Currencies and their increased impact on portfolio performance
While G20 finance ministers seem to have agreed to avoid a "competitive devaluation" of their currencies, we believe currency volatility will remain abnormally high as investors wait for more detail on how they plan to resolve the longer-term global growth imbalances behind recent ‘currency wars’.
At the recent G20 finance ministers meeting in South Korea, there was surprisingly broad consensus on giving greater voting rights within the International Monetary Fund (IMF) to countries such as China, Brazil or India at the expense of European members. But intense discussions were also held around the ongoing "currency war" and the extreme fluctuations it has caused.
Anticipation of a second round of quantitative easing (QE2) in the US has triggered a sell-off in the dollar to record lows on trade-weighted basis and caused several emerging countries to take action in order to avoid further currency appreciation. The most prominent example was Brazil, which introduced a tax on foreign investors. We believe geopolitical tensions will remain high until the IMF provides more detail on how they plan to avoid further extreme currency moves.
As mentioned in a recent Daily Theme - Time to dust off the risk-pricing monitors – we believe investors should keep a close eye on currency moves. Volatility is likely to remain high and could therefore have a substantial impact on returns for global investors. The chart opposite shows the increasing impact of currency moves. The chart represents the average deviation in monthly returns over rolling 4-year periods for the dollar, euro, sterling and Swiss franc on a trade-weighted basis. Currency moves have had a substantial impact on portfolio performance recently.
Dollar weakness over the third quarter has been positive for US investors, investing in a global equity portfolio, while earlier sterling and euro weakness had a significant positive impact on euro-zone and UK investors’ returns, as seen in the chart below. In particular, the euro’s debt-crisis-related sell-off translated a substantial first-half loss for the MSCI World in local currency terms into a gain of 4.4% in euro terms. By contrast, Swiss investors have had a challenging time this year as the strength of the Swiss Franc has meant losses across the globe.
We believe currency volatility will remain high into 2011, and continue having a substantial impact on global investments, as major western economies try to improve their export competitiveness through currency weakness. In contrast, emerging countries seem to be growing increasingly wary of inflationary risks stemming from the additional liquidity about to be unleashed through QE2.
In an environment of modest equity returns and historically low bond yields in developed markets, which we envisage, currency movements could dominate the performance of un-hedged investment portfolios. We therefore believe global investors need to carefully evaluate their currency exposure.
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The value of investments, and the income from them, can go down as well as up, and you may not recover the amount of your original investment. Past performance should not be taken as a guide to future performance. Where an investment involves exposure to a foreign currency, changes in rates of exchange may cause the value of the investment, and the income from it, to go up or down.
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