap rewards from currency
appreciation through exchange rate differentials. Currency diversification
is an active choice to achieve an additional level of portfolio diversification
by investing globally. Currency diversification, in this context, is different
from a currency overlay program, in which a portion of the portfolio
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A brief history of currency
Since the advent of money, there has been
a struggle to create a universal currency
standard so that trade between nations
would be both possible and facile. At
times, various empires have managed
to establish their currencies as reigning
candidates, but to date, there has never
been a true universal currency. Which
currencies are dominant fluctuate with
global political and economic changes.
The first widely-used currency was
the coinage of the Roman Empire;
Roman military power ensured that
its currency was utilized throughout
the Mediterranean region. However, as
Rome consumed the land it claimed
conquest over, an increasing need for
money caused the Romans to begin
debasing their currency. It went from
silver coins to fiat money, silver-coated
coins whose value relied on government
decree. Eventual economic and political
instability — partially caused by
the currency debasement and rising
inflation (which is equivalent to a tax
on citizens) — resulted in the currency’s
and the Empire’s demise.
Medieval China’s Tang dynasty also had
a long-running currency that was used
throughout the Chinese Empire.Political
and monetary stability made it possible
for paper money to be introduced in
China during the Kao-tsung dynasty of
650-683 A.D., nearly a thousand years
before it appeared in Europe. (Taylor)
Going Global
Why understanding currency diversification within a global portfolio is important for U.S.-based investors
is engaged in currency trading as a strategy separate from international
security investing.
It is an inherent aspect of holding foreign assets to be also indirectly
invested in the foreign currency necessary to purchase those securities;
some currency diversification is a natural aspect of international investing.
As an investor buys and sells a foreign currency in order to invest abroad,
the exchange rates of both the dollar and the foreign currency impact
investment returns. A strong dollar is beneficial when purchasing foreign
currency. However, after selling securities and exchanging a foreign
currency back into dollars, the return of an investment will be enhanced if
the other currency has appreciated against the dollar and can thus buy
more dollars. The following example outlines this process:
Vodafone stock- Purchase of one share for one year 2006-2007
Dollars
invested
Stock price
9/28/2006
Stock price
9/28/2007
Stock
return
in local
currency
Dollars
at 2006
exchange
rate
Return with
exchange to
USD in 2007
Total
dollars after
investment
$228.39
£ 120.75
£ 176.50
46.2%
$333.84
56.2%
$356.64
Source: finance.yahoo.com
If you bought a single share of Vodafone stock on 9/28/2006, it would have cost £120.75, or $228.39
at the then exchange rate. A year later, Vodafone’s price increased 46.2% and the stock share was worth
£176.50. At the 9/28/2006 exchange rate, that would amount to $333.84. But if you sold your share
of stock and exchanged your British pounds back into U.S. dollars, you would have earned an additional
10.0% return because the pound appreciated against the dollar during that time. Your total dollars after
investment would have been $356.64.
Vodafone stock- Purchase of one share for one year 2004-2005
Dollars
invested
Stock price
12/30/2004
Stock price
12/30/2005
Stock
return
in local
currency
Dollars
at 2004
exchange
rate
Return with
exchange to
USD in 2005
Total
dollars after
investment
$353.07
£ 184.16
£ 163.59
-11.2%
$313.63
-19.8%
$283.03
Source: finance.yahoo.com
If you bought a single share of Vodafone stock on 12/30/2004, it would have cost £184.16, or $353.07
at the then exchange rate. A year later, Vodafone’s share price decreased 11.2% and the stock share was
worth £163.59. At the 12/30/2004 exchange rate, that would amount to $313.53. But if you sold your
share of stock and exchanged your pounds back into U.S. dollars, your return would have been further
reduced to -19.8% because the pound had depreciated and couldn’t buy as many dollars. Your total
dollars after investment would have been $283.03.
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However, political problems during
the Yuan Dynasty created inflationary
pressures and the currency failed.
Bullion, gold and silver, reigned
in Europe throughout the Middle
Ages, with no unifying or dominant
currencies. Although different nations
had their own printed currencies, none
were widely accepted outside of their
own borders until in 1865, the Latin
Monetary Union was established in
France, Belgium, Switzerland, and Italy.
Coins minted to the LMU standard were
accepted legally by member countries
untilWorldWar I.
The gold standard was perhaps the
closest to a unifying currency the
world has ever had. Currencies were
fixed against the value of gold, and a
country’s gold standard currency could
be exchanged for gold bullion. England
was using a gold standard in the early
1700s but it did not spread to the rest of
Europe until later, becoming widespread
by the 1870s. The United States began
to adopt a gold standard in the early
1800s. While not universal, the gold
standard was widely used until World
War I. The period of the gold standard
was one of smooth international
trading. Currency exchange was
greatly simplified because of the fixed
rates; furthermore, long-term prices
were stabilized. However, having fixed
currencies limited governments’ ability
to use monetary policy to counteract
short-term economic volatility.
