Lazard Insights
Understanding the Effects of FX Yvette Klevan, Managing Director, Portfolio Manager/Analyst Robert A. Failla, CFA, Director, Client Portfolio Manager
Summary • The strength of the US dollar relative to other currencies over the past year has heightened investor awareness of currency effects. • The main drivers of foreign-exchange rates include fundamental factors such as interest rate and economic growth differentials. At the same time, technical factors and flows are also important as they are effective at indicating exchange rate trends. • While currency volatility is an important consideration in both fixed income and equity investments, because equities are inherently more volatile on their own, the additional volatility created by currencies typically has a more pronounced effect on fixed income investments. • Currencies fluctuate just like any other financial asset and can have a significant effect on investors’ portfolios. However, decisions to hedge foreign exchange exposure are not straightforward—as there are times when unhedged performance can be favorable.
Lazard Insights is an ongoing series designed to share valueadded insights from Lazard’s thought leaders around the world and is not specific to any Lazard product or service. This paper is published in conjunction with a presentation featuring the authors. The original recording can be accessed via www.LazardNet.com.
The strength of the US dollar relative to other currencies over the past year has heightened investor awareness of currency effects. Currency fluctuations are an important consideration for global investors in both fixed income and equity investments and can have a profound effect on investors’ portfolios. In this paper, we present important factors about foreign exchange, the main drivers of currencies, and the effect of currency movements on both fixed income and equities. Global foreign exchange markets are deep, as daily turnover exceeds $5.3 trillion. These massive flows add complexity to currency markets and can often overwhelm fundamental conditions. Over the past five to ten years, changes have been occurring in currency market share, with the euro, Swiss franc, and Canadian dollar losing some significance while the Japanese yen, Australian dollar, and New Zealand dollar gained a more prominent role in the world’s foreign exchange market. Importantly, the Mexican peso and Chinese renminbi are now on the list of top ten most actively traded currencies—as China is vying for reserve currency status. Today, global foreign-exchange trading is more fragmented than in the past with a slowdown in top inter-bank dealing (due to increased regulation after the global financial crisis), as institutional investors, hedge funds, and high-frequency trading firms become the main drivers of growth. Exhibit 1 lists some additional important facts about the evolving currency market.
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Exhibit 1 Important Facts about Foreign Exchange • Daily turnover in the currency markets exceeds $5.3 trillion ($1.5 trillion in 1998). • Cross border transactions represent 58% of foreign exchange activity. • The United Kingdom, because of its location/time zone, is still the most active trading center in the world with 41% market share (United States is second with 19%). • In terms of global reserves, approximately 63% are held in US dollars—which is high—but down from 71% in 1999. • Japanese individual day traders account for 20% to 30% of Tokyo spot market turnover. • Over 50% of global foreign-exchange activity is driven by algorithmic trading.
Exhibit 2 Interest Rate and Foreign Exchange Differentials Move in Similar Patterns (%) 1.5
CAD per USD CAD/USD [RHS, inverted scale]
0.9
1.0
0.5
1.0
1.1
Canada-US, 2-Year Government Bond Yield Differential [LHS]
0.0
1.2
As of 31 December 2014 Sources: Bank for International Settlements (BIS), Euromoney, Financial Times, Bloomberg, Bank of England
-0.5 2010
2011
2012
2013
1.3 2015
2014
As of 30 April 2015
Drivers of Foreign-Exchange Rates The main drivers of exchange rates include fundamental factors, technical factors, and flows. Two of the most important fundamental drivers are interest rate and growth differentials which can influence currency direction and valuations. For instance, the Canadian dollar versus the US dollar is closely correlated to the short-term interest rate differential between Canada and the United States (Exhibit 2). In addition, other important fundamental factors include the balance of payments, inflation, and the mix of government policy tools—a combination of fiscal, monetary, and foreign-exchange policies. Technical factors are another important driver of currency valuations, which may become self-fulfilling and often override fundamentals for extended periods. Exhibit 3 illustrates two typical technical factors, moving averages and the relative strength index, which provide different signals. The moving averages indicator may suggest a currency is changing direction, while the relative strength index may indicate a currency is oversold or overbought. Both of these metrics are closely watched by currency analysts. Furthermore, option activity and strike levels are often positioned around these technical levels. It is important to evaluate these technical signals in the context of other asset classes, such as commodities and equities. Flows are a key part of foreign-exchange analysis, especially for smaller markets including emerging and frontier markets. Equity market flows are an important consideration due to their magnitude and because there is generally less hedging involved in this asset class. Exhibit 4 shows the similarity between spot currency movements of the Mexican peso versus the positioning of the Mexican peso on the futures market. As currencies weaken, the number of net long minus short future contracts (a proxy for flows) typically decline. For instance, during late 2013 through the beginning of 2015 the Mexican peso was sharply weakening at the same time the flows were decreasing in the Mexican peso futures exchange.
