A UK investor going on holiday in continental Europe or the US now will find their purchasing power seriously eroded despite the positive inflation-adjusted sterling returns from their investment portfolio.
They will have to pay a much higher (sterling) price for foreign assets and goods, be it a baguette at a French boulangerie or a S&P 500 index tracker in their fund supermarket. In other words, a portfolio that does not hedge against base currency risk fails to protect purchasing power as far as an international portfolio of assets is concerned.
Hedging back to euros equals foregoing returns
If you have high net-worth clients who run their own business, base currency risk could be a lot greater still. If you manage the assets of a company that has more costs than revenues in a particular foreign currency, you would do well to hedge this risk by taking measured exposure to this currency.
Currency shock
The fear that euro-based investors will experience the sort of currency shock their British counterparts lived through last year is not just imaginary. Geopolitical uncertainty and untested central bank policies have introduced a new kind of volatility to currency markets.
As all major central banks have introduced various monetary stimuli, it has become even more difficult to estimate