Going Global
Why understanding currency diversification within a global portfolio is important for U.S.-based investors
For many international investors, historically, currency risk has been
a secondary consideration; something to be aware of but not a primary
concern. Foreign accounting practices or political instability have been
considered the major risks associated with international investing.
Additionally, with the dollar entrenched as the world’s major currency
and having a long history of stability, seeking out international investments
specifically to diversify currency may not have seemed particularly
important to many American investors. The environment now, however,
requires a new look at the opportunities afforded by diversifying across
currencies. With a depreciating dollar and a number of other economies
growing rapidly, in addition to the wider distribution of the world’s market
capitalization, currency diversification may become a key consideration in
developing a portfolio of international investments.
The world’s major currencies
The U.S. dollar and other reserve currencies
Britain abandoned the gold standard in
1914 because it needed its gold to fund
the war effort. An attempt to return to
the gold standard after the war caused
economic difficulty for all countries
using the pound sterling, as the currency
adjusted to the inflated value of gold.
The collapse of the gold standard in
1931 went hand in hand with the end
of the British Empire’s hegemony and
may have contributed to the economic
troubles of the Great Depression.
As the United Kingdom ceded its status
as world superpower to the United
States, the position of the pound sterling
also lost its place as reserve currency to
the U.S. dollar.
Since shortly after World War II, the U.S. dollar has been the foremost currency of international trading. As U.S.
dollars represent the primary reserve currency, governments around the world hold most of their reserves in
dollars. This has a few important effects. Commodities, such as gold and oil, are usually denominated and traded
in U.S. dollars for the simple reason that it is more convenient to trade in a currency everyone holds. Because
demand is always high for a reserve currency, the United States is able to borrow money at a slightly better rate
than otherwise. The dollar’s status as reserve currency is one of the main reasons we are able to sustain such a large
trade deficit, provided other governments are willing to continue to hold dollars. “In a very real way, the dollar
has assumed the status that gold bullion used to have as a repository of value trusted worldwide. This special status
gives the dollar considerable protection from the potential consequences of the huge U.S. trade deficit.” (Davis,
2004)
Reserve currencies are selected by countries based on the stability and strength of the underlying economies,
which historically have also often been backed by military power. At the beginning of the twentieth century, the
British pound sterling was the world’s foremost reserve currency. This was a result of Britain leading the world in
the gold standard, but was strongly supported by British military hegemony. The dollar replaced the pound at the
same time that the United States established its military dominance through World Wars I and II.
The table on the following page shows the major reserve currencies of the world and how the percentage of
reserves held in each currency has shifted over the last thirteen years. The euro is clearly gaining popularity as a
reserve. British pounds sterling are currently the third largest reserve currency. Up until the last few years, that
place was held by the Japanese yen, but it has recently declined.
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Going Global
Why understanding currency diversification within a global portfolio is important for U.S.-based investors
Currency Composition of Official Foreign Exchange Reserves
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
U.S. dollars
59.0%
62.1%
65.2%
69.3%
71.0%
71.1%
71.5%
67.0%
65.9%
65.8%
66.7%
64.6%
64.2%
pounds sterling
2.1%
2.7%
2.6%
2.7%
2.9%
2.8%
2.7%
2.8%
2.8%
3.4%
3.6%
4.4%
4.5%
Deutsche mark
15.8%
14.7%
14.5%
13.8%
-
-
-
-
-
-
-
-
-
Japanese yen
6.8%
6.7%
5.8%
6.2%
6.4%
6.1%
5.1%
4.4%
3.9%
3.9%
3.6%
3.2%
3.1%
euros
-
-
-
-
17.9%
18.3%
19.2%
23.8%
25.2%
24.9%
24.2%
25.9%
26.1%
other*
16.3%
13.8%
12.0%
8.0%
1.8%
1.8%
1.6%
2.0%
2.2%
2.0%
1.9%
1.9%
2.1%
*Includes French francs, Swiss francs, Netherlands guilder, and european currency units
source: International Monetary Fund
Currencies of the Broad Dollar Index
There are also major world currencies that are not reserve currencies. The Federal Reserve Board considers seven
currencies to be “major” and includes them in the Major Currencies Index, a subindex of the Broad Dollar Index.
The currencies of the Major Currencies Index, which in addition to reserve currencies include the Canadian
dollar, the Australian dollar, and the Swedish krona, are considered major world currencies because they are widely
traded outside of their country of origin. The rest of the currencies in the Broad Dollar Index are part of another
subindex, dubbed the OITP Index (other important trading partners). These are selected for the Broad Dollar
Index based on their shares of U.S. imports and exports. (See next page.)