Source: Bloomberg
Exhibit 3 Technical Factors Often Override Fundamentals for Extended Periods Moving Averages (MA) USD per EUR 1.6 MA (100) MA (200)
USD/EUR MA (55) 1.4
1.2
1.0 2010
2011
2012
2013
2014
2015
2014
2015
Relative Strength Index (RSI) RSI (30) 100 Overbought
Oversold
0 2010
2011
2012
2013
As of 30 April 2015 Numbers in parenthesis for moving averages and RSI indicate number of days. Source: Bloomberg
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Exhibit 4 Flows Can Substantially Influence Exchange Rates (contracts, thousands)
MXN per USD 11.0
200
Exhibit 5 The Effect of Currency on Global Fixed Income Performance Is Volatile, and Cancels Out over Time Rolling One-Year Performance, Unhedged minus Hedged (%)
MXN/USD [RHS, inverted]
12
Weaker Mexican Peso
12.7
100
6
14.3
0 MXN Futures Net Longs minus Shorts [LHS] -100 2011
2012
Decline in net long minus short futures contracts
2013
2014
Global Fixed Income, Unhedged minus Hedged
0 Average -6
16.0 2015
As of 1 May 2015 Source: Bloomberg
Views on the US Dollar For the past few years, the US dollar has been supported by better growth prospects and monetary policy differentials relative to other countries. However, we believe the potential for a US Federal Reserve interest rate hike this year is largely priced in. The euro zone and even Japan are now catching up to the United States, in terms of their growth and inflation outlook, and have been helped by the tailwinds of lower energy prices, extensive monetary and fiscal stimulus, and weaker currencies. These factors are starting to weigh on US dollar strength. The landscape for currency valuation and volatility is diverse in this current environment. From a fundamental standpoint, certain regions are improving, but there are still some countries, such as Turkey, South Africa, and Brazil, that are under pressure. Currency markets are famous for overshooting in both directions, but it appears that, based on current fundamentals, technical positioning, and flows, many currencies have reached an inflection point. For the remainder of 2015, while there will definitely be more currency volatility, we are also likely to see a reversion to the mean. Select commodity-linked currencies, such as the Norwegian krone, Australian dollar, and Canadian dollar are trading stronger, in concert with the bounce off the low of oil, energy, and other commodity prices. We are also monitoring certain countries, such as the United Kingdom, New Zealand, Chile, and Mexico, whose central banks may be very close behind the Fed in terms of raising rates over the coming year. Generally, such an increase in rates will support their currencies.
The Effect of Currencies on Bonds It is important to understand currencies’ effect on bond returns. Exhibit 5 shows the difference between unhedged and hedged returns for the Barclays Capital Global Aggregate Bond Index. The main point is that currency cycles change and strong US dollar cycles are not permanent. Hence, the recent US dollar strength may be a
-12
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
As of 30 April 2015 Data are based on the Barclays Capital Global Aggregate Bond Index, unhedged and USD hedged versions. The performance quoted represents past performance. Past performance is not a reliable indicator of future results. The indices above are unmanaged and have no fees. It is not possible to invest directly in an index. Not intended to represent any product or strategy managed by Lazard. Source: Barclays, Bloomberg
good opportunity for select currency exposure in the future. Over two decades, performance leadership has frequently shifted from unhedged to hedged—based on one-year rolling returns.1 Although currency exposure may be volatile relative to bonds, we believe it should be considered an additional tool to diversify a portfolio and potentially enhance returns through positioning, either opportunistically or defensively.
How to Think About Currencies in Equities Since the summer of 2014, US dollar strength has significantly impacted equity investing. Over long periods of time, currency movements have tended to wash, but for nearly a year, dollar strength has been an important theme for equity investors. We have seen very significant shifts in the euro and yen relative to the US dollar as well as changes in the US dollar relative to most emerging markets currencies. Investors are concerned about how these currency moves may affect their portfolios. We will frame our discussion in terms of two principal effects of currency moves in non-US equity portfolios. One involves the effect of foreign operations in the income statement of individual companies and the other is related to how currency affects the returns of a portfolio composed of foreign currency stocks. While investors are ultimately interested in the return in their home currency, it is also important to understand that the underlying stocks within a portfolio are affected by currency movements in specific ways. Cross-border operations are prevalent in global companies and management teams may or may not engage in currency hedging, depending on the geographic source of revenues and costs.
