Following three consecutive years of strong depreciation against the US dollar, this year the euro has regained around 10% against the greenback.
The recent strength of the euro has caught several investors off guard, when the returns on many of their foreign currency denominated assets were negatively affected when converted back to the European currency. Many clients have been questioning if this trend has further to go or if a reversal is on the cards, if it is time to increase their holdings of non-euro assets or to dispose of them.
When it comes to currencies, however, a view should always be expressed taking into account the context of each client portfolio allocation, risk profile, current and future expenses. It is also of extreme importance to consider what kind of assets are being bought with the foreign currency. Let’s take the example of the British pound on the day the UK voted for Brexit. A euro-based investor holding just GBP in cash would have “lost” 6.2% that day; if, however, he had used the GBP to buy shares in Randgold Resources, a gold-mining company listed in London, the investor would have instead “gained” almost 8%. In fact, whenever allocating to foreign currency denominated assets, there are other considerations that go beyond the simple FX itself. This is especially true when it comes to the equity market, and in this case analysing the revenue stream and cost base of each investment can save investors some nasty surprises.
Currency management also has a key role that is sometimes overlooked: the management of the risk factors. When it comes to portfolio construction, it is key to analyse each currency correlation and the advantages of diversification vis-à-vis the portfolio existing holdings and market expectations; for example, the Japanese Yen and the Swiss Franc certainly do not exhibit the same characteristics of the South African Rand or the Brazilian Real in a period of high volatility. In a low-yield world, where government bonds will not be able to provide the same “cushion” as they did in the past, currency management can become one of the main tools for risk mitigation.
Another important investor “bias” to consider is short-termism. Currency trends tend to play over several years, and the spot market can sometimes trade far from its “fair value”: focusing too much on micro-managing FX exposures is more likely to dampen than improve returns in the long term. Nevertheless, for investors confident in their shorter term trading abilities, a sound approach is to separate the strategic asset allocation risk budget from the tactical one, in order to maintain the right discipline in the investment process.
Coming back to the specifics of the Euro, despite the recent strength, the European Central Bank remains extremely accommodative and even though the first talks of “tapering” its stimulus are taking place, this will likely be very gradual, considering the fragility of the European economic recovery. In one sense, it would be more relevant to speak about US dollar weakness as opposed to euro strength, due to the recent doubts as to how fast the new US administration can implement the much talked-about fiscal reform and at the pace of the FED rate hike cycle.
In these uncertain times, investors should spend more time than ever on their portfolio construction and risk management, with most of their currency allocations being a “by-product” of that process. Private Banks and wealth managers should be a guide for clients, providing the right quantitative tools and qualitative expertise in order to build sound portfolios able to navigate through very different market conditions.