Emerging markets growth
As today’s advanced economies
become a shrinking part of the world
economy, the accompanying shifts in
spending could provide significant
opportunities for global companies.
Being invested in and involved in
the right markets — particularly
the right emerging markets — may
become an increasingly important
strategic choice.
(Wilson & Purushothaman, 2003)
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Emerging markets economies are growing rapidly and a number of
economists project that they will become larger than advanced economies
within the next few decades. In a 2003 paper entitled, Dreaming with
BRICs: The Path to 2050, Goldman Sachs researchers posited that “over the
next 50 years, Brazil, Russia, India, and China — the BRICs economies
— could become a much larger force in the world economy.” (Wilson &
Purushothaman, 2003) The largest emerging market economies are often
referred to as the E7: China, India, Brazil, Russia, Indonesia, Mexico,
and Turkey. (Hawksworth, 2006) As emerging markets tend to experience
more rapid economic growth, the currencies of these nations may present
valuable opportunities for currency diversification.
Going Global
Why understanding currency diversification within a global portfolio is important for U.S.-based investors
Fixed or pegged currencies
There are a number of emerging markets currencies that are pegged
to the dollar, meaning that their countries’ governments maintain the
currency at a fixed exchange rate relative to the dollar. In order to
maintain a dollar peg, the country must hold a large quantity of reserves
in both dollars and the local currency which it can use to manage
fluctuations in the market. When the local currency appreciates, the
government floods the market and brings the currency’s value down;
conversely, when it depreciates, the government buys back excess
currency with dollars and restores the balance. A country might choose
to fix its currency in order to aid in stability. A currency pegged to the
dollar won’t provide a diversification opportunity, since the exchange
rate with the dollar fluctuates only slightly; however, currency regimes
shift, sometimes frequently. Currencies currently pegged to the U.S.
dollar include the Venezuelan bolivar (as of July 2007), United Arab
Emirates dirham (as of July, 2007), Saudi riyal (as of September
2007), Qatar riyal (as of September 2007), and Lebanese lira (as of
March 2007).
Currencies may also be pegged or fixed, but to a basket of currencies
rather than to the dollar alone. For instance, the Russian ruble is fixed
against a basket that includes the U.S. dollar and the euro. China’s
yuan, recently unpegged from the dollar, is now pegged against an
undisclosed basket of currencies. Singapore, also, manages its dollar
against a basket of currencies of its major trading partners. Some
believe that a pegged currency is an intermediate step toward a floating
regime, and so is likely a temporary situation.
What makes a strong currency?
There is no single criterion by which a currency is deemed a strong
currency. The strength of a currency may fluctuate with market
cycles, economic trends, and local and world politics. A variety of
factors contribute to a currency’s standing in both the world market
and in the markets of trading partners. A country’s economic growth
definitely affects its currency, but healthy GDP growth does not
necessarily translate into a strong currency. Fiscal and monetary
Currencies in the Broad Dollar Index
Major Currencies Index
Euro area
Canada
Japan
U.K.
Switzerland
Australia
Sweden
Weighting
in 2007
17.6%
16.5%
9.5%
4.5%
1.4%
1.2%
1.1%
source: Federal Reserve
Currencies in the Broad Dollar Index
OITP Index
(other important
trading partners)
China
Mexico
Korea
Taiwan
Hong Kong
Malaysia
Singapore
Brazil
Thailand
India
Philippines
Israel
Indonesia
Russia
Saudi Arabia
Chile
Argentina
Colombia
Venezuela
Weighting
in 2007
15.1%
9.6%
3.6%
2.5%
1.9%
2.1%
1.9%
2.1%
1.4%
1.3%
0.7%
1.0%
0.9%
1.0%
0.8%
0.7%
0.5%
0.5%
0.5%
source: Federal Reserve
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Why understanding currency diversification within a global portfolio is important for U.S.-based investors
policy, trade weights, current accounts (trade surplus or deficit),
strength in exports, political stability, interest rates, and inflation —
all of these play a role in establishing the value of a country’s currency.
“Short-term movements in exchange rates can be extremely volatile
and hard to predict, largely because speculators play a major role in
day-to-day currency trading. On occasion, too, a government will
intervene unexpectedly to prop up its own currency or manipulate
the flow of other currencies. Still, over periods longer than one year,
trends in exchange rates will reflect international differentials in
trade balances, productivity growth, interest rates, and inflation.”
