Faceoff: Foreign exchange

Justin G. Charbonneau, CFA, DMS, FCSI, VP, Portfolio Manager, Matco Financial Inc.

Stance: It only makes sense when downside risk is high

Now ain’t the time

There are two separate schools of thought on currency exposure. One school propounds diversification—some will fall, some will rise; the net result is neutral. The other promotes hedging.

We do non-traditional currency hedging through macroeconomic analysis and bottom-up security selection. It entails an overall risk management, asset allocation and investment selection strategy, which seeks the best risk-adjusted return (as opposed to using traditional currency hedging tools).

When building a global portfolio with currency risk layered on, you need to gauge where your currency historically stands, relative to present-day valuation versus foreign currencies.

If there’s a strong probability your currency will rise, you could invest locally to mitigate or avoid currency risk. If it’s poised to fall, you should look to invest in other currencies. Investors should also match up their foreign liability exposure with foreign-denominated assets so as to naturally hedge their portfolios.

In the last 10 years, if you were a Canadian investor making U.S. investments, you’ve seen the value of your investments drop because the American dollar depreciated roughly 30% to 40%, relative to Canadian currency.

With the loonie just under parity today, it doesn’t make sense to hedge in USD, given the downside risk is much lower compared to a historical maximum CAD $1.10 (that means the quantified downside risk is 10%). The upside of not hedging is 25%, assuming a CAD valued at $0.80 USD (which is the midpoint of the last decade).

We actually doubled our exposure to foreign assets—most of them U.S. dollars—six-to-nine months ago when the CAD/USD exchange rate was around $1.02 to $1.03.

We believed the risk of the Canadian dollar rising was much lower than the risk of it falling, given the correlation of Canada’s resource-based economy and how commodity prices affect inflation. If investors were to actively hedge now, they might lose out on a potential tailwind if the Canadian dollar depreciates.

Currently, our flagship balanced fund comprises about 20% foreign equities (2.5% European; 2.5% Asian; and 15% U.S.) and 35% Canadian. The rest of the fund is investment grade fixed income and cash equivalents.

When hedging makes sense

The underlying purpose of hedging is to mitigate the risk of an unfavourable, yet likely, outcome. The Canadian dollar back in the late 1990s was worth $0.65 US. Today, it’s just under parity.

The approximate 50% appreciation relative to the USD in valuation over the last 10 years meant hefty gains for global investors with assets denominated in Canadian dollars. Looking back, currency hedging to USD, from a Canadian investor’s perspective, made a lot of sense given the downside risk was high. Not now.

Currency hedging may be warranted in the case of bonds where the variation of returns is low and investors need to protect themselves from seeing their returns wiped out by potential FX losses.

Again, one has to look historically in terms of the relative valuations of one’s currency against foreign assets.

Currency exposure is dependent on the client’s risk/return objectives, and any future liabilities with respect to generating a portfolio return. For risk-averse clients with shorter time horizons, currency hedging may make sense.

However, holding a well-balanced portfolio of cash, bonds, some commodity exposure, and dividend-paying equities in the more defensive sectors (staples, utilities, telecom, REITs), would work better over the short-to-medium term.

For the less risk-averse with longer time horizons, currency hedging may not necessarily be the best approach given the hard and soft costs associated with implementing a strategy—entering a contract, hedging currency and monitoring the position.

It’s like buying another security in the portfolio. If your clients are concerned about currency negatively impacting their rates of return, try hedging their currency risk through options, futures, and other derivatives.

Long-term investors, with significant and continuing Eurozone exposure, have two options: either hedge tail risk, as you’d do for a Lehman-type event, or hedge both currency and portfolio risk by owning assets and currencies that traditionally do well in a risk-off environment (e.g. USD-denominated investments such as U.S. Treasuries or high-quality, investment-grade corporate bonds).

Riding Europe

Sometimes the best risk-management strategy is minimal exposure. Europe is a case in point. We’re not really present in Europe as we have only 2.5% exposure.

