The ‘free lunch’ in currency hedging?Since 2012, WisdomTree has been a leader in helping investors understand the impact that currency risk can have on their portfolios. When investors allocate funds internationally, there are two sources of return: the local asset return and the return from changes in foreign exchange (FX) rates. This can be problematic during periods in which foreign currencies are depreciating against the investor’s home currency, leading to underperformance.
Historically, the default allocation of a majority of investors has been to keep the equity and currency exposure combined. However, this doesn’t have to be the case and it is possible to uncouple those risks.
Currencies, a significant source of risk and tracking difference
A globally diversified equity portfolio, like the MSCI World point of view, is a bundle of equity and currency risk. 68% of the MSCI World is invested in US equities and, therefore, denominated in US dollars. 6% is invested in Japanese equities and, therefore, denominated in Japanese yen and so on. The exposure to currency can add to or detract from the performance of the equities themselves. This means that the performance of the MSCI World (unhedged) is quite different for an investor with the US dollar as the base currency compared to an investor with the euro as the base currency.
Every year, the difference in performance between the MSCI World hedged or unhedged is significant for both euro and pound-based investors. For euro-based investors, the difference in performance driven by the currency exposure oscillated between -9.41% and +10.1%. For a British pound investor, the difference is between -5.9% and +20.4%.This embedded currency exposure also tends to increase the risk in the portfolio.
Because the currency risk sits on top of the equity risk when investing in global equities, taking currency risk or not taking currency risk has to be a conscious investment decision.
Currency hedging as a tactical endeavour
Foreign exchange rates change over time. Many factors contribute to those deviations:
interest rate expectations
inflation differentials
public policy
growth forecast
balance of payments
Over the short to medium term, currencies can move quite dramatically against each other leading to potential losses or gains for investors invested in unhedged foreign equities. For investors with strong conviction on the direction of foreign currencies relative to their domestic currency, it is therefore possible to tactically currency hedge, or not, their portfolio to try to benefit from those moves.
Currency hedging for the long run
Whilst in the short and medium term foreign exchange rates fluctuate, over the very long term, currencies tend to fluctuate around a long-term equilibrium. This phenomenon is often called ‘long term mean reversion’. This means that for long term investors in global equities, the performance impact of currencies should offset itself over long periods of time. In other words, the performance of currency hedged and unhedged investments should be similar.
However, from a risk point of view, this is not the case. As discussed previously, the long-term volatility of the unhedged investment tends to be higher than that of the currency hedged investment. A reduction of risk with zero long term expected returns sounds like a ‘free lunch’ which is why investors could look at currency hedged investments in foreign equities as their default long term investment policy.
For example, a portfolio manager with a base currency of euro and a holding of 1 million US dollars of US equities can hedge the US dollar currency risk by selling a 1 million US dollar forward contract against euro for settlement in a month’s time at today’s rate.
Operationally, this process can be quite cumbersome, in particular for a portfolio with multiple currencies and/or with hard to access currencies. The MSCI World comprises 13 currencies which means that investors would need to trade 12 FX forwards every time they want to hedge the currency exposure and then they would need to roll those 12 forwards on a regular basis.
This is why WisdomTree has been launching currency hedged share classes for its strategies, providing turnkey solutions for their investors and their currency hedging need.
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Brace for volatility as inflation meets recession2023 has been ushered in with a rebound in pockets of equity underperformance from 2022. Markets are coming to terms with the fact that stickier inflation and more resilient economic data globally are likely to keep central banks busy this year. Owing to which the spectre of interest rates staying higher for longer appears to be the dominant theme for the first half of 2023. Global money market curves are re-pricing higher to reflect the tighter monetary scenario.
For the Federal Reserve (Fed), markets have priced in a 5.5% terminal rate, somewhat higher than was suggested by the median dot plot back in December. While in Europe, 160Bps of additional rate hikes are being priced for the European Central Bank (ECB) with terminal rate forecasts approaching 4%. The speculative frenzy witnessed since the start of 2023, indicates that equity markets are discounting the fact that the global economy has not faced such an aggressive pace of tightening in more than a decade and the ramifications, although lagged, will eventually be felt across risk assets.
