Back to the future
Often in this job you wish you had known what was coming up next. Investment would be a much easier business if you actually knew future investment returns rather than having to rely on dividend yields, earnings yields or credit spreads as guides to where value lies. So supposing a time traveller arrived in his DeLorean to tell you over the next 3 years that the US would be the top performing equity market (up 48%!) followed by Germany and then Japan. Then he drives off again. How useful would that be?
The answer is less useful than you think. The reason is that Marty McFly didn’t tell us the currency the returns were quoted in. As he’s an American, let’s assume they were in dollars. And, to drop the conceit, let’s assume this all happened three years ago so we in fact have actual three year index returns for each market. We show these in the first table below.
In the table below we then show the actual 3 year returns in local currency terms. Note the returns are exactly reversed. Now Japan is the top performing market with almost twice the return of the US. And these returns were all perfectly achievable if you are currency hedged.
The message: currencies are important and wishing them away either as unknowable or something that tends to even out over long periods of time is, to our eyes, simply wrong.
If you agree with us then you should know that this sort of thinking is something we often come across on our travels. It is used to justify large unhedged international equity positions for example. Separately, we have seen euro clients have large sterling equity positions simply because the manager sits in London and there is a UK stock market tilt to all their portfolios.
We prefer to separate the currency from the equity investment decision for three good reasons:
- Currencies are risky. It’s possible that over long time horizons the ups and downs of currency moves may smooth out. But this is true of almost all risky investments including equity markets. Why should clients be carefully assessed for the amount of equity type risk they can take and then currencies be dealt with almost as an afterthought? US dollar investors have just lost 20% on their unhedged overseas investments as the dollar has strengthened over the last 9 months. Why is this different from international assets falling 20% in value with the dollar remaining the same?
- Future currency returns are not unknowable. Traditionally currency markets have often been the hardest to call. Currencies are able to stay off their theoretical long run purchasing power parity levels for long periods of time and the currency forecasts of Wall Street’s best and brightest often have little better predictive power than a coin toss. However, central bank quantitative easing (QE) has made the forecasting job a little easier. One of the main transmission mechanisms of QE is to weaken the currency. We have seen this in the US, Japan and now Europe. Indeed, in Japan authorities were and remain very explicit and public about their targets for the Yen. For this reason our European and Japanese equity positions remain currency hedged.
- Currency returns are important. As you can see from the charts above the hedged Japanese equity return is almost three times the unhedged version for US dollar investors. At IPS we try to focus our efforts on the areas that have the most impact on our clients’ future returns. This year, getting the fall in the Euro right has clearly had a far larger impact on client portfolios than the choice of owning European equity X instead of equity Y.
For these reasons we will continue to be active with currency positioning and hedging in our client portfolios. And if anyone does see a DeLorean driving round the streets of London could they point it our way. We wouldn’t mind knowing what equity returns are going to be like for the next few years.