Currency markets have been very volatile in the past year, with the U.S. dollar exhibiting its strongest rally on a trade-weighted basis in over 10 years. For U.S. pension executives with substantial international investment portfolio exposures, the key question is whether this rally is in its ninth inning or closer to the fifth, as a prolonged U.S. dollar rise for several more years would result in large losses on overseas investment holdings if these remain unhedged back to the dollar.
Hence, it is critical for U.S. pension plan chief investment officers to assess the outlook for the dollar as the impact on international investment returns is likely to be significant in an era of higher currency volatility. Furthermore, the proportion of total returns in international portfolios coming from the currency impact is likely to be high in an era of low expected future nominal returns from equity, sovereign fixed income and corporate credit markets given the lofty valuation levels that have now been reached. Indeed, given the above, these currency effects are likely to be more significant as a proportion of total returns from international asset returns than for many decades of financial market history.
The cyclical and monetary policy divergence argument, which pivots around the idea that the U.S. is far ahead in the cyclical recovery compared to most other advanced economies (as illustrated in Chart 1), has clearly been a key powerful driver for the dollar, leading to broad dollar appreciation of over 10% in the past year.