Preference for international vs US equities
Exchange-traded fund (ETF) flows since the start of 2023 resonate investors’ preferences to diversify their portfolios with a higher allocation to international markets versus the US. Since the start of 2023, international equity market ETFs have received the lion’s share of inflows, amounting to US$20.6bn in sharp contrast to US equity ETFs that suffered US$9.3bn in outflows.
Looking back over the past decade, US companies outpaced international stocks owing to two main drivers of equity price appreciation: earnings and valuation. Earnings remain the key driver for equity markets over the long term. If we try to think about what lies ahead, we can see that earnings revision estimates are displaying a marked turnaround for China, Japan, and Emerging Markets (EM), whilst the US and Europe are poised to see further earnings contractions.
China’s recovery remains the important swing factor that could enable its economy, alongside EM and Japan, to outperform global equities in 2023. At 8% of sales, Europe has the second highest exposure after Asia-Pacific (ex-Japan) to China. Yet it’s important to bear in mind that European companies earn twice the amount of revenue from the US than from China. So, a soft landing in the US will be vital for Europe to continue its cyclical rally.
US valuations remain high vs international developed and EM equities
US equity market valuations from a price-to-earnings (P/E) ratio remain high globally, whilst Japan continues to trade at a steep 29% discount to its 15-year average. Amidst the recent rally, European valuations at a 13.7x P/E ratio remain at a 14% discount to its 15-year average. That being said, three months ago European equity valuations were trading at a 35% discount to its 15-year average. After travelling half the distance to their long-term average, European valuations might have to contend with the headwinds of tighter monetary policy.
Evident from the chart above, international markets ex-US continue to boast of favourable valuations allowing for a higher margin of safety, which is why we expect investor positioning to tilt in favour of international markets ex-US over the course of 2023.
The battle between Energy and Technology stocks
The Energy sector is coming off a strong year, as tight supplies and rising demand drove energy prices higher in 2022. While these dynamics have failed to play out so far in 2023, owing to the speculative frenzy in riskier parts of the market, we expect earnings results for energy companies, and their stock performance across the spectrum (including oil, gas, refining and services), to maintain momentum in 2023. Whilst investment in oil and gas production has been rising, it will still take multiple years for global supply to meet demand, which continues to support the narrative of higher energy prices.
Refining capacity continues to look tight this year, given the reduced capacity and long lead time required to bring new capacity online. We expect this to support another strong year for the profitability of refining operators. At the same time, energy service companies should also benefit as spending on exploration and production continues to gather steam. The biggest risk to the sector remains if demand for energy falters in the face of a severe recession. However, as we expect most economies to face a modest recession, this risk is less likely for the Energy sector.
Meanwhile, higher interest rates were the key driver of the underperformance of the Technology sector last year. We continue to see weakness in the Technology sector amidst rising risks of peak globalisation, weaker earnings, and the potential for more regulation. Despite the recent layoff announcements by technology firms, they still appear inflated, with employee growth in recent years 20% too high relative to real sales growth. The COVID-19 pandemic had accelerated the demand in software and technology spending with the rise of remote work and social distancing. However, companies today are more likely to cut their technology spending to offset the higher costs of energy, travel, wages, and other factors. The key risk, in our view, remains that valuations have come down, and if rates do begin to peak, selective technology companies could benefit from the growth generated by their cost-cutting initiatives.
Value vs Growth in 2023
Value stocks tend to be positively correlated with higher inflation. In 2022, high inflation was a result of rising commodity prices, labour shortages, and fiscal stimulus provided by Western economies, whilst Growth stocks were penalised for their lofty valuations. Value-based stocks flourished on commodity supply constraints and cheaper valuations amidst a rising rate environment. Much of this is now priced into Value stocks. Most Value stocks’ earnings growth and valuation re-ratings rely on higher commodity prices or interest rates or a factor outside of their control. Owing to this, we still believe there are opportunities where constrained supply in the absence of falling demand will continue to support higher prices.
