THE RETURN OF CURRENCY VOL ATILIT Y
What a Strong Dollar Means for Investing
Russ Koesterich and Heidi Richardson
march 2015
about the authors
Russ Koesterich, CFA, Managing Director, is BlackRock’s Chief
Investment Strategist and Head of the Model Portfolio & Solutions
business. He is a founding member of the BlackRock Investment
Institute, delivering BlackRock’s insights on global investment issues.
During his 20+ year career as an investment researcher and strategist,
Russ has served as the Global Head of Investment Strategy for
scientific active equities and as senior portfolio manager in the U.S.
Market Neutral Group at BlackRock.
russ koesterich
Managing Director,
BlackRock Chief
Investment Strategist
Russ is a frequent contributor to financial news media and can regularly
be seen on CNBC, Fox Business News, CBS, CNN and Bloomberg TV. He is
the author of two books, including his most recent “The Ten Trillion Dollar
Gamble,” which details how to position portfolios for the impact of the
growing U.S. deficit. Russ is also regularly quoted in print media including
the Wall Street Journal, USA Today, MSNBC.com, and MarketWatch.
Russ earned a B.A. in history from Brandeis University, a J.D. from Boston
College and an M.B.A. in capital markets from Columbia University.
Heidi Richardson, Managing Director, is a Global Investment Strategist
for BlackRock where her responsibilities include relating the
Investment Strategy Team’s research and investment views to key
institutional and financial advisor clients and offering perspective on
all asset classes, including equities, fixed income, alternatives and
multi-sector approaches to investing. She is also the lead Investment
Strategist for iThinking, an iShares initiative designed to distill
BlackRock’s thought leadership and best ideas into implementable
actions, using iShares ETFs.
heidi Richardson, CPM
Managing Director,
BlackRock Global
Investment Strategist
Ms. Richardson joined the firm in 2010 with 23 years of experience in
active investment management. Prior to joining BlackRock, she spent
six years at AllianceBernstein as a Managing Director and Senior
Portfolio Manager specializing in non-U.S. equities. Before that, she
was a Vice President and Client Portfolio Manager with both Marsico
Capital Management and Goldman Sachs Asset Management. She
began her career in 1987 as a short-duration portfolio manager for
the Blackstone Bank & Trust Company.
Ms. Richardson holds the CPM designation and is a member of the CFA
Society of San Francisco. Ms. Richardson earned her B.S. degree from
Bentley University.
[2]
The Return of Currency Volatilit y
The Return of
Currency Volatility
What a Strong Dollar Means for Investing
Introduction
Over the past several months, the U.S. dollar has risen to
multiyear highs against other currencies, particularly
the euro and the yen.1 The forces behind the surge in the
greenback are both secular and cyclical, and as such,
we believe the trend—and impact—of a strong dollar
will be with us for some time to come.
The Federal Reserve has set the stage for hikes in shortterm interest rates later this year. The European Central
Bank (ECB) has embarked on an ambitious quantitative
easing program in the eurozone. Other central banks
around the globe, particularly the Bank of Japan (BoJ),
are promoting lower interest rates and easing measures
(the Bank of England is a notable exception). Meanwhile,
over the long term, reduced dependence on imported
energy will likely trim the U.S. current account deficit.
All of these factors point to a stronger dollar.
A strong dollar has significant implications for investors for
both the domestic and international portions of their portfolios.
If you are a U.S.-based investor, the strong dollar has an
impact on the earnings of many large U.S. corporations that
depend on exports for revenue. Indeed, we have seen many
such firms reduce their earnings expectations throughout
the early months of 2015.2
Combined with the fact that valuations for the U.S. are
already fairly pricey, investors this year have begun favoring
non-U.S. developed equities, which have outperformed the
U.S. year to date.3 But U.S. investors who take this route face
the possibility that the exchange rate will reduce returns.
In other words, the total return for U.S. investors buying
non-U.S. securities depends on both asset returns and
currency movements.
Currency fluctuations add to returns of a U.S. investor with
dollars as their home currency when a local currency
appreciates against the dollar (e.g. the euro/USD from 1.12 to
1.22). Conversely, currency fluctuations detract from returns
of a U.S. investor with dollars as their home currency when a
local currency depreciates against the dollar (e.g. the USD/Yen
from 80 to 100.)
For that reason, the recent dollar appreciation has led to
demand for financial vehicles that attempt to help investors
to diminish, eliminate or in some cases even profit from the
effects of shifting foreign exchange rates on their portfolios,
including currency-hedged exchange traded funds (ETFs).