The biggest risk in the Eurozone crisis lies in a disorderly exit of Greece, Portugal, Spain and Italy, which will hurt banks that hold sovereign debt (bonds) of all these countries.

Countries that decide to, or are forced to, exit would see a reversion to their stand-alone currency, likely resulting in a default on their debt obligations.

However, if you have a three-to-five-year time frame, there still are some good European companies you could buy. You could also buy the best-of-breed—by focusing your investments on Germany where the weak euro actually helps their export-driven economy. We’ve done that while minimizing risk by maintaining minimal exposure to Europe.

Going forward, there are better opportunities in the U.S. for Canadian investors looking to reduce risk, while capitalizing on less cyclical equity exposure. Even with the euro potentially falling, the U.S. dollar will likely rise in a down market. So, you’re actually better insulated by not hedging.

We have a bias toward Canada; however, looking forward, we are more favourable on markets such as the U.S., which offer Canadian investors some sectors such as technology and healthcare, which are absent from the Canadian market.

Using our strong currency to buy foreign assets makes sense in a global economy that will likely see slow growth for the foreseeable future. We typically buy securities that pay us a dividend or provide cash flow.

Income investing, whether bonds or stocks, is in vogue at the moment. We’re in the sweet spot as three of our four funds have a low volatility income bias.

Blake Jespersen, Managing Director of Foreign Exchange at Bank of Montreal

Stance: Hedging is prudent risk management

Contrary to some beliefs, being completely unhedged could be more risky than being fully or partially hedged.

When there’s increased volatility and uncertainty, removing currency risk via hedging is prudent risk management. You can experience rapid change in exchange rates that quickly erode profitability and create cost uncertainty. The European debt crisis has underscored the need to protect the value of foreign cash flows and investments.

There are a few different ways you can manage currency risk. The most straightforward—and risk averse—being the forward contract, which locks in a rate for a specified delivery date.

You could also get into structured solutions or currency options, which present opportunities to hedge downside risk, but also allow some participation in favourable moves.

For instance, on the Canadian dollar you could lock in parity and have participation up to $1.05. But such a strategy requires firms to entertain a level of risk commensurate with the potential reward. We favour a combined approach.

Mitigate risk

Large exaggerated currency moves can either work in your favour or against you. But there’s also the risk of potentially large market exposures resulting in reduced liquidity. A lot of companies and investment funds need a trading line with banks to secure hedging. And if some of your hedges are underwater, it can reduce your overall liquidity in the bank market.

There’s also a risk the asset moves in the opposite direction to the hedge. But you use a hedge to offset another asset. If you’re short on the U.S. dollar and it appreciates, your hedge is underwater, but your U.S.-dollar asset will be worth a lot more. So it isn’t really as speculative an endeavour as critics of hedging may suggest.

Many permutations that could take place in the Eurozone will impact the global market. But unless you’re a professional investor with a mandate to trade currencies, trading in the Eurozone isn’t wise in the current environment.

I’d prefer to focus on securing cash flows against budgeted rates. If you do have the mandate to trade currencies, I’d focus on being risk averse: going long on the U.S. dollar or the Japanese yen against the euro, both of which provide strong liquidity and safe havens during periods of stress.

I combine both fundamental and technical analysis when I’m looking at currency moves—fundamentals to form a view, and technicals to confirm it.

If you’re analyzing the Canadian dollar, fundamentally you’d want to look at GDP growth, employment, inflation, and fiscal position etc. Once you’ve formed a view, you need to back it up with technical analysis—where the currency is trading historically; is it getting close to some moving averages?

It’s also important to understand the relationship between different asset classes. If the Canadian dollar has a high correlation to oil prices, then energy companies and investors need to consider that relationship when they’re looking at risk-management policies.

Currencies are also closely correlated with other assets. So it’s important to see what’s going on from a macro perspective.

