Currencies
Stephen Grissing
Investment Strategist
The far-reaching US dollar
During 2022, the US dollar had its strongest run in two decades compared with other major currencies. This strength has prompted global investors to reassess both the impact and role of the US dollar in investment portfolios.
In this article, we discuss the merits of valuation metrics that aim to measure how under and over-valued a currency is, in comparison to another. We also discuss the investment implications of US dollar fluctuations over the short and long-term, and the options that are available to manage this risk. Former US Treasury Secretary, John Connally, captured the far-reaching nature of the US dollar nicely when he famously stated that “the dollar is our currency, but it is your problem”.
The dollar is our currency, but it is your problem
An over-valued US dollar?
What do we mean when we say the US dollar is over-valued? Firstly, we cannot state that a currency is under or over-valued on a standalone basis. Currencies are viewed through a relative lens i.e., the US dollar can be under or over-valued versus another currency. Commonly used currency valuation metrics that have stood the test of time include Purchasing Power Parity (PPP) and the Dynamic Equilibrium Exchange Rate (DEER).
Purchasing Power Parity
Earning the title of the oldest theory of exchange rate determination, PPP assumes that the price level of goods in two regions should be equal when expressed in a common currency, and as a result, real exchange rates adjust for relative price levels. Critics of PPP argue that by not accounting for items like trade restrictions, transit costs and input costs, deviations from a currency pair’s fair value can persist for prolonged periods.
Dynamic Equilibrium Exchange Rate
In an attempt to enhance the PPP approach, DEER fair value models were introduced. They adjust for economic fundamentals like productivity differentials and terms of trade (relative prices of exports vs. imports).
Figure 1: EURUSD versus fair value determined by Goldman Sachs Dynamic Equilibrium Exchange Rate (GSDEER)
Source: Bloomberg, Goldman Sachs. Updated as of 31st March 2023
The US dollar is currently over-valued versus the euro and sterling based on the PPP and DEER’s determination of fair value. It is worth noting that the fair value level determined by DEER has changed significantly over the past year. In Goldman Sach’s version of DEER, the fair value for EURUSD moved from $1.31 in April 2022 to $1.17 by the end of 2022.
DEER is sensitive to changes in a country’s relative terms of trade. In 2022, the euro area, which is a large net energy importer experienced a negative term of trade shock. The euro area’s current account shifted from a surplus of close to 3% of GDP (Gross Domestic Product) in the third quarter of 2021 to a deficit of -0.3% by the end of 2022. The more recent dramatic decline in energy prices has resulted in the current account for the euro area bouncing back into surplus territory. This is likely to move the EURUSD fair value higher once again.
As Figure 1 above shows, considerable deviations of a currency pair from its fair value can persist for a prolonged period – with deviations from PPP tending to be more persistent than from DEER. Although both approaches have limited predictive power in the short to medium-term, our analysis shows that significant deviations from fair value can be useful for predicting longer-term moves in currency pairs. For EURUSD, our analysis shows that PPP deviations explain 41% of 5-year forward returns of the currency pair, this increases to 65% for 7-year forward returns. For GSDEER, the equivalent figures improve to 62% and 83%.
Short to medium-term currency drivers
There are also several drivers that influence currency pairs in the short to medium-term causing oscillations away from a currency pair’s longer-term fair value. In a previous version of MarketWatch, we discussed a number of these drivers and how the significance of each driver tends to change over time.
- Interest rate differentials: a currency tends to benefit in an environment where interest rates in a region, or expectations for future interest rates outpace that of its peers.
- Economic outlook: an economy that is outperforming or is expected to outperform its peers tends to provide support for its currency. The US dollar is considered a safe haven currency, so it also tends to outperform in times when global economic growth is deteriorating in tandem.
US dollar implications for global investors
By investing in overseas assets, you are also investing in a foreign currency. Simply investing in a diversified global equity index like the MSCI World ACWI, due to the size of the equity market in the United States (U.S.), means that over 60% of your investment will be in U.S. companies, denominated in US dollars. As a result, a European or UK investor is taking on significant unintended currency risk. The US dollar currency exposure for an investor of global government bonds is close to 50%.