(Davis, 2004)
Economic growth and export demand
Broadly speaking, exchange
rates are determined by
supply and demand as the
world’s currencies are traded
daily on foreign exchange
markets. Changes in a nation’s
exchange rate are closely
scrutinized because they affect
the relative value of foreign
and domestic goods, services,
and investments. As with other
asset prices, the impact of
exchange-rate fluctuations on
mutual fund returns depends
on a number of complex and
interrelated factors.
A country’s economic growth affects
its currency in several ways. The
value of a given foreign currency
relative to other currencies is based
on supply and demand. A country
experiencing rapid economic growth
presents investment opportunities
for which interested investors will
purchase the foreign currency, driving
up demand and appreciating the
currency. However, many countries
rely on export trading as a major
source of economic growth, and
when a currency appreciates, exports
become more expensive and demand
declines. For nations that depend on
(Davis, 2004)
exports, continued economic growth
may be predicated on maintaining a
cheap currency and thus providing
inexpensive exports. For example, China has been accused of keeping
the yuan artifically low in order to continue to export goods and services
at a low price: “Even after Beijing agreed to a gradual appreciation of
the yuan in 2005, China’s current account surplus has surged to record
levels, fueling speculation that the currency needs to appreciate even
further.” (Wingfield, 2007)
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Bretton Woods and beyond
From the late 1800s until World War I,
international trade relied upon the gold
standard; exchange rates of local currencies
were fixed to gold, which served as the
international reserve currency. Having this
international standard of value simplified
international trade, making it relatively
easy and straightforward. However, after
World War I, the gold standard broke
down. With a great deal of flexibility
in currency valuations, international
trade became more complicated. There
were a series of issues, such as nations
manipulating a devaluation of their
currency in order to sell exports and related
uncertainty about the value of money.The
resulting decrease in international trade
may have contributed to the severity of the
Great Depression.
Following the Great Depression and World
War II, the international community
recognized the need for formal agreement
and order in the international monetary
system. The Bretton Woods conference,
held in July 1944 in Bretton Woods,
New Hampshire, included representatives
from 45 different countries. The
conference resulted in the creation of the
International Monetary Fund (IMF), an
institution charged with the responsibility
of overseeing the international monetary
system, monitoring economic policies,
and providing advice and assistance to
government and central banks.
The BrettonWoods Conference also resulted
in the adoption of the “Bretton Woods
System.” With the United States having
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Why understanding currency diversification within a global portfolio is important for U.S.-based investors
Fiscal and monetary policy
Fiscal policy can enhance or detract from fiscal stability, also a
determinant of currency strength. For example, real GDP growth
in the European Union has been relatively modest — 3.1% in 2006
(CIA, 2007) — yet the euro has been appreciating steadily against the
dollar. Hans Martens, Chief Executive of the European Policy Centre,
believes this is due to fiscal stability: “...looking at economic growth
and job creation alone will not explain why exchange rates change
in the way they do. What is required is a holistic view that takes into
account the fiscal performance of the economy.” (Martens, 2006)
A country’s monetary policy affects the status of the currency as
well. A country experiencing high interest rates will attract investors
and drive up demand for the local currency, causing the currency to
appreciate. On the other hand, a risk of high inflation causes investors
to worry about currency devaluation.
Trade weights
Trade weights, which reflect the amount of trade one country does
with another, determine in part the demand for a foreign currency.
The U.S. Broad Dollar Index is based on trade weights. As an example,
the Chinese yuan was only 6.6% of the Broad Dollar Index in 1997
when Chinese imports were 7.8% of the total imports to the U.S. By
2007, Chinese imports had grown to 18.3% of total imports and the
weight of the yuan in the Index grew to 15.1%. (Federal Reserve)
Current trends in international currencies
According to the International Monetary Fund Research Department,
“Financial globalization, measured by gross external assets and liabilities
relative to a country’s GDP, has approximately tripled since the mid1970s.” (Mauro and Ostry, 2007) Along with the increase in globalization
have come changes in the currency landscape as well. Among these
are the rise of the euro as an international currency, the fluctuations in
the yen and yuan, developments in the Middle East, and more recent
pressures on the U.S. dollar as America’s debt and trade deficit grow.
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emerged as the world’s strongest economy,
the international community agreed to fix
their currency relative to the United States
dollar,keeping their values within a narrow
band of parity. The dollar continued to
be backed by the gold standard, in which
not only was it valued relative to gold,
but could be exchanged by a bank at any
time to the U.S. government for actual
gold. However, dollars had the advantage
of greater liquidity; thus did the dollar
become the world’s reserve currency.
This system was in place until the late
sixties, when it became evident that there
was not enough gold in the world to
sustain the growth in world trade. In
1971, under economic pressure, the U.S.
abandoned the gold standard and the
BrettonWoods system collapsed.