There are significant prospects in Europe and Asia where discounts remain wide and sizeable valuation gaps exist across sectors. Europe’s energy sector accounted for two-thirds of Europe’s EPS (earnings per share) growth in 2022. The continuing trend of capital discipline, resilient earnings, and high shareholder returns should keep attracting flows into the sector in 2023. We expect Value stocks to be in better shape to withstand the global economic slowdown. Historically, the Value factor has demonstrated resilience during periods of interest rate volatility.
Conclusion
There is considerable uncertainty about how 2023 will unfold. As the key focus moves from inflation to a recession in 2023, it opens up the possibility of several outcomes for central banks and interest rates. Keeping this in mind, 2023 may well be a tale of two halves, with higher interest rates in the first half, followed by lower rates in the second half as a global recession takes centre stage.
Equity outlook Restrictive policy and geopolitical risks raise the odds of a global recession
What a difference a year makes. 2022 saw the ‘reopening’ of markets from the COVID pandemic evolve into a ‘recession’. Margaret Thatcher put it succinctly on 27 February 1981 – “The lesson is clear. Inflation devalues us all.” Monetary policy has been on the most pronounced tightening campaign in decades as inflation progressed from being transitory to potentially permanent due to the energy crisis.
Politics is driving economics, not the other way around
In the pre-war global economy, globalisation was an important source of low inflation. A large amount of global savings had nowhere to be deployed, rendering interest rates lower on a global basis. However, post-war, global defence spending has risen to a level not seen in decades as national security consumes government’s agendas. There will be vast opportunity costs involved, tied to the increase in world military spending. We expect the rate of globalisation to take a back seat, as Europe would never want to be as dependent on Russian energy as it is today. In a similar vein, the US does not want to fall privy to the same mistake Europe made and will aim to strengthen ties with Taiwan in order to ensure the smooth flow of chips.
National security is inflationary
We are in the midst of a war in Europe, owing to the brutal battle being waged by Russia in Ukraine. While the war is centred in Ukraine, the reality is we are all paying the price of this war by allowing it to continue. There is another war brewing in the background that we must not fail to ignore. The United States’ deepening ties with Taiwan is aggravating China.
The Taiwan issue remains sticky. Taiwan’s role in the world economy largely existed below the radar, until it came to prominence as the semiconductor supply chain was impacted by disruptions to Taiwanese chip manufacturing. Companies in Taiwan were responsible for more than 60 percent of revenue generated by the world’s semiconductor contract manufacturers in 20201. Tensions between Taiwan and China could have a big impact on global semiconductor supply chains. The United States’ dependence on Taiwanese chip firms heightens its motivation to defend Taiwan from a Chinese attack. The desire for control of technologies, commodities, and straits is paving the way for economic wars ahead.
China needs to get its house in order
The economic headwinds that China faces are multifaceted. Unfortunately, policy easing from China in H1 2022 has been insufficient to arrest the extent of the slowdown. Of late, China’s State Council stepped up its economic stimulus further by announcing a 19-point stimulus package worth $146 billion (under 1% of GDP) to boost economic growth2.
The property markets continue to deteriorate. The problem stems from a lack of financing among many developers that is needed for construction of their residential projects. All of this came about from the central government’s decision in 2020 to introduce the ‘three red lines’ policy to rein in excessive borrowing in the real estate sector. Vulnerable property developers are struggling to secure capital to sustain their businesses. Alongside, demand for housing has deteriorated due to intermittent COVID lockdowns, weakening economy, and doubts over developers’ ability to deliver completed housing units.
However, the weakness in China’s economy extends beyond the property sector with rising unemployment and energy shortages. Chinese earnings growth since Q3 2019 has lagged the rest of the world. China has also suffered significant capital outflows, owing to its adherence to COVID-zero. This has set back its rebalancing towards a consumption-driven economy, rendering China to remain more addicted to export-led growth. However, export demand has begun to weaken as the rest of the world slows.
