I spoke at the Irish Association of Pension Funds (IAPF) annual investment conference at the Print Works, Dublin Castle on 26th March 2015 on the topic of Currency Management. Here is my presentation...
When interest rates hit 0% and central bank money printing has stretched stock market valuations, the effectiveness of monetary policy becomes limited and only enforceable through the currency. The chart on the lower left shows plunging 10-year government bond yields while the chart on the right shows the prospective 10-year total return for the S&P 500 based on a range of historically reliable valuation methodologies. We also see overlaid on the chart the actual subsequent 10-year total return for the S&P 500 (dark green line). The chart suggests that the total return for S&P 500 for the next 10 years will be approximately 0% per annum, down from approximately 8% per annum today.
So, when interest rates hit 0% and QE has stretched market valuations, monetary policy effectiveness is limited and only enforceable through the currency.... and central bankers have made full use of this policy tool in recent years. The US money supply has increased from $3.5 trillion in 1995 to over $12 trillion today, a compound annual growth rate over 6%. The Euro area money supply has grown from €4 trillion in 1995 to over $12 trillion today, also a compound annual growth rate just over 6%. In the US, the monetary base, which reflects the balance sheet of the Federal Reserve, has exploded higher by over $3 trillion since the Great Recession of 2008. Prior crises (and central bank intervention) are barely noticeable on the chart. The 1985 Plaza Accord represented the first time that a group of central banks intervened in the capital markets to devalue the US dollar. The Federal Reserve intervened again in 2001-2002 under Alan Greenspan when the dot-com bubble collapsed. However, Fed Chair Ben Bernanke took matters to a whole new level in 2008.
The Federal Reserve passed the baton to the ECB this year and the ECB has committed to a €1 trillion asset purchase programme. What impact does money printing on such a record scale have on global currency markets?
Historically, interest rates have served as a relative pricing mechanism for currencies. When investors are bullish on a currency, savings in that currency tend to rise, while borrowings tend to fall. This demand drives the exchange rate higher and interest rate lower until the currency appreciation offsets the lower interest rate earned on that currency. Today, as central bankers keep the major currency rates near zero, interest rates no longer discount future exchange rate moves. Changes in spot currencies have become the only way to resolve the imbalance and spot currency rates are getting more volatile. Central bank intervention is leading to price instability and rising volatility in currency markets, in direct contravention of their mandate.
Today, interest rates no longer discount future exchange rate moves. We saw a perfect example of this in January 2015 when the Swiss central bank decided overnight to remove the Swiss Franc peg to the Euro. On 15th January 2015 the Swiss Franc rocketed +40% higher versus the Euro in 2 minutes (before settling +20% on the day), blowing up a number of hedge fund investors in the process. The Swiss stock market plunged -20% in hours on the same day. I am not sure what is more remarkable: the enormous swings in each market or the subsequent recovery in both the following month! It appears that some Swiss central bankers changed their minds in the aftermath of the market turbulence.
Currency volatility is not confined to the Swiss market. The Euro is also swinging aggressively versus the major currencies and has lost -25% of its value versus the USD in the last 12 months alone.
The US dollar has surged +62% versus the Japanese Yen in the last three years as the US Federal Reserve has cut back on money printing (for now) while the Japanese central bank continues its QE experiment as the Japanese government attempts to inflate away its runaway debt load, which now stands at over 230% of GDP. This will not end well for Japan.
How long will the United States tolerate a rising US dollar before they take action? The last time we witnessed a sharp rally in USD over a relatively short period of time was 1980-1985 when the trade-weighted USD rose +65%. Concerned about the impact a rising USD was having on US trade, the Federal Reserve convened a meeting of the G5 central banks at the Plaza Hotel in New York City in 1985 and an agreement was reached - the Plaza Accord - to intervene in the currency markets and devalue the USD. The USD collapse -48% over the next two years before another agreement was struck - the Louvre Accord - which put a halt to the US dollar decline.
Roll forward to today and we have the trade-weighted USD +38% from its 2011 low. A +65% rally (similar to the 1980-1985 rally) would get us to 120 on the USD Index, similar to the USD Index peak reached in 2001 prior to the dot-com bubble bursting. This would imply a euro-dollar exchange rate in the region of $0.85-$1.00.
The Plaza Accord was successful at reducing the US trade deficit with Europe but failed to alleviate the trade deficit with Japan. As noted above, this was the first time that central banks agreed to intervene in the currency markets. At the time, the US devaluation was planned, orderly and pre-announced, so it did not lead to financial panic.
There are some similarities between 1985 and today. The US economy is growing albeit at a more moderate pace than in 1985 and is running a current account deficit. Inflation is tame and unemployment rates are moderate and falling. The key differences of course are debt/GDP, which at 102% is nearly double the 1985 level and 10 year government bond yields, which is significantly lower today. Given the similarities overall, we may experience a rally in the USD Index to 120 and the EUR/USD rate to $0.85-$1.00 before this run in the USD is over.
So, how should an Euroland investor manage their non-currency exposure? Let's take a look at the impact of currency on stock market returns in recent years. A US investor investing in the S&P 500 made +213% since the March 2009 lows and +16% since January 2014, while a Euroland investor investing in the S&P 500 has made +278% since the March 2009 lows and +51% since January 2014.
A Euroland investor investing in the Euro Stoxx 600 made +153% since the March 2009 lows and +25% since January 2014, while a US investor investing in the Euro Stoxx 600 has made +128% since the March 2009 lows and only +3% since January 2014. Currency volatility is having a very significant impact on investor returns.
Today, the typical global equity portfolio has 89% invested outside the Eurozone. While investment managers and pension fund trustees have tended not to take active currency decisions when managing their portfolio to date, as currency volatility increases, it may now make sense to revisit the impact currency volatility has on portfolio performance. Hedging extreme currency moves has the potential to produce an additional source of return for the astute investor.
We recommend hedging to protect against extreme currency moves, either by working with your investment manager to implement a currency overlay strategy, or by investing in a mix of hedged and unhedged global equity share classes, actively managing the allocation to each over time.
Finally, no conversation on currency management should end without a brief comment on the safest currency of them all.... It is not the USD, or the EUR, or GBP or even the Chinese renmimbi. The currency I speak of has been considered money for thousands of years, just not the last 45 years since President Nixon removed the US from the Gold Exchange Standard. Gold has no central bank increasing its supply at will. A fundamental part of the allure of gold is the scarcity of the precious metal. To implement quantitative easing in the gold market you have to dig a mine! Gold provides an excellent store of value and and offers significant diversification to a traditional multi-asset portfolio. Gold has also delivered a cumulative return of +122% since 2007 compared to +81% for global equities and +84% for Eurozone government bonds.
Thanks very much for your time today and please do let me know any questions or comments you have. Thank you.