In addition to the currency that stocks are denominated in, beneath the surface a non-US listed stock might provide indirect exposure to the US dollar from the revenues that it generates overseas. The MSCI UK index is a standout example. In a year like 2022 when the US dollar strengthened, the significant overseas revenues of MSCI UK-listed companies benefitted from the currency move and the index outperformed many of its peers.
What is currency risk?
Currency risk is the impact of an exchange rate on the investment returns from an overseas investment. In the short term, currency moves can be volatile and are very difficult to predict. These moves can have a significant impact on returns from foreign investments from one year to the next.
Figure 2: Annual US dollar moves versus the euro and the impact on US equity returns for a euro-based investor, annual percentage change
Source: Bloomberg, MSCI. Updated as of 31st December 2022
To hedge or not to hedge, that is the question
The answer to the currency hedging question is not a binary one. Instead, we believe that timeframe, asset class, and the proportion of hedging implemented are all important considerations.
Although currency pairs can be highly volatile in the short term, over the long term currency pairs tend to mean revert to fair value. Therefore, in theory, any returns from currency moves are minimal. This theory diminishes the argument for long-term hedging of currency risk within risk assets where the currency impact fades to a negligible level compared to the returns from the risk asset.
Figure 3: Impact of currency fluctuations on long-term global equity returns.
Source: Bloomberg, updated as of 31st March 2023
Having said that, at Davy, we believe that currency hedging can play an important role in managing multi-asset portfolios. At this juncture, it is important to distinguish between equities and bonds. Global bonds generally produce lower returns than equities, while displaying a lower level of volatility than currencies. This means that bonds are more vulnerable to currency moves which have more potential to eliminate returns for bond investors. For this reason, we generally recommend hedging the foreign currency exposure within fixed income investments.
Hedging currency risk within risk assets can also be beneficial, particularly at times when a currency pair has departed significantly from its fair value. This is currently the case with the US dollar versus a number of currencies. Implementing a partial currency hedge within risk assets, rather than a full hedge may be more appropriate for the reasons outlined below. Taking account of the partial currency hedge that is currently in place within Davy discretionary portfolios, there is approximately 35% exposure to the USD within risk assets.
- Diversification benefits: the US dollar demonstrates a negative correlation to risk assets like global equities. Over the past ten years, the US dollar has exhibited a correlation to global equities of -0.53. At times when equities are depreciating, US dollar exposure in your portfolio can dampen the level of drawdown experienced. By fully hedging the US dollar exposure of your risk assets, you are also removing the diversification benefit that the US dollar provides.
- Currency view: when you decide to implement a short to medium-term currency hedge, you are taking a view on a currency pair. If your view is incorrect, and the US dollar appreciates for example, this can negatively impact returns.
US dollar historical correlation with risk assets, January 2011 – December 2022
Source: Bloomberg, Davy. Updated as of 31st December 2022
Note: US dollar = DXY index. Global equities = MSCI ACWI Net Total Return USD Index. Commodities = Bloomberg Commodity Total Return Index. US equities =MSCI USA Net Total Return USD Index. Global high yield corporate bond = ICE Global High Yield Index. Global investment grade corporate bonds = ICE Global Investment Grade Index.
An alternative approach for reducing currency risk in a portfolio is to implement a ‘home bias’. The term home bias refers to an investor who tilts their portfolio in favour of domestic assets. This approach will achieve the objective of reducing currency risk, but also has downsides such as reducing regional diversification benefits and narrowing the scope of investment opportunities.
Our US dollar view
Given stretched US dollar valuations and a narrowing of the interest rate differential between the US and regions such as Europe and the UK, we expect US dollar strength to fade further in the medium term. For this reason, in Davy discretionary model portfolios we continue to hedge a portion of the US dollar exposure within our equity holdings. Over the longer term, the US dollar remains by far the most prominent global currency, so a dramatic fall from grace remains unlikely.
Warning: Past performance is not a reliable guide to future performance. The value of your investment may go down as well as up. These products may be affected by changes in currency exchange rates.
Warning: Forecasts are not a reliable indicator of future performance.