In the last two years, investment in currency-hedged ETFs by
investors around the world has grown to $59 billion, and the
number of these funds available globally doubled to 194.4
Currency hedging involves either exchanging foreign
currency for U.S. dollars or entering into a short-term
financial contract (typically futures) that neutralizes the
impact of exchange rate fluctuations. Investors who fully
hedge their currency exposures should not suffer when a
foreign currency depreciates relative to the dollar because
the depreciation will be offset by gains on the dollar hedge.
Against this backdrop, this paper takes a look at the outlook
for the dollar, and the implications for currency-hedged
strategies. In particular, we’ll focus on:
}Why we expect the dollar to appreciate
Investing in international securities can be thought of this way:
}What are the implications for stocks
Return = Return in Local Currency +/- Effect of Change in the
Exchange Rate
}Why you should know your currency exposure
}When you should hedge and why
1 Source: Currencies Gyrate, But There’s No War, Wall Street Journal, March 11, 2015.
2 Strong Dollar Squeezes U.S. Firms, Wall Street Journal, Jan. 27, 2015.
3 As of 4/13/15 MSCI Developed Equities returned 4.38%, Japan Topix 13.62% compared with S&P500 which returned 2.21%, according to Thomson Reuters Datastream,
BlackRock Investment Institute.
4 Source: iShares Global Business Intelligence, February 16, 2015.
B l a c k R o c k [3]
THE ASCENDANT DOLLAR
The recent strengthening of the dollar is the result of a
confluence of factors. With the ECB bond-buying program
in full swing, bond yields in Europe have fallen precipitously
and in many cases into negative territory, increasing demand
for U.S. debt securities where yields are substantially higher.
Similarly, the BoJ continues to pursue an aggressively
accommodative monetary policy stance, while India, China
and many of the world’s central banks are relaxing monetary
policy amid subdued nominal growth.
In contrast, the Fed’s expected rate rise, combined with
better U.S. economic growth and surging domestic oil
production, is accelerating the dollar’s ascent. The U.S.
current account deficit is shrinking largely thanks to rising
energy production and reduced oil imports.
As seen in Figure 1, since the 1970s when the Bretton
Woods fixed-currency regime ended and currencies began
floating, a typical dollar rally lasts roughly six to seven
years. The increase in the dollar we’ve seen so far is muted
compared with those strong dollar episodes of the early
1980s and late 1990s. Therefore, the dollar’s recent rally
may just be getting started. Keep in mind, however, that
while the direction may be clear, there are inevitably
pockets of turbulence to be expected in any ascent.
Trade-weighted U.S. Dollar Index, 1973 – 2014
140
DOLLAR INDEX
The stronger dollar and cheaper energy prices are a boon for
U.S. consumers. But they represent a headwind for larger
companies that depend on exports. The higher dollar could
stall the U.S. economic momentum as exporters become less
competitive. Indeed, full-year earnings expectations for the
S&P 500 have declined steadily since the beginning of 2015.
The impact of the stronger dollar on earnings helps explain
why, while U.S. economic data continue to show decent
growth, the pace is moderating. Although the labor market
has surprised to the upside, most measures are coming in
below expectations, delivering the most downside surprises
to investors since last spring. Put simply, the U.S. is still doing
well, just not as well as many had expected.
The same headwind to U.S. earnings is a potential tailwind for
Europe and Japan. A weaker currency makes exports from
Europe and Japan cheaper and supports earnings for those
firms. And low oil prices, which are partially attributable to
the robust dollar (since oil is traded in dollars), supports
stronger household consumption. With respect to Europe
specifically, the weaker currency is among the factors behind
the recent stabilization of economic data. At least relative to
expectations, Europe is actually doing better than the U.S.
120
100
80
60
1978
1983
1988
1993
1998
2003
2008
2014
Sources: BlackRock Investment Institute and U.S. Federal Reserve, November
2014. Note: The shaded areas show the periods of a rising U.S. dollar. Past
performance is no guarantee of future results.
4 Source: BlackRock Weekly Investment Commentary, March 16, 2015.
[4]
IMPLICATIONS FOR STOCKS
In addition, the headwind to U.S. earnings is occurring at a time
when U.S. valuations are expensive relative to other developed
markets. The S&P 500 Index is trading at nearly three times
book value, versus 1.67 for Europe and 1.75 for Japan.4
figure 1: dollar perspective
1973
Nevertheless, the factors behind the strengthening of
the dollar are here to stay for the near term. Interest rate
differential between the U.S. where the Fed is on course to
raise rates, and Europe and Japan, both pursuing central
bank easing, will be with us for at least the rest of the year.
Growth may moderate in the U.S. and improve elsewhere,
but the U.S. still looks to have the strongest economy in the
world. All of this suggests the strong dollar may be with us
for a while, and investors are wise to consider the potential
impact on their portfolios.
