Hedging Foreign Currency Exposure vs. Accepting Unmitigated Foreign Currency Risk
Many forces undercut and bolster the greenback. Rather than accepting unknown risk around its near- or long-term direction, dollar-based equity investors may be better served using currency hedges so they can focus more on the individual merits of overseas securities.
From the middle of 2014 through the end of 2017, currency markets had two seemingly easy, one-way trades. The first ran from mid-2014 to the end of 2016, when market consensus was clear that going long the U.S. dollar (USD) versus other currencies was the “smart money” bet. Then, at the beginning of 2017, market consensus reversed, and suddenly, “of course” it was clear that investors should be shorting the dollar versus other currencies, nearly to the point that betting against the USD became a momentum trade.
Saying these were “easy” currency trades is tongue-in-cheek because successful investing is never easy. Moreover, for international, emerging market and global funds, currency can be a notable component of returns for U.S. dollar-based investors. Hedging foreign exchange (FX) risk isn’t cost free when the hedges don’t turn out to be needed, but such insurance against adverse currency impacts can be well worth the cost. In a global fund, hedging foreign currencies in line with foreign companies economic exposure can lock in local market returns and mitigate less predictable macro risks.
Currency unpredictability is apparent in this year’s u-turn from 2017’s one-way FX trade. Since mid-April, the dollar has completely reversed its weakening trend against other currencies. The DXY Index, which measures the dollar against a basket of other major currencies, has strengthened 6% from its February lows and is back to October 2017 levels. It’s quite a turnaround for the dollar, which shed 17% against the euro from January 2017 to January 2018, and declined 11% against the Japanese yen from peak to trough.
At a high level, there’s been no single “aha!” moment changing the direction of the dollar. Rather, after a year in which market participants got excited about economic strength outside the U.S., there seems to be renewed appreciation for the U.S.’s own relatively strong, steady-as-she goes growth. Major foreign central banks are either tapering or signaling reduced monetary stimulus, reflecting the commitment of monetary authorities from Europe to Japan to fuel economic recovery at home. The Fed, by contrast, is transparent in its view that the U.S. economy can sustain continued monetary tightening. Consequently, interest rate and economic growth differentials between the U.S. and the rest of the world still make the U.S. relatively attractive.
Other dynamics are also bolstering the dollar. For instance, if global growth is good, then global trade expands, and much of global trade is conducted in dollars. Oil and other commodities have long been priced in dollars for transactions around the world. The U.S., India, Italy, and others buy oil from Saudi Arabia, for example, and pay in dollars, often causing commodity producers to “recycle” their excess dollar profits into dollar-denominated bonds. Beyond commodities, multinational companies often prefer to manage their supply chains in a single currency (USD), rather than many local currencies. This global trade- and invoicing-related architecture creates demand for the greenback regardless of U.S. rate, fiscal and external balance considerations.
That’s not to say U.S. budget and trade deficits don’t matter. The “twin deficits” exert depreciation pressures on the dollar. We buy more from the rest of the world than it buys from us, putting downward pressure on the dollar as U.S. companies need foreign currencies to pay for some imports. And as Washington, D.C., spends more than it receives, we depend on investors—both U.S. and foreign—to buy U.S. Treasuries. In emerging markets generally, or countries with less macroeconomic stability or government credibility, twin deficits are a recipe for disaster and have often led to financial crises, not to mention political crises.
But a closer view shows why the U.S. twin deficits haven’t yet caused the type of violent weakening of the dollar that has been seen in emerging market currencies. It can even explain the dollar’s recent strength. Significantly, the U.S. remains among the most attractive places to invest in the world. Foreign investors like the U.S.’s large, wealthy market; strong rule of law and property rights; transparency; and investment liquidity, relative to, say, China, Brazil or Italy. Unsurprisingly, the U.S. is the world’s largest recipient of foreign direct investment, attracting around $460 billion yearly in calendar 2015 and 2016, largely offsetting the roughly $500 billion trade deficits in each of those two years.
The dollar also remains the world’s reserve currency, thanks to the U.S.’s status as the largest economy, world policeman, and largest importer. The Japanese, then the eurozone, and now China have each hoped to offer a second reserve currency, but none has been able to reach the critical mass needed to play a strong second fiddle to the U.S., let alone to displace the dollar. That’s also why the dollar dominates cross-border borrowing.
Yet the dollar, like other currencies, continues to exhibit volatility, and not just over the last five years. In 1971, the Nixon administration ended the post-World War II Bretton Woods currency regime which fixed exchange rates and guaranteed dollars could be converted into gold at a fixed price. Since the early 1970s, the DXY has hit a 163 high when interest rates were peaking in 1984 and a 71 low in 2008, right as fashion model Gisele Bündchen (in)famously began insisting she be paid in euros rather than dollars.
Deep fundamental research can enable an investor to clearly identify the company-specific risks being taken when investing in a particular stock, while so many macro variables make it much more difficult to predict currency movements relative to upside and downside risks. The choice to hedge currency is a choice to mitigate foreign currency risk. Not hedging is a decision to accept unmitigated currency risk, which is separate and apart from the assessment of whether a security is undervalued in its home currency.
We believe we can have a much more differentiated view on a specific company’s outlook than we can for a currency’s outlook. So, we’d prefer to diminish currency risk through hedging a good portion of foreign currency exposure, and we then take company-specific risk at the security level.