Facing the challenges of a strong currency

With the Australian dollar reaching record highs in the last few months, Dominic McCormick looks at the issues a strong currency has raised for investors.

On Monday 9 May 2011, the Australian dollar (AUD) was trading at around 107 US cents. In the business section of The Australian that day, there was an article with the headline ‘Rampaging dollar could hit $US1.70’.

On that same day, The Australian Financial Review ran an article entitled ‘Big challenge if $A swoons to US85c’. Both articles discussed the views of various fund managers/hedge funds on the direction for the AUD in the next few years. 

This is an enormous range around the 107 cents level – almost 86 per cent. If the AUD were to head towards either extreme it would have dramatic and very different impacts on investor portfolios and the broader economy. Clearly, there is plenty of confusion about the future course of the local currency.

While the difficulty of forecasting the future direction of the AUD is one challenge, it is clear that the high and rising AUD has already created major problems for investors. For example, it has:

• Negatively impacted the returns on unhedged overseas assets both over the long-term and even more so in recent years – the AUD has risen around 6.5 per cent per annum against the USD over the past 10 years and 21 per cent per annum over the past two years;
• Reduced the appetite of overseas investors to buy Australian assets (especially shares and property), which has contributed to their underperformance; and
• Negatively impacted the local value of overseas earnings of significant components of corporate Australia. 

Clearly, currency has become one of the more important factors driving returns in recent times – particularly with a lacklustre local sharemarket.

Portfolios that have had their overseas exposure unhedged have suffered, while just having more invested in Australia has not helped significantly.

While the US and other overseas markets have done better than Australia, this advantage has all but been wiped out if one was unhedged. 

Staying hedged

In hindsight, the best approach has been to have significant overseas exposure, but to have all or most of the currency exposure hedged. However, this is not how the vast majority of Australian portfolios have been positioned. 

At the recent Morningstar conference, the almost universal consensus among fund manager panellists was that investors should hold their international share exposure unhedged. It was unclear how long they had held these views. 

However, I was struck by the seeming disconnect between the ease which such views were put forward and the practical challenges for advisers and clients who have worn losses on unhedged portfolios in recent years (or at least not participated in the high local returns from underlying markets). 

I was also surprised that while currency positioning was discussed frequently during the day, the deeper issues relating to the global currency and monetary system were largely ignored. Recent extreme currency movements were seen as just ‘business as usual’ that investors had to accept. 

I have a different view about these issues. While the starting point for most advisers and investors is that their overseas equity exposure should be unhedged, or at most 50 per cent hedged/50 per cent unhedged, a 100 per cent hedge on passive foreign exchange exposures should be the neutral ‘starting’ position.

The AUD is the currency local investors judge their returns in, and the one in which the vast majority of their expenditure is denominated. 

Of course, I cannot argue against the premise that as the AUD has risen and become overvalued on a purchasing power parity basis (see figure 1), the case for taking off some of these hedges and running more unhedged exposure as a diversifier has increased.

However, currencies can stay overvalued or undervalued on this basis for years, and this decision has been highly stressful given the relentless recent strength of the AUD.

However, this stress is probably considerably more for those with largely unhedged portfolios having to make the decision to remain unhedged in the current environment. 

A new reality?

Complicating the whole currency positioning is a nagging feeling – and I know this is dangerous to say – that ‘this time is different’ both in respect of the dynamics of the AUD/USD relationship and the broader global monetary/currency system. 

Let’s look at AUD/USD. There are two sides to every currency pair. On the AUD side, the Australian terms of trade are the highest in more than a century, we are one of the few countries in the world with positive real short-term interest rates and we have a central bank focused on inflation that is seemingly happy to see a higher currency as it dampens those inflationary pressures. 

Meanwhile, the US (and much of the western world) is struggling with high unemployment and a slow recovery from the global financial crisis (GFC), has negative real short-term interest rates and close to zero nominal rates, and has a central bank that is actively pursuing policies that lead to a lower currency in a quest to spur growth. 

Is it any surprise that the AUD/USD has moved the way it has? The acceleration we recently saw as it surged over $US1.10 was unusual (and some of it quickly retraced), but is the longer term trend for a higher AUD and lower USD really unexpected in a world where none of the key drivers described above are likely to reverse dramatically any time soon? 

Meanwhile, many seem to be waiting for another 2008 – where the AUD plunges 30 per cent against the USD in a matter of weeks or months, back to somewhere in the 60s or low 70s. I could be wrong but excepting a total collapse of the Chinese and Indian economies and the associated commodity prices, I just can’t see this happening. 

Australians have become accustomed to big falls in AUD having experienced them regularly in the 1990s, 2000s and particularly in 2008. While some serious setbacks are to be expected, there is a strong case that the AUD will fluctuate around a much higher average than in previous decades. The rise in the AUD and decline in the USD is secular, not cyclical.