Since then, most major governments have
had a policy of floating exchange rates,
allowing them the most flexibility in terms
of monetary policy. The IMF continues to
serve its members with macroeconomic
monitoring and crisis prevention. And the
U.S. dollar continues to serve as the world’s
international reserve currency, backed now
by America’s force as an economic and
military superpower and the convenience
of tradition.
There are advocates today of a universal
fixed currency, as well as those who favor
a completely open-market floating system.
Alan Greenspan was famously in support of
returning to the gold standard. (Luskin,
2003) The only certainty is that, as in
the past and especially in light of shifting
trends in globalization, monetary regimes
are likely to continue to change.
10
Going Global
Why understanding currency diversification within a global portfolio is important for U.S.-based investors
The growth of the euro
The European Union is the largest
single economic entity in the world...
Its presence in the world economy is
powerful: it is the largest exporter
and the second largest importer
(behind the U.S.) of goods; the largest
exporter and importer of services;
the largest importer of energy;
the largest donor of foreign aid;
the second largest source of foreign
direct investment...
(Sapir, 2007)
The euro made its debut in 1999 as an accounting currency, with actual euros in
circulation in 2002. The European Union is made up of 13 member countries; the
euro is also used by several other non-member nations. The European Central Bank
(ECB) and the European System of Central Banks (ESCB) manage the euro based on
a set of fiscal rules established by the European Growth and Stability Pact. Before it
went into circulation, the euro struggled, but since 2002 has strengthened steadily
in relation to the U.S. dollar and other currencies.
Economists disagree on whether having a unified currency constitutes an advantage
or disadvantage for the individual countries of the European Union. It certainly
restricts their ability to use fiscal and monetary policy for anything other than
maintaining the strict terms of the ECB, and holding a common monetary ground
while maintaining independent democratic politics is a challenge of the highest
order. However, the system seems to be proving its worth, as the euro has quickly
become the world’s second-largest reserve currency after the U.S. dollar.
As noted earlier, it doesn’t seem that the euro’s recent strength is predicated on economic growth in the European
Union, which has been modest. Rather, the strength seems to be founded on a strong fiscal policy: “It has puzzled
many that the euro within a relatively short time rose from an exchange rate of 0.85 U.S. dollar to over 1.30
U.S. dollar, not least because the U.S. economy has been performing much better than the euro-zone as [far as]
economic growth and employment [are] concerned in the same period. However, in the same period the euro-zone
economies have performed much better than the United States when looking at the fiscal side of the economy, i.e.
the public budgets and — not least — the current accounts.” (Martens, 2006)
The Economist reports that the European Union is economically powerful
but lacks the will and organization to have equal strength in global politics:
“Half the G-8 group of rich countries come from the EU, as do nearly a
quarter of the executive board members of the International Monetary
Fund.” However, “...a Brussels think tank, Bruegel, constructs a careful
case that the EU is a ‘fragmented power,’ in which institutions, member
governments and citizens do not agree on how to exploit or defend
Europe’s economic strengths.” (The Economist, 2007) The euro-zone has
economic stability and shows signs of strong and consistent continued
growth; how the euro will fare compared to more rapidly growing
emerging markets is uncertain.
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...the U.S. dollar is no longer the world’s
only real reserve currency. Although the
euro cannot yet match the universality
and global use of the dollar, it is a valid
alternative as a global reserve currency.
(Martens, 2006)
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Why understanding currency diversification within a global portfolio is important for U.S.-based investors
China: will its undervalued currency be allowed to appreciate?
China’s GDP is second only to that of the United States (as an individual
country) and is experiencing rapid growth — 10.7% in 2006 and
11.1% in the first quarter of 2007. (Treasury Department, 2007) China
managed its currency (the renminbi, of which the yuan is the major
unit) pegged against the U.S. dollar until 2005, when it announced a
switch to a floating exchange rate. Officially, the renminbi was to be
managed against a new basket of undisclosed currencies, but in fact
has remained closely tied to the U.S. dollar. This has caused concerns:
“China’s tightly managed exchange rate regime is a substantial obstacle
to the resolution of economic imbalances that foster China’s high
savings, high investment, and large trade surpluses.” (Treasury Department,
2007) China’s current account surplus is at a record $249.9 billion in
2006 (Treasury Department, 2007) and the current sentiment is that the
Chinese renminbi is significantly undervalued relative to the dollar.
GDP of the 15 largest economies
Country
GDP
(U.S. $B)
U.S.
13,130
European Union
13,060
China
10,170
Japan
4,218
India
4,156
Germany
2,630
U.K.
1,930
France
1,891
Italy
1,756
Russia
1,746
It has been suggested that this is due to a purposeful manipulation,
orchestrated to keep the yuan artificially low and thus continue to grow
Brazil
1,655
China’s booming export trade. Forbes magazine reports: “On Capitol
South Korea
1,196
Hill, Sens. Charles Schumer (D-N.Y.)