US is in the early innings of a recession
The US economy appears a safe haven amidst the ongoing energy crisis as it is less exposed to the vagaries of Russian oil supply. It also recovered faster from the pandemic compared to the rest of the world. The labour market remains strong as jobs continue to be added, wages accelerate, consumption has continued to grow (albeit more slowly), and unemployment remains at a five-decade low. Despite the recent upswing in GDP growth, caused by noise in the foreign trade numbers and technicalities in inventory data, the big picture of a slowing economy in the face of aggressive monetary tightening remains intact. There are mounting signs of slowing too, especially in the housing sector owing to the rapid rise in mortgage rates.
Earnings in 2022 have reflected the challenging environment being faced by US corporates with earnings growth for companies grinding down to 3.17%3.The more value-oriented sectors such as energy, industrials, and materials continue to outperform. Looking ahead, earnings revision breadth for the S&P 500 Index are in deeply negative territory suggesting downside is coming from an earnings growth standpoint.
Core inflationary pressures remain concerning, especially housing rents and medical inflation – components that are typically much stickier compared to goods and transport inflation. The stickier high services inflation reflects strong labour market dynamics as services are labour intensive and housed domestically. The Federal Reserve (Fed) appears unwilling to declare victory in its war against inflation. As we look ahead, it’s clear that the Fed’s role in quelling inflation without tipping the economy into recession will take centre stage.
Harsh winter ahead for Europe
Europe is heading for a recession in response to a strong external shock. Gas flows from Russia to Europe have declined substantially to 10% of their levels in 2021, causing gas prices to spike. The Russian war in Ukraine is showing no signs of abating, with Russia deciding on a partial mobilisation after a rather successful Ukrainian counter-offensive. These higher energy prices are squeezing real disposable income out of consumers and raising costs higher for corporates, causing further curtailment of output. The energy driven surge in headline inflation to 10.7% year on year4 has sent consumer confidence to a record low, leaving Europe in a bind.
Fiscal policy in focus
The European Union (EU) aims to define the direction and speed of Europe’s energy policy restructuring through REPowerEU strategy. However, crucial energy policy decisions have been taken by EU countries at national level. In an effort to shield European consumers from rising energy costs, EU governments have ear marked €573 billion, of which €264 billion has been set aside by Germany alone. In most European countries, both energy regulation and levies are set at the national level. The chart below illustrates the funding allocated by selected EU countries to shield households and firms from rising energy prices and their consequences on the cost of living.
No pivot yet from the ECB
We experienced a decade of almost no inflation and quantitative easing in Europe. We have now entered a phase in which the European Central Bank (ECB) has gone ahead with its third major policy rate5 increase in a row this year, thereby making substantial progress in withdrawing monetary policy accommodation. The ECB remains eager to have policy choices dominated by risks, rather than the base case, owing to which more rate hikes are coming. If Eurozone inflation continues surprising to the upside, the ECB will have to continue raising rates and determine when to activate the Transmission Protection Instrument (TPI) to support the periphery. We expect the ECB to take the deposit rate to 2.5% by March, as it continues to see risks to inflation tilted to the upside both in the short and long term.
A tightening cycle into a slower-growth macro landscape has never been helpful for equities. European equities are faced with an extremely challenging backdrop ranging from high energy prices, growing cost pressures, negative earnings revisions estimates, and cooling growth. Amid the sell-off in equity markets in the first half of this year, European equities currently trade at a price-to-earnings ratio of 14.3x, marking the steepest discount versus its long-term average of 21x compared to other major markets. The risk of a recession to a certain degree is being priced into European equity markets.
Conclusion
In our view, the global economy is projected to avoid a full-blown downturn; however, we expect to see a series of individual country recessions take shape at different points in time. Evident from recent data, the downturn in the US is expected in the second half of 2023 whilst the Eurozone and United Kingdom will enter a recession by Q4 this year. Contrary to the rest of the world’s key central banks, China and Japan are expected to keep monetary policy accommodative which should help buffer some of the slowdown. Given the highly uncertain environment, investors may look to consider US and Chinese equities, whilst potentially reducing weighting towards European equities. Across factors, we continue to tilt to the value, dividend, and quality factors given the expectations for weak economic growth, higher rates, and elevated inflation.
