On competitive currency devaluation (part 2)

Cash in on currency wars

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Don't let a move in the wrong direction erase your gains

War has never favoured the unprepared, be it those waged by generals or by finance ministers.

Whether the world’s reigning economies are on the eve of all-out currency war, or whether it is an issue of the week driven solely by political posturing, the global debate over exchange rates has taken on an undeniable momentum.

Considering the dramatic swings in foreign exchange markets of late, and the fact the loonie is poised to again surge past parity, Canadian investors need to ensure they don’t get caught in the crossfire. Currency shifts can erode and even erase gains made on foreign equity holdings.

Of course, one could always invest in gold, the asset class for the fearful and the pessimistic. While traditionally viewed as a hedge against inflation, gold futures have come to be seen as a panacea for all symptoms of instability, including currency troughs.

More and more, however, Canadians are turning to currency hedges to insure their foreign equity. At the institutional level, there are a number of funds fully hedged against currency risk, while forward contracts, futures and over-the-counter currency options can be purchased directly from a bank by the retail investor.

But where there is risk, there is also opportunity, and many investors are choosing to ride the currency swings rather than hedge against them.

“There’s a whole new world of currency speculators out there because of this added volatility, and what’s interesting is, we’re seeing FX being taken on as much more of an individual asset class because of this volatility,” said CJ Gavsie, managing director of corporate and institutional foreign exchange sales at BMO Capital Markets.

How to tackle currency risk depends on the region of the world in question.

United States

For the final 25 years of the last century, the Canadian dollar, measured against its U.S. counterpart, fell almost without interruption. That long slide lulled many a Canadian investor into a sense of immunity from currency fluctuations. It’s been a very different story ever since. The loonie has twice risen above the greenback and is set to ring the parity bell again.

In fact, some observers have the Canadian dollar rising as high as US$1.15 in the next couple of years, considering the prospect of a rising interest rate differential between Canada and the United States, the strength of commodities and a resumption of activity in mergers and acquisitions. That kind of spike can eat away at the value of U.S. holdings in a Canadian investment portfolio. In addition, the cycle of currency fluctuations has shrunk in recent years. Volatility is the new norm. And that can make for an interesting ride for the unhedged investor.

“If you’re just buying U.S. stock and you’re putting it away and forgetting about it, sometimes looking at that portfolio and seeing it shift up and down, despite what might be a stock that continues to perform for you, if you can’t stomach that volatility, it’s a very difficult one to hold,” Mr. Gavsie said.

Multinational U.S. companies with operations in a variety of countries have a natural hedge built into their equities. Almost all of Apple’s production facilities, for example, are located outside the United States.

“That’s a great example of something that gives you some diversification and tempers currency risk a little bit,” said Bill Chinery, chief executive of BlackRock Asset Management Canada Ltd., which owns the iShares family of ETFs.

Still the effect of currency movement on a portfolio is much quicker than on company profits and investors should mind that lag. While the U.S. dollar has rallied of late, most predict it will resume its tumble, especially considering the likelihood of additional quantitative easing. And iShares, as well as a number of other funds, have products that hedge 100% against U.S. dollar fluctuations.

On the other hand, for those predicting spikes in the greenback, investing directly in U.S. equities will give the exposure needed. But passive investors that would rather not speculate either way might opt for a balanced approach, with half a portfolio hedged against currency risk and half exposed directly to the U.S. market. “It’s a perfect way if you don’t have a view on markets and directionality in the short term,” Mr. Chinery said.

Europe

Pity the investor with exposure to the euro over the last year. Over that time, the euro has swung from US$1.50 down to US$1.20 during the sovereign debt crisis, and has since rallied back up to US$1.40.

“That could be a real shock treatment to an investor’s portfolio,” Mr. Gavsie said.

Yet, while the swings in either direction in currency markets have been swift and deep, most often currencies end up somewhere in the middle.

“People who are concerned about what’s going on in the market should actually be comforted by currency volatility,” Mr. Gavsie said. “Currencies trade in both directions quite frequently. Rarely do we see a long run on a consistent basis in one direction over a short period of time.”

However, that’s not to say that investors want to be exposed to the euro. Especially now, while many serious concerns linger about some economies in the eurozone.

“I think we’re within months of having another crisis, whether it be Ireland or somebody else that will set it over the edge,” Mr. Chinery said. “I think you’re going to see the euro going under a lot more pressure into the next year or so. That currency is going to be in trouble for quite a while.” He recommends avoiding exposure to the euro altogether.

Emerging Markets

The world’s hottest economies, those generally credited with leading the way out of the financial crisis and tempering ongoing softness in developed economies, are in emerging markets. Many of those countries are free from debt concerns, are avoiding any significant deficits and enjoy robust stock markets.

“I always learned in economics that they had the cheap labour and we had the capital,” Mr. Chinery said. “It looks like now they have both.”

As a result, investors have piled money into countries like Brazil, Chile, China and India in search of yield. With such inflows of capital, the resulting demand for foreign currencies has heaved exchange rates upwards. So, many investors have been quite happy to have exposure to the Brazilian real or the South Korean won. In fact, the stellar performance of most emerging-market currencies has helped boost foreign exchange markets as a distinct asset class.

“Investors are getting more accustomed to the asset class,” said Rick Harper, director of fixed income and currency funds at WisdomTree Investments Inc. in New York.

A year-and-a-half ago, WisdomTree introduced the market’s only ETF specifically focussed on a basket of emerging market currencies, a dozen in all, ranging from the Malaysian ringgit to the Chinese yuan.

Since the fund’s inception, it has gained more than 15%, and now trades above US$23. It generally benefits from any sustained fall in the U.S. dollar.

“We’ve seen significant inflows into this space in recent months,” Mr. Harper said.

And he is not overly concerned about recent threats by foreign governments to resort to interventions in currency markets and try to reverse the spikes.

Even if competitive devaluations become the ammunition in a global currency war, foreign exchange markets are not likely to be thrown into disarray.

While the United States has the capital resources to influence its currency through monetary policy, central bankers in emerging markets don’t enjoy that kind of power, Mr. Chinery said. So any shift they can affect on their currencies is likely to be short-term and not all that dramatic.

“I certainly wouldn’t hedge any emerging market currency other than India,” he said.

With the Indian stock market at a two-year high, there are fears that too much money has poured into the country and has created a potential asset bubble.

The Japanese yen, which has risen incessantly despite a sluggish economy and the government’s best efforts, may also be one to avoid, Mr. Chinery said.

“I’m not a big fan of the yen. I think it’s more of a basketcase as far as the country is concerned.”