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Exhibit 6 Cross-Border Operations and Company Results Hypothetical European Company with Activity in the United States
Assumptions
Scenarios
(thousands)*
Year 1
Year 2
US revenue
$1,000
$1,000
(thousands)*
€ 1,000
US Operating Costs
European Revenue Exchange Rate USD/EUR Total Revenue Interest
€ 1,000 1.35
1.10
€ 1,741
€ 1,909
€ 50
€ 50
Scenario A
Scenario B
Year 1
Year 2
Year 1
Year 2
—
—
$750
$750
European Operating Costs
€1,500
€1,500
€750
€750
Total Operating Costs
€1,500
€1,500
€1,306
€1,432
Net Income
€134
€251
€270
€299
€0.27
€0.50
€0.54
€0.60
—
88
—
11
Tax Rate (%)
30
30
EPS
Shares Outstanding
500
500
EPS Growth (%)
*Except exchange rates, EPS, or where indicated otherwise. This information is for illustrative purposes only.
First let’s look at what could be the effect of a change in currency on corporate profits and the income statement of a company. It is important to keep in mind that this example is very basic and most multinational companies could have multiple hedging programs in place and often attempt to match their regional sources of revenue with a more local cost structure. Exhibit 6 analyzes two scenarios for a corporate income statement and the impact a change in currency has to its earnings. Our assumptions examine a European company reporting earnings in euros over two years. This is a hypothetical multinational company that generates $1 million in revenue from the United States and €1 million in revenue from Europe. The revenue is the same in both years. During year 1, the exchange rate is 1.35 dollars per euro and in year 2, that exchange rate is 1.10 dollars per euro. In scenario A, all costs are in euros; that is, the company’s physical plants and labor are in euros. In scenario B, those same costs and revenues are split evenly between the United States and Europe. In scenario A, the company experienced a significant benefit to its earnings growth, as there were no currency effects on costs. By contrast, in scenario B the stronger dollar offset the benefits of US-dollar revenue, as there was a cost component in US dollars in this instance. Without knowing how a company hedges or whether or not costs are matched with revenues around the globe, the currency move we have seen over the past nine months appears to have improved earnings for European companies. This effect is illustrated in Exhibit 7. The left-hand axis shows the ratio (upgrades to downgrades) of euro zone earnings estimates to those in the United States. As the line moves up, European consensus estimates are improving faster than those in the United States. The right-hand axis is inverted and represents the euro/dollar exchange rate. As this line moves up, the US dollar is appreciating relative to the euro. Over the last nine months, there has been a pronounced improvement in European companies’ earnings revisions. Importantly, while investors may or may not judge these currency moves as impactful to the valuation they are willing to pay for a company, the fact remains that, if everything else remains static (and we understand that nothing is ever static in investing), a stronger US dollar should benefit European corporate profits.
Exhibit 7 Foreign Exchange Can Influence Earnings Revisions Ratio of EPS Revisions and Exchange Rate (%)
USD per EUR
60
30
USD/EUR, 3-Month Moving Average [RHS, inverted scale]
Euro Zone vs US EPS Revisions, 3-Month Moving Average (Ex-Energy and Financials) [LHS]
1.05
1.16
0
1.28
-30
1.39
-60 2009
2010
2011
2012
2013
2014
2015
1.50
As of 22 April 2015 Data are based on MSCI country/region indices. EPS revision ratio is defined as the number of EPS upgrades to downgrades based on IBES data. Source: MSCI, J.P. Morgan
Exhibit 8 Currency Fluctuations Can Have a Significant Effect on Foreign Holdings Hypothetical European Stock Investment— Local Stock Currency: EUR; Investor Home Currency: USD
Amount Invested Stock Price
Year 1
Year 2
$10,000
—
€ 50
€ 60
—
20%
Exchange Rate USD/EUR
1.35
1.10
Shares Owned
148
148
$10,000
$9,778
—
-2%
Local Return
Ending Investment Actual Return
This information is for illustrative purposes only.