The Return of Currency Volatilit y
To be sure, both Europe and Japan face significant challenges.
But given the relative attractiveness of the valuations in both
Europe and Japan, we would favor overweighting them, while
underweighting the U.S. at this point.
figure 2: Relative performance of hedged and unhedged major MSCI indexes in 2014
MSCI
EAFE Index
MSCI Emerging
Markets Index
MSCI
EMU Index
MSCI INDEX PERFORMANCE
10%
5
MSCI
Japan Index
MSCI
Germany Index
8.5%
5.7%
4.6%
2.4%
2.1%
0
-5
-2.2%
-4.0%
-4.9%
-10
-8.4%
-10.4%
-15
Hedged to USD return (equity market return)
Unhedged return (equity market return + currency return)
Source: MSCI, including Unhedged - MSCI EAFE Index, Hedged - MSCI EAFE 100% Hedged to USD Index, as of December 31, 2014. Index returns are for illustrative
purposes only and do not represent the performance of any investment. Index performance returns do not reflect any management fees, transaction costs or
expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.
CURRENCY EXPOSURE
The impact of currency on returns has been significant with
the strengthening of the dollar. Indeed, recent experience
demonstrates how exchange rates can be highly volatile,
sometimes more so than the underlying asset as measured
in its domestic currency. For example, the MSCI European
Monetary Union Index weakened 8.4% in U.S. terms in 2014,
but a position hedged against the dollar gained 4.6%. That
represents a 13% differential due to currency erosion.
In general, currency hedging does not produce benefits over
the very long term. Indeed, over time, hedging may increase
volatility from overseas equity returns. For U.S. based
investors, then, it may make sense to hedge when the dollar
is strengthening, less so when it is weakening.
TO HEDGE OR NOT
Currency hedging typically involves forward contracts, to
help protect against adverse exchange rate movements
and enable capitalizing on favorable currency fluctuations.
Two parties agree to swap an amount of one currency for
another at a predetermined exchange rate at some future
date, usually a week or one month ahead.
These contracts allow investors to trade the risk that a
currency will move in the future by foregoing the exchange
rate for dollar returns and eliminating the volatility of
currency movement from their portfolio.
Given our belief that the strong dollar is probably with us
for the near term, we believe investors should consider
investment vehicles that include an effective currency hedge.
B l a c k R o c k [5]
figure 3: historical currency impact
35%
30 28%
25
20
15
-5%
6%
3%
0% 0%
-3%
-5%
-7% -6%
-10%
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
1999
-12%
1998
1997
1996
1995
1993
1991
7%
2014
-5%
-10%
1990
1989
1988
8%
7%
2%
-6%
-9%
1987
7%
2002
-4%
1992
-5
-10
-15
3%
2001
3%
2000
9%
-5
0
1994
10
14% 15%
10%
Annualized Performance Difference between MSCI EAFE USD and MSCI EAFE Local Index
Source: MSCI. As of December 31, 2014. Index returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one
cannot invest directly in an index. Past performance does not guarantee future results. The inception date of the MSCI EAFE Index and the MSCI EAFE Local Index
is March 31, 1986.
Figure 3 illustrates the historical effects of currency
fluctuation, comparing the MSCI EAFE Currency USD Index
and the MSCI EAFE Local Currency Index.
dollar strengthened relative to other currencies, and marked a
year where many hedged investments paid off.”
For example, the effect of currency in 2003 added 15% to the
returns of the MSCI EAFE Index. This was a time when the U.S.
dollar weakened relative to other currencies, in particular the
euro and the yen, and an unhedged investment paid off. Two
years later in 2005, the effect of currency took 12% from the
returns of the MSCI EAFE Index. This was a time when the U.S.
Time is a fundamental determinant in deciding whether to
hedge. Currency volatility is significant viewed over shorter
time periods. An investor that has a high conviction that
their home currency will increase in value relative to one or
more other currencies over some foreseeable time horizon
should consider hedging investments denominated in the
other currencies.
Figure 4: Hedged v. Unhedged Returns
Figure 5: Risk-Adjusted Returns
MSCI EAFE
Index
Return
Unhedged
Hedged
Difference
MSCI EAFE
Index
Return/
Risk
Unhedged
Hedged
2010-2014
5 Year
5.3%
7.9%
2.5%
2010-2014
5 Year
0.32
0.66
2005-2014
10 Year
4.4%
6.0%
1.6%
2005-2014
10 Year
0.24
0.42
1993-2014
Longest
Available
6.2%
6.4%
0.2%
1993-2014
Longest
Available
0.38
0.44
MSCI EM
Index
Return
Unhedged
Hedged
Difference
MSCI EM
Index
Return/
Risk
Unhedged
Hedged
2010-2014
5 Year
1.8%
2.4%
0.6%
2010-2014
5 Year
0.10
0.19
April 20052014
Longest
Available
8.4%
8.2%
-0.2%
April 20052014
Longest
Available
0.35
0.45
Source: MSCI. Unhedged - MSCI EAFE Index, MSCI Emerging Markets Index. Hedged
- MSCI EAFE 100% Hedged to USD Index, MSCI EM 100% Hedged to USD Index.
