As the U.S. dollar is likely to remain strong in the near future, currency risk will be at the front of investors' minds. The theme of global monetary policy divergence among central banks will also prove a major source of volatility for currency and could lead to currency losses for U.S. investors holding international assets.
Before the change of administration in the U.S., we had felt the dollar was set to rally because of higher growth and monetary policy divergence relative to the rest of the world as the Federal Reserve's tightening bias evolves.
Now, our view is reinforced as Donald Trump's administration and its proposed policies of tax reform and infrastructure investment will provide a significant additional boost to U.S. GDP growth and inflation and will cause the Fed to be more hawkish in 2017. We expect three 25-basis-point rate hikes in 2017. This is in contrast to the rest of the world, particularly Europe and Japan, where economic growth is below trend, inflation is subdued and monetary policy is accommodative.
More complicated to access is the trend away from globalization and free trade toward a more local or closed economic policy. It is far from clear that this is detrimental to the U.S. dollar. On balance, the focus on domestic employment and investment is likely to support a currency of an economy especially if it was previously running a current account deficit, as is the case for the U.S.
As monetary policy and growth between the U.S. and the rest of the world continue to diverge, we forecast a broad appreciation of the U.S. dollar against most developed and emerging market currencies over the medium term.
Managing the impact on portfolios
When an investor buys a foreign asset, they purchase an equal amount of foreign currency and assume currency risk. Currency can add a significant amount of volatility to an international portfolio, which may lead to underperformance.
Appreciation of the U.S. dollar has important consequences for investors holding international assets, and U.S. investors need to hedge currency risk to protect against losses.
Commonly, investors wish to leave the currency hedging decision to their equity or fixed-income managers who claim they will hedge the risk if necessary. This is wishful thinking as managers would be taking off benchmark positions when hedging. Therefore, it is incumbent on the investor to take direct responsibility for establishing a currency hedging approach.
A range of solutions
A typical institutional fund in the U.S. has 30% of its assets abroad, with about half of that concentrated in northern Europe, and an annual standard deviation of return due to currency movements of about 8%.
A spectrum of currency management approaches is available to institutional investors ranging from pure risk-reducing passive hedging to return-seeking pure alpha approaches.
Passive hedging reduces currency risk by hedging a fixed proportion of each foreign currency exposure. This activity is usually confined to developed markets because there is a weak yield advantage to holding some emerging market currencies. At the moment there is an interest pickup of 1.4% per annum from this activity, making it immediately attractive to U.S. investors. Dynamic hedging can limit losses and increase gains by adjusting the hedge periodically based on an option-replication methodology or a trend-following strategy. This is essentially a passive approach that attempts to provide an option-like payoff if the dollar appreciates.
While passive hedging can reduce risk, it can also lead to a painful series of negative cash flows during any intermittent periods of dollar decline, necessitating the liquidation of assets. For this reason, many institutions opt for a more nuanced approach to currency and risk management.
Active currency programs offer a more versatile solution, and include three main strategies:
- Selective hedging strategies are designed to reduce risk and protect value by hedging individual currencies that are expected to depreciate against the dollar. They are a useful way to protect the portfolio against currency depreciation without indiscriminately hedging everything, but are unlikely to add value if the dollar falls.
- Asymmetric hedging approaches are similar to selective hedging strategies and are designed to reduce portfolio risk and add return especially when the dollar is strengthening, but additionally add limited alpha through cross-hedging when the U.S. dollar is weakening.
- Pure alpha strategies can reduce risk at times, and increase it at other times, according to the opportunity in the market, and are designed to add the most return possible in all environments.
All the above approaches can be applied to any benchmark, combining intelligent risk reduction with excess return in any number of combinations. Active currency management doesn't require funding, so there is no need to reduce allocation to any other asset class.
Examples of such approaches are given in the table below.
All portfolios benefit from a well-structured currency program. With the dollar set to rise, investors need to acknowledge the headwinds that will occur as a result and consider a suitable strategy to manage the currency exposure of their portfolios.
Adrian Lee is president and CIO of active currency manager Adrian Lee & Partners, London.