For example, when equity markets are under pressure, you’re usually seeing a flight to quality or a flight to the U.S. dollar, and therefore you can anticipate a weakening of the Canadian dollar or other commodity-based currencies.

FX basics

Currency markets are underpinned by the principle that money flows to where it can earn the highest return for the least amount of risk. If a country’s assets, such as shares and bonds, offer high rates of return for low risk, then people will demand that currency.

Overall, a currency can be viewed as a bellwether for the economy’s health. As a rule, a growing economy with stable prices and a wide range of competitive goods and services will see more demand than one in political turmoil, with high inflation and few exports.

Currency fluctuations depend on several factors:

• Underlying risk-free rate (otherwise known as the bank’s overnight and/or prime interest rate). The higher this rate, the stronger the currency.
• Economic strength
• Trade deficit or surplus
• Government bond rating
• Demand for currency from a structural perspective. The dollar and yen are two of the biggest and largest bond and currency markets in the world, yet their currencies have gone in opposite directions based on negatively correlated economic strength. The U.S. has seen its dollar fall while Japan has seen its yen appreciate despite being in a multi-decade deflationary period.
• Depth of the markets. Given that Canada is one of the few remaining AAA-rated government bonds in the world, you’d think foreign investors seeking safe havens would flock to our dollar. But Canada is such a small market compared to other countries that people aren’t comfortable over-allocating their capital here. Canada’s bond market size is akin to that of a small tugboat, while the U.S. is the equivalent of the largest cruise ship—there are only so many lifeboats in case of a risk-off event.

Source: Justin G. Charbonneau, CFA, DMS, FCSI

Sometimes currencies can be the leader or the laggard in large marketn moves. For instance, oil prices recently fell from over $100 a barrel to almost $80 a barrel, and yet the Canadian dollar fell only 3%. There have also been times where that’s been the inverse.

Euro dynamics

Greece could leave the EU. However, the overall health of the global economy is much more vulnerable to a Spanish or Italian exit, given the size of their economies. We’re paying close attention to sovereign bond yields in those two countries.

If Greece leaves the EU there could be contagion, and the euro could collapse. There’s also a view that once Greece is out of the picture Europe can begin to heal, and the worst problem will be behind them. In that scenario you could actually see quite a rally in the euro and in equity markets in general. It’s a tough trade given the two scenarios are so drastically different.

I think investors have accepted the idea of a potential Greek exit, and therefore you haven’t seen the euro fall much further than it has recently. In our view, Greece is already in a lost situation.

Should they remain within the EU, the reluctance of the Greek populace to adhere to austerity measures will prolong the uncertainty of their membership over the long term, and that will increase headwinds for the Eurozone as a whole. Conversely, a Greek exit would raise global concern about other exits and the potential for the complete dissolution of the EU.

All things considered, we’d prefer a long U.S.-dollar position that would serve as an effective hedge against these scenarios. However, we are cautious about the possibility of Euro bonds which could trigger an equity rally and a subsequent U.S.-dollar selloff.

Leveraging crisis

A long-short European debt strategy could certainly be employed to preserve capital, as opposed to naked exposure in the same products.

But allocation among sovereign nations becomes a lot more difficult as the crisis intensifies, especially with Spanish and Italian 10-year bond yields well above 6%.

As the EU crisis deepens, inversely correlated sovereign debt relationships could begin to assume a positive correlation, which would exacerbate losses from a uni-directional strategy.

The U.S. dollar and the Japanese yen will continue to be safe havens. Historically, the Swiss franc was considered a safe haven but I would argue it’s no longer one because of the Swiss National Bank’s decision to peg it against the euro. There has been recent talk that the Australian and Canadian dollars deserve some credit, but both these markets are still not deep or liquid enough.

Diligent analysis of portfolio exposures is certainly encouraged to protect capital and maintain an effective market hedge. Given the heightened level of risk, I don’t think it’s for the faint of heart to be active in that market.

Kanupriya Vashisht is a freelance journalist and writer based in Toronto.