Canada
1,178
and Lindsey Graham (R-S.C.)... [have
“Will all this turn the been] arguing that China has continued
Mexico
1,149
yuan into a super- to manipulate its currency and engage in
Spain
1,109
currency soon? No, but illegal trade practices in the past two years,
Data based on purchasing power parity (this means
to be a true global player and that stronger action on the part of the
that foreign currencies are expressed in dollars not
according to their actual exchange rate, but accordyou need economic power, administration to bring China into line in
ing to their ability to purchase a comparable basket of
global ambitions, and the order to protect U.S. workers.” (Wingfield,
market goods.)
willingness to trade your 2007) Although Chinese officials state that
source: Central Intelligence Agency
currency freely. China has they are working to correct the imbalances,
the first two requirements the process has been slow. “While China has
in spades. Slowly, it is taken some steps to increase the flexibility
of the renminbi, the pace of appreciation that the authorities have allowed is much too
working on the third.”
slow and should be quickened.” (Treasury Department, 2007) If the Chinese do begin to
(Bremner, Dawson, Shameen, Ihlwan, 2005)
manage their currency floating on the open market, it may propel China’s economy even
further to the forefront of the world’s stage.
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Going Global
Why understanding currency diversification within a global portfolio is important for U.S.-based investors
Currency developments in the Middle East
The Middle East, because of the oil trade, has a strong influence in currency markets: “Saudi Arabian and other
Middle Eastern investors pack a punch in currency markets that is disproportionate at times to the thin slice of
global foreign exchange reserves they hold.” (Parry, 2003) One of the reasons the dollar holds such prominence
as a reserve currency is that commodities such as oil are priced and traded in U.S. dollars. However, Bloomberg
reports that Iran, the world’s fourth-largest oil exporter, has begun to trade oil in other currencies, particularly
euros: “The Tehran Times said today Iran has started substituting euros for dollars in oil sales, citing an unidentified
person at the Oil Ministry. Iran Daily reported Iran wants to cut its dollar-based transactions to a minimum, citing
Minister of Economy Davoud Danesh-Ja’fari.” (Wolfensberger, 2006) There are rumors of the possible opening of an
Iranian oil exchange that uses euros to trade oil, but the various scheduled launches have not yet materialized.
Further, when Kuwait unpegged its dinar from the dollar in 2007, there were rumors that other Middle Eastern
nations, such as the United Arab Emirates, would follow suit. The Gulf countries are looking at developing their
own currency, with an arrangement similar to that in the euro-zone. “The six Gulf Arab monarchies of Saudi
Arabia, the United Arab Emirates, Kuwait, Qatar, Oman and Bahrain plan to form a single currency by 2010.”
(Sharif & Brown, 2007) If this move is successful, it may further dilute the dollar’s position in the oil markets, as well
as reduce demand for reserve dollars.
Pressures on the dollar
The dollar has been depreciating for several years against many of the world’s major currencies, including the euro,
yen, and yuan. A depreciating dollar increases the risk of inflation; as the dollar is worth less and less versus foreign
currencies, imports cost more and more.While depreciation makes our exports less expensive and drives up demand,
the U.S. only exported $1.4 trillion in goods and services in 2006, whereas we imported $2.2 trillion in goods and
services. (U.S. Census Bureau, 2007) With the size of the U.S. import trade, the inflationary impact of a depreciating
dollar may be difficult to contain.
Also, the pressure on the world’s foremost reserve currency is mounting as the United States continues to set records
in its trade imbalance and national debt. One of the biggest questions is whether the dollar can maintain its status as a
reserve currency under the weight of these twin deficits. As dollars lose value, the international community will likely
want to hold fewer and fewer of them. The subsequent question is whether the dollar will experience a “soft landing,”
in which a slow depreciation along with an increase in exports and lowering of the trade deficit ultimately balance
out, or whether a “hard landing” will cause recession and other economic troubles for the United States. Joseph Davis,
Ph.D., an investment analyst with Investment Counseling and Research, favors the soft landing theory: “This process
will takes years, not weeks, and so will be accompanied by a secular depreciation in the U.S. dollar that should be
generally beneficial to both the U.S. and global economies.While this more pallid long-run scenario is still bearish for
the U.S. dollar, it surely need not be so for insitutional and individual investors holding portfolios well diversified not
only among asset classes, but also between domestic and international mutual funds.” (Davis, 2004)
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Going Global
Why understanding currency diversification within a global portfolio is important for U.S.-based investors
Currencies that have recently
unpegged from the U.S. dollar
Argentine peso
2001
Egyptian pound
2003
Chinese renminbi 2005
Malaysian ringgit 2005
Kuwaiti dinar
2007
Syrian pound
2007
Further, a number of countries have shifted their currencies from a dollar
peg to a managed float regime. As part of this shift, those countries will
need to hold fewer dollars as reserves. Some suggest that this may be a
negative sign: “Global central banks’ ongoing reserve diversification has
been a main factor weighing on the U.S. currency and Treasury market in
recent years. Many people argue because foreign central banks have played
a vital role in financing U.S. borrowing by buying U.S. debt, a diminished
appetite for dollar-denominated reserves could have a significantly negative
impact on the dollar and the U.S. economy.” (Zhou, 2007)
These issues should serve as a warning to investors. As events continue
to develop and unfold, currency diversification will only become more
important. An investment portfolio that includes a significant international
component will be better prepared to take advantage of future global
growth and weather shifts in the exchange market.