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Exhibit 9 The Effect of Currency on Non-US Equity Performance Is Volatile, and Cancels Out over Time
Exhibit 10 Currencies Have Periods of Strength and Weakness Relative to the US Dollar
Rolling One-Year Performance, USD minus Local
Calendar Year Spot Currency Returns Relative to USD (%)
(%)
April 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
20 MSCI EAFE Index, USD minus Local
CAD GBP CAD JPY AUD JPY JPY 3.43 13.69 16.76 23.29 27.75 14.68 5.47
10
0
Average
-10
-20
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
As of 30 April 2015 MSCI indices are total return, gross. The performance quoted represents past performance. Past performance is not a reliable indicator of future results. The indices listed above are unmanaged and have no fees. It is not possible to invest directly in an index. Not intended to represent any product or strategy managed by Lazard. Source: MSCI, FactSet, Lazard
GBP 4.58
EUR GBP 4.17 -5.92
CHF 6.64
AUD EUR AUD CHF CAD AUD AUD CAD -6.09 11.38 10.98 6.06 15.72 13.99 -0.23 2.94
CHF 2.52
JPY 0.34
GBP CHF EUR EUR GBP CHF CHF -10.18 7.65 10.55 -4.24 10.81 10.69 -0.31
GBP CAD GBP 1.86 -8.59 -1.45
CHF 2.48
AUD -8.32
EUR AUD -12.58 7.60
CHF CAD CHF 7.64 -18.08 3.24
CAD GBP AUD CAD CHF AUD 5.53 -0.44 1.81 -6.61 -10.20 -3.30
JPY CAD -12.84 -0.32
JPY AUD EUR GBP CAD EUR AUD EUR CAD 6.54 -19.70 2.51 -3.45 -2.28 1.79 -14.21 -11.97 -3.78
CHF JPY GBP GBP JPY EUR EUR JPY JPY JPY EUR -13.17 -1.10 1.34 -26.48 -2.57 -6.54 -3.16 -11.34 -17.62 -12.08 -7.22
AUD
CAD
CHF
EUR
GBP
JPY
As of 30 April 2015 The performance quoted represents past performance. Past performance is not a reliable indicator of future results. Not intended to represent any product or strategy managed by Lazard. Source: Bloomberg
The second effect of currencies on equity investing is dependent upon an investor’s base currency. We illustrate this in Exhibit 8 with a simple example of a US investor who owns European stocks directly—movements in the euro/dollar exchange rate will affect returns, both positively and negatively. The conclusion from Exhibit 8 is that despite a healthy return in local currency terms for the stock (+20%), the exchange rate effect turned this into unfavorable results in the investor’s home currency (-2%). This dynamic is effectively what happened last year. In 2014, the strength of the US dollar took over 10% from the MSCI EAFE Index local currency returns, which were positive in local terms (Exhibit 9). An important takeaway from this exhibit is that US dollar strength has ebbed and flowed dramatically over the past two decades and while the move we have seen over the past year has been more severe than those experienced over the past twenty years, recent economic news has been favorable for Europe relative to consensus, which has helped the euro improve from its March low. Finally, it is important to note that non-US equity investing typically involves more currencies than just the US dollar and euro. We examined a basket of developed markets currencies over the past ten years, and found that there have been no calendar years when the US dollar has appreciated relative to all other major currencies, except in 2014 (Exhibit 10). Clearly, currencies fluctuate just like other asset classes. Each currency has periods of strength and weakness relative to the US dollar. Last year, 2014, was different, which is frankly why there has been so much attention on the topic. However, for those investors who were unhedged in 2014 it does not appear, in our view, that now would be a favorable time to start implementing currency hedges.
Conclusion The drivers of currencies include fundamental factors, technical factors, and flows. The strength of the US dollar relative to other currencies over the past year has heightened investor awareness of currency effects, and it is important to consider the sustainability of this trend in light of the underlying drivers. While currency volatility is an important consideration in both fixed income and equity investments, because equities are inherently more volatile on their own, the additional volatility created by currencies typically has a larger effect on fixed income investments. The effect on equity investments can be seen through the lens of a company’s income statements as well as the return of a currency in the home country where the investment was made. Clearly, there are many different ways currencies can affect the returns of both fixed income and equity investments and a decision to hedge or not to hedge these investments should take into account multiple factors.
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Notes 1 In the presentation accompanying this paper, we evaluated three-year rolling returns since 1993. That analysis smoothed some the performance fluctuation between unhedged and hedged, and showed that the unhedged version outperformed in 58% of the monthly observations. In this paper, we shortened the data series to conform to a two decade period and used a shorter rolling window (one year).
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