A course of action

So what should advisers and investors do? As I wrote last year (‘The here and now’, Money Management 28 October, 2010) I believe they need to first reject the notion that currencies just average out in the long term, so it doesn’t really matter what exposure they have. In a world where some countries seem to be going all-out to debase their currency, these effects on return don’t just ‘wash out’ in the end. Specifically, they should: 

• Not rule out that the AUD could go higher, perhaps significantly so. They need to think about what this would mean for portfolios. And even when the next significant downward move occurs, it may be from higher levels and may be relatively shallow compared to history. Certainly those expecting it to revisit the US0.60s or 0.70s are likely to be disappointed;
• Develop a plan regarding currency exposure. The worst possible approach is to simply react to movements and to clients’ emotional experience with different investments. Some adopt a relatively simple 50 per cent hedged/50 per cent unhedged approach, which at least discourages such reactive changes; and
• Be diversified (even with a 50/50 approach) and think carefully about which currencies one is exposed to. Having some foreign exchange (FX) exposure can be a good diversifier, but that foreign exchange exposure should also be well diversified. If your FX exposure is largely in USD, does this make sense given the policies the US central bank is currently pursuing and the problems the US government faces from a fiscal and debt standpoint? 

On shaky ground

The global monetary/currency system is becoming increasingly dysfunctional, yet this worrying development receives little attention from fund managers focused on the status quo and who assume that the current arrangements will persist unchanged into the future.

Take a look at some of the symptoms of this dysfunctional status:

• Countries in the Eurozone periphery are in economic straightjackets and suffering severe recession, after years of abusing the ability to borrow at excessively low Eurozone interest rates;
• A race to the bottom in terms of currencies is underway as western economies look for an easy way to help their economies;
• Currencies pegged to the US dollar even though their economic situation is completely different. For example, in Hong Kong, property investors can borrow at 2 per cent even when their property market surged 40 per cent last year;
• The world’s reserve currency, the USD, is being pummelled by monetary policies to revive growth at home, with little consideration of the inflationary and destabilising ‘bubble’ implications of those policies globally; and
• There are desperate attempts to diversify away from the USD, which dominates global reserves, given the deteriorating purchasing power of these reserves. 

The centre of this increasingly flawed system is the USD. Yet the US has done exactly what all countries privileged with the global reserve currency status have done through history (ie, carelessly and relentlessly abuse that privilege over time).

It is this system that has allowed the high levels of debt to build up, which was a major cause of the GFC. And it is the maintenance of record low interest rates and debasement of the USD that has enabled a whole range of new imbalances to develop after the GFC. 

Major currency debasement and even hyperinflation is a real risk in the world today. If Greece, Ireland and Portugal had freely trading currencies they would have already collapsed.

These are small countries, but bigger countries within the Eurozone, as well as the UK, US and Japan, have many of the same excessive debt characteristics of these countries. 

The endgame

Most just extrapolate the past and expect business as usual but, increasingly, I think that is the least likely outcome.

The bust-up of parts of the Eurozone is something that could happen. China needs to free its currency to help solve its inflation issues and is attempting to gradually wean itself off US dollar dependence through a range of diversifying measures. 

The linkages of various Asian and emerging currencies to the US dollar are quickly running past their ‘use by’ dates and look increasingly unsustainable.

The US dollar’s days of abusing the ‘reserve currency privilege’ look to be drawing to a close. 

Predicting how this all plays out is extremely difficult. Some suggest that the response to this dysfunctional global monetary system should be a move back towards more rigid exchange rates, the formation of one world currency, or even a formal gold standard.

In my opinion, a better outcome would be a world where there are a reasonable number – but not too many – of well managed, liquid, freely floating currencies competing globally for use in transactions and as a global store of value.

Yet no currency should be allowed to become as dominant as we have allowed the USD to become, given the adverse consequences for global imbalances that are discussed above. 

We need to move towards a world where no one country is formally or informally allocated the privilege of being the dominant ‘reserve’ currency – that is, a currency used for the vast majority of global trade, the link for other currencies to use as a peg, and the dominant asset in most global reserves.

History shows that this reserve currency privilege is always eventually abused – and the value of that currency ultimately seriously debased – with adverse consequences for the world as a whole.

Gold’s role in all of this is to stand as another ‘currency’ of choice, if any or all of the authorities of those countries’ currencies pursue policies that seriously debase their value. 

In this world, investors would approach currencies much the same way they approach other aspects of investing – aiming to be well diversified, but with a skew to those currencies that are well managed and representing value. Gold will have a role as one of these diversifiers.

This would be particularly important for investors where their own local currency is being poorly managed. 

Of course, I don’t see an orderly transition to this more balanced and responsible global monetary system. It is only likely to come about through a series of crises in the current system, and a much greater recognition of its inherent flaws.

These crises are likely to produce major winners and losers. I suspect the volatility of recent times is the beginning of this period of recognition. 

In this environment, discerning the near-term and long-term direction of various currencies is likely to remain extremely difficult.

However, I am more confident in my prediction that the stress relating to managing currency exposure is likely to remain very high. 

Dominic McCormick is chief investment officer at Select Asset Management.