Where are we now?
The 2006 NACUBO Endowment Study found that higher education
endowment funds held an average of 17.9% of their portfolios in non-U.S.
securities: 12.8% in developed equities, 3.9% in emerging equities, and 1.2%
in international fixed income securities. (NES, 2007) Of the largest 200
pension plans in the Pensions & Investments 2006 survey, international equities
made up 18% of their asset allocations. Corporate plans had a slightly higher
allocation — 19.2% — compared with public plans at 18.3% and union
plans at only 10.6%. (O’Connor, 2007) Two of the largest collectors of
401(k) participant data — the Employee Benefits Research Institute and the
Vanguard Group — do not separate international equities from the equity
asset class when reporting participant-directed asset allocations. This probably
suggests that the percentage of participants’ assets invested internationally is
likely quite small; we estimate it at between 10-15%.
The pie charts on page 3 show the makeup of the MSCI World Index. In 2006,
the U.S. made up less than half of the index; the United States represents
less than half of the world’s market capitalization. But it is common to see
investment portfolios in which U.S. securities make up 70, 80, 90, or even
100% of the portfolio. Our research suggests that a weighting of 20% or less
to international securities may not be sufficient to capture the broad range of
growth opportunities available, as well as manage market risk and currency risk.
Arnerich Massena & Associates, Inc.
Diversification beyond dollars
The world is your oyster
We believe that expanding investors’
horizons to include global perspectives
will increase the opportunities for risk
management,
diversification,
return
premium, and growth, as well as help to
maintain the purchasing power of assets in
an inflationary environment.We also believe
that currency diversification is particularly
important at this stage in U.S. history but
that guidance on the subject is limited
at best. At this time, the most important
goal for an investor is to maintain an open
mind and strive to look at global investing
objectively. A bias toward U.S. investments
is natural for U.S. investors, both because of
a certain degree of nationalism and because
the United States has been a dominant
world force for such a long time. And while
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Going Global
Why understanding currency diversification within a global portfolio is important for U.S.-based investors
it is possible that the United States could retain some of its economic power with strong leadership and economic
policies that address our deficits, a broader outlook for investors takes advantage of growth opportunities outside
of the country while hedging against the risk that the U.S. dollar may be facing a struggle.
Recommendations and conclusions
How do we recommend achieving a global portfolio? Given that everyone has individual goals and investment
requirements, we would recommend giving careful consideration to what will be most appropriate for any given
portfolio. Again, key at this point is an open mind and the willingness to consider opportunities as they become
available.
However, the following are a few strategies we believe would be well worth consideration in incorporating currency
diversification into an investment portfolio:
•
Be open to increasing your portfolio’s international allocation. For many of our clients, we are recommending
allocations of up to 50% in international and global securities, depending on their individual situations.
•
Consider overweighting your portfolio in U.S. large cap. Many U.S. large cap funds incorporate global
multinational companies. An overweighting to U.S. large cap in a portfolio may help capture some of the
domestic growth to come out of the globalization trend, without currency risk.
•
Broaden your international asset classes. Most investors separate their domestic equity portfolio among large
cap, small cap, and other sub-asset classes. Consider including large cap international, small cap international,
and even international specialty funds.
•
Include foreign bonds. This may be an excellent method for achieving currency diversification while minimizing
risk.
•
Include emerging markets. “In our base projections, the E7 economies will by 2050 be around 25% larger
than the current G7 when measured in dollar terms at market exchange rates (MER), or around 75% larger
in PPP [purchasing power parity] terms. In contrast, the E7 is currently only around 20% of the size of the G7
at market exchange rates and around 75% of its size in PPP terms.” (Hawksworth, 2006) That’s a great deal of
potential growth.
•
Consider currency diversification opportunities in private equity and real estate investments.