Past performance is no guarantee of future results.
[6]
The Return of Currency Volatilit y
Source: MSCI. Unhedged - MSCI EAFE Index, MSCI Emerging Markets
Index. Hedged - MSCI EAFE 100% Hedged to USD Index, MSCI EM 100%
Hedged to USD Index. Risk-Adjusted Return is the ratio of annualized index
return over the period to annualized standard deviation of returns. Past
performance is no guarantee of future results.
For longer-term passive investors, however, currency hedging
generally does not add significantly to returns. Any benefits of
hedging tend to disappear over very long time periods (eight
years or more). The local returns of equities in various global
developed markets have tended to be approximately equal to
U.S. dollar returns since 1900, according to 2013 equity
research by the BlackRock Investment Institute. That being
said, currency fluctuations do not net out completely and
currencies can change relative value significantly, particularly
over medium term periods of two to five years.
Generally, there are also transactions costs of implementing
forward hedges, and also any costs of transacting in the
underlying asset markets to rebalance or meet currency
hedging losses.
“However, given our belief that the dollar will likely remain strong
for the near term, because it is based on factors that will be with
us for at least the next several months, we believe investors who
share those views may want to consider using a currency
hedged vehicle as part of their international exposure.”
CONCLUSION
The stronger dollar is having a significant impact on markets.
It is causing U.S. firms dependent on exports to revise earnings
downward, while giving a boost to their European counterparts.
It has contributed to a sharp decline in oil prices over the past
several months. And since it is rooted in the divergent paths
that central banks are taking—and that divergence in many
ways is just beginning—we believe this phenomenon is likely to
continue shaping the markets for at least the rest of the year.
While investors can seek to improve the risk-adjusted
performance of their portfolios by investing internationally, the
exposure to foreign currencies potentially alters the risk-return
profile of international investments. During periods when the
U.S. dollar is strengthening, it generally makes sense to
consider hedging the risk that exchange rate shifts could
substantially diminish overseas investment returns or perhaps
even sink otherwise positive returns into negative territory.
But while currency volatility is significant over shorter time
periods, in the long run, currency hedging generally doesn’t
contribute to returns. Nonetheless, given our outlook for the
dollar, and our belief that central bank divergence—which is
behind the rise of the dollar—will continue to shape markets in
2015, currency hedging may make sense for investors looking
overseas for opportunities.
Why do currencies need hedging?
Currency values fluctuate based on factors similar to
other assets, such as supply-and-demand as well as
short-term technical factors, but over time they are
correlated with changes in economic fundamentals.
Improving economies tend to attract more capital,
increasing the currency’s value, and weakening
economies tend to have declining capital flows,
decreasing the currency’s value.
Two economic measures in particular are positively
correlated with the directional move of a currency’s
value, including interest rates and the balance of a
nation’s current account in international trade.
Investors tend to deploy capital to wherever they
believe they can get the highest returns and rising
interest rates make a currency attractive. In addition, a
country with a current account surplus will generally
have a strengthening currency, as buyers of the
country’s goods and services need to sell other
currencies to buy the country’s currency in order to
finance purchases. These commercial transactions
generally employ currency hedging to help protect
against adverse moves in exchange rates.
When it comes to investing, however, different
relationships between equity markets and currencies
have meant that similar hedging strategies have had
varying efficacy across different currency exposures.
While the optimal hedge ratio varies according to
prevailing correlations, a 50% hedge balances some
volatility reduction against exposure in the short term
to unhedged currency exposure, where the return may
be either positive or negative.
In terms of cost, for developed markets the transaction
costs in equity and currency markets are comparatively
small. However, they would be more significant in
emerging market equities, potentially reducing annual
returns by 0.25% to 0.5%, depending on the magnitude
of the currency movements in each period.5 Currency
hedging is therefore potentially more beneficial, all else
being equal, where exposures are large and currencies
are most liquid (e.g. the dollar, euro, sterling and yen).
5 Source: BlackRock, Strategic Perspectives, January 2014.
B l a c k R o c k [7]
This material represents an assessment of the market environment as of the date
indicated. The views expressed are subject to change and are not intended to be a
forecast of future events or a guarantee of future results. This information should
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