Currency volatility returns
In the second half of 2014, foreign exchange (FX) markets shifted as investors began to recognise the divergence between the U.S. Federal Reserve (Fed) and the European Central Bank (ECB). After a brief respite, China’s recent devaluation of the renminbi has put currency volatility back in the spotlight.
In a global economy with little organic growth, countries are looking for any way they can to boost economic activity. With fiscal and monetary measures all but tapped out, many policymakers are turning to currency to strengthen exports. In theory, a country that can manage its exchange rate lower should benefit from increased exports, as their goods become relatively cheaper in currency terms, and decreased imports, as their imports get relatively more expensive. This lift to net exports (exports minus imports) accrues as additional growth to the country.
While China had several reasons for devaluing its currency in August, the main reason was to support faltering exports as the country adjusts to its slower growth rate. To maintain export competitiveness with China, economies across Asia and other emerging markets had to reduce their FX values as well.
So who will win the currency wars?
Perhaps no one. Recent research from the World Bank has documented that currency devaluation doesn’t have the same export-boosting effects it once had1. Today, exports are more likely to be finished goods derived from imports in an earlier stage of the value chain. As a result, the price benefits of a lower FX rate on exports are somewhat (or mostly) offset by the cost increase of imports. The research highlighted Japan as an economy that had undergone significant foreign exchange devaluation with minimal improvement to net exports. Countries will continue to manage (manipulate?) their currencies to maximize economic growth, but there is no free lunch. Ultimately, the real winners are the countries and companies that produce goods and services most efficiently.
Diverging central bank policies, China’s slowdown, and a collapse in commodity prices suggest that currency volatility will be with us for a while. How may investors mitigate these risks? First, it isn’t certain that the U.S. dollar will continue to appreciate – at least not at the same pace. The U.S. Dollar Index rose 25%, peaking in March of this year – without a single rate hike from the Fed. While the dollar could continue to appreciate at the margin, much of the currency adjustment from future rate increases has already been priced into the market. Don’t assume that continued U.S. dollar strength is a foregone conclusion simply because the Fed will raise rates at some point.
Second, currency volatility creates another reason for investors to diversify assets outside of their local markets. When you diversify your stocks and bonds globally, you also diversify your currency exposure. Oftentimes, the movement of the currencies can smooth the ride.
Finally, investors should understand if and how their managed portfolios are hedged with respect to currency movements. Foreign stock and bond portfolios can be unhedged, partially hedged, or completely hedged. When currency volatility is low to moderate, FX exposure can actually diversify away some risk (see above). But when currency volatility spikes, investors could be blindsided by FX losses that can swamp the return of the underlying assets. For that reason, using managers with a well-designed hedging strategy may help you sleep better at night.
1. Ahmed S, M Appendino and M Ruta (2015). “Depreciations without Exports? Global Value Chains and the Exchange Rate Elasticity of Exports”, World Bank Policy Research Working Paper No. WPS7390, Washington, DC