It is our hope that the information in this paper serves as a spark to ignite conversation with your consultant. Our
job is to look ahead for our clients and address trends and events that may influence their investment strategies. We
believe that globalization is having a significant impact on the world’s markets, changing the risks and presenting
opportunities. By providing education to our clients, our primary goal is to open the door to a dialogue about
specific ways to take advantage of these market trends and changes.
Arnerich Massena & Associates, Inc.
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Why understanding currency diversification within a global portfolio is important for U.S.-based investors
Endnotes:
2006 NACUBO Endowment Study; National Association of College and University Business Officers and TIAA-CREF,
January 22, 2007
Carry on Living Dangerously; The Economist, February 8, 2007
China’s Currency Problem, by Brian Wingfield; Forbes.com, May 3, 2007
Currency Composition of Official Foreign Exchange Reserves (COFER), International Monetary Fund
Currency Risk and the U.S. Dollar by Joseph H. Davis, Ph.D.; Journal of Financial Planning, March 2004
Currency Weights: Broad Index of the Foreign Exchange Value of the Dollar; Federal Reserve Statistical Release,
January 2, 2007
Dreaming with BRICs:The Path to 2050, Global Economics Paper No: 99, by Dominic Wilson and Roopa Purushothaman;
Goldman Sachs, Inc., October 1, 2003
Euro-Dollar - A Holistic View of The Economy by Hans Martens; paper presented at The Euro and the Dollar conference
organized by the Jean Monnet Chair of the University of Miami with the support of the European Commission,
April 25, 2006
The Evolution of Exchange Rate Regimes Since 1990: Evidence from De Facto Policies by Andrea Bubula and Ínci ÖtkerRobe; International Monetary Fund Working Paper, September 2002
Foreign lands look good to investors by Cecily O’Connor; Pensions & Investments, January 22, 2007
Fragmented Power: Europe and the Global Economy, edited by André Sapir; Bruegels, July 2007
Gold Standard by Michael D. Bordo; The Concise Encyclopedia of Economics
Greenspan Comes Home to Gold, by Donald Luskin; National Review, January 31, 2003
Hegemony and Decline: Britain and the United States by Andrew Gamble in Two Hegemonies: Britain 1846-1914 and the
United States 1941-2001 edited by Patrick Karl O’Brien and Armand Clesse; Aldershot: Ashgate Publishing, Ltd.,
2002; pp. 127-140
A History of Universal Currencies by Dr. Bryan Taylor; Global Financial Data
Indexes of the Foreign ExchangeValue of the Dollar, Federal Reserve Bulletin 2005
Iran May Reduce Use of Dollar,Tehran Papers Say by Marc Wolfensberger; Bloomberg.com, December 6, 2006
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Why understanding currency diversification within a global portfolio is important for U.S.-based investors
Kuwait ends dollar peg, pressuring region to follow by Arif Sharif and Matthew Brown; Bloomberg.com, May 21, 2007
Kuwait unhooks dinar and dollar, signaling a possible trend, by Wanfeng Zhou; MarketWatch, May 21, 2006
Lebanese Pound to Stay Pegged to Dollar, Central Banker Says by Massoud A. Derhally and Dania Saadi; Bloomberg,
March 6, 2007
Mideast accounts help drive euro’s rise and fall by John Parry; Forbes.com, July 17, 2003
Overweight but underpowered; The Economist, September 6, 2007
Report to Congress on International Economic and Exchange Rate Policies, U.S. Department of the Treasury, June 2007
Riyadh rules out revaluing currency; The Peninsula, Qatar’s Leading English Daily, September 27, 2007
Saudi Plans to Keep Riyal Pegged to the U.S. Dollar, King’s Adviser Says by Arif Sharif and Zainab Fattah; Bloomberg,
September 20, 2007
UAE rules out dirham revaluation in ‘foreseeable future’ by Shakir Husain; Gulfnews.com, July 6, 2007
U.S.Trade in Goods and Services- Balance of Payments Basis; U.S. Census Bureau, Foreign Trade Division, June 8, 2007
The Venezuelan Economy in the Chavez Years by Mark Weisbrot and Luis Sandoval; Center for Economic and Policy
Research, July 2007
What is the IMF, International Monetary Fund, September 2006
Who’s Driving Financial Globalization? by Paolo Mauro and Jonathan D. Ostry; IMF Research Department, August
16, 2007
TheWorld Factbook; Central Intelligence Agency, August 16, 2007
The World in 2050: How big with the major emerging market economies get and how can the OECD compete? by John
Hawksworth; PricewaterhouseCoopers, March 2006
The Yuan Grows Up by Brian Bremner, Chester Dawson, Assif Shameen, and Moon Ihlwan; Business Week, August
8, 2005
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