Seeking to enhance diversification? Time to explore currency strategies

The Who: Unlike traditional asset classes (bonds and equities), FX markets are dominated by liquidity seekers (corporates, banks, among others), not by profit seekers. Trading in currency occurs electronically over-the-counter (OTC) 24 hours a day via a global network of dealers comprised of major international banks. The FX market is truly global, with major financial centres being the United Kingdom, the United States, Singapore, Hong Kong SAR and Japan. With the rise in EM currency trading, Asian markets are developing a more relevant role, with their combined market share rising (21% in 2016 vs 15% in 2013).

1. Portfolio with currency exposure: In this first case, a portfolio has a FX exposure. This is the case in which there are assets in the portfolio in currencies that differ from the base currency of the portfolio (ie, a EUR-based portfolio invested in US Treasuries). It can be a small and exceptional position or a vast range of investments in foreign currencies, which is mainly the case when we look at global bond, equity or emerging market portfolios with investments in local foreign currencies. In this case, there is a given currency exposure already in the portfolio which makes an important contribution to the performance and to the risk in the portfolio. Anything in a portfolio that influences risk and performance has to be known, evaluated, monitored and, most importantly, managed. There is a large range of possible ways via which this currency exposure can be managed, from a complete hedging of the risk to using fully active currency management. The approach and the style of currency management has to be chosen according to the investor’s goal and risk preference. There is no one-size-fits-all solution. For example, in a global bond portfolio, the predefined FX exposure has a significant impact on the overall portfolio performance and therefore becomes a vital part of the management. The active positioning in currencies away from the given benchmark weights represents an additional source of risk and performance just like active positions in credit and duration risk. Depending on the particular correlation, FX positions can reduce, stabilise or increase the overall risk of a portfolio.

2.Portfolio with no currency exposure in search of an alpha⁶ currency overlay: The second situation is that a portfolio that has no predefined currency risk and no original investment in foreign currency assets, but the investor is interested in actively including  currency positions for performance enhancement, diversification or risk management purposes. In fact, as currency trading involves no credit or liquidity risk (at least in the most liquid currencies), with low transactions costs, and is, by nature, a relative trade (one currency vs another), it can be an attractive way to target returns that have a low correlation with other assets, such as equities, bonds, credit and commodities.

As the main drivers of currency moves change often and sometimes rapidly in FX markets, we believe that flexibility and diversification are very important. There is no single strategy available in the FX market that will allow a manager to produce systematically superior risk-adjusted returns. To achieve this, we believe it is important to use both judgmental and quantitative techniques by blending different currency strategies. The four major investment strategies to consider are, in our view: Fundamental, Trend, Carry and Options. They are based on the combination of a fundamentally driven macro approach, which is a judgmental and opportunistic approach (for Fundamental and Options strategies) and quantitative techniques (for the Trends and Carry Strategies).

Fundamental:

The fundamental approach is based on the analysis of the main factors thatcould drive fundamental divergences between currencies, such as capital flows, economic and political environments, monetary and fiscal policies, and current and capital account.
These strategic factors are tactically influenced by market risk on/ risk off behavior: for example some currencies, like the JPY of the CHF – tend to appreciate in times of higher volatility and risk-off moves, therefore creating short-term divergences in currency valuations which offer arbitrage opportunities.

Options:

Options are another source of potential returns in the FX market that allow investors to take views on currency volatility or the direction of a currency pair with a different risk profile compared to an outright position. Options are also useful risk management tools that can be used to hedge overall portfolio risk.

Carry model:

The carry trade is defined as selling low-yielding currencies and buying higheryielding currencies. This strategy can offer opportunities, but it requires serious monitoring of the fundamental risk of each country in order to be able to close a position in case of a sharp deterioration of country risk.

Trend Model:

The trend strategy exploits the momentum in the currency market, where it buys/sells currency pairs when momentum moves in a strong direction. Based on historical price data, this quantitative model can help to capture behavioral factors driving decisions to
buy and sell a currency and identify new trends or confirm existing ones in exchange rate movements. Trend-following strategies are ultimately self-fulfilling: if enough investors follow a strategy, it is likely to move the market.

All in all, we think that when investing in currencies, the main focus should be less on the forecasts regarding a specific currency and more on the search for the most appealing investment ideas based on their risk/return profiles and their risk contribution to the overall portfolio in order to build a well-diversified portfolio that can seek stable returns over time.

USD

The medium term outlook is negative for the US dollar. Given the currency’s strong appreciation in 2014-2016, a correction was expected. We would also note that the economic cycle in the US is more mature than in other developed economies, a situation that historically has coincided with a weaker currency. Moreover, other elements could exert downward pressure on the US dollar, such as a potentially continuing flattening curve in the US (which would make the US Treasuries less attractive for investment on a hedged basis) and US fiscal stimulus. Investors appear to be particularly concerned about the impact of the large fiscal package so late in the US cycle, which could lead to increasing inflationary pressures (weighing on the valuation of the currency) and a deterioration in the current US fiscal deficit. With regards to the recent US dollar rebound, we interpret this move as mostly driven by technical aspects and risk sentiment. Given the extreme short positioning of investors on the USD, a catalyst such as the recent disappointments on Eurozone’s macro data can give the USD price momentum. The diminished market’s concern on geopolitical threats like the situation in North Korea and the risks of a trade war between US and China have also supported the resurgence of investor’s sentiment towards the dollar. Uncertainty surrounding the Italian political crisis has contributed to weaken the EUR and favor the USD. However, we believe the trend on the USD for the medium term is still a downward one, as we expect to see better data in the Eurozone (and the other major economies) and the comeback to a more hawkish rhetoric from ECB and the major CB.

EMFX

The global backdrop supporting appreciation in EM FX remained in place at beginning of 2018. A strong global trade rebound, global rates rising in line with market expectations, positive growth surprises from China, and a weak USD, among other factor helped EM FX. However, these tailwinds for EM FX have started to fade, due to USD strength and Treasury yield bonds on the rise. We have a more ‘cautious’ view on EM FX overall as an asset class, although we believe there is still room for selective opportunities in EM currencies based on our assessment discussed below. It is important to highlight, country differentiation within EM is becoming more relevant as global liquidity peaks and volatility increases. We expect USD to remain generally weak, but don’t forecast further incremental weakness to the extent seen at the beginning of 2017. EM-DM growth differentials should increase marginally or flatten going forward through 2018 as an acceleration in global growth is shifting from China to DM/other EM. Incremental EM export volumes appear to be cooling after extremely strong growth in 1Q17 (base effect). We do not expect a significant rally in commodity prices to drive EM FX in 2H18. This is a key component to capital flows into EM. The differences between local and DM rates are expected to narrow, marginally supporting hard currencies. From the perspectives of EM CB, we expect less of an ‘easing’ bias in 2018. Based on our assessment, EM rates for 2018 should be determined mostly by output gaps, not by inflation gaps, as inflation in most EM (except Turkey) should stay within CB targets. In addition, we expect EM CB to continue to accumulate FX reserves at least to pre-taper levels as EM inflation should remain (broadly) low and within CB targets. Risks from rising US rates are a key trigger for an EM FX selloff, and the busy political calendars in many EM will continue to add more volatility in 2018.

Lastly, uncertainty regarding US ‘protectionist’ measures and the application of higher US tariffs should be seen as negative for the USD, as protectionism is generally associated with a weaker USD. However, if we were to see substantial declines in US equity markets and if global trade were to experience a significantly negative impact, then the USD might actually benefit on risk-off trades vs other currencies, including those of EM.

However, the latest developments suggested that China is working in multiple directions to push for a deal with US to avoid serious escalations. In any case, we think it is unlikely for China to use large depreciation of its currency as a tool of retaliation, as it would threaten China’s own financial stability, with potential global impacts to hurt China’s bargaining power, while RMB internationalization to suffer. China does not want to damage its reputation as an attractive place for portfolio investment, particularly after it was included in new benchmark indexes. The impact on the rest of EM is dependent on their integration of supply chains with China and the extent of their exports of technology products. However, Asian currencies in particular would be impacted by any significant depreciation in China’s currency. Hence, the trade issues is likely to increase EM FX volatility in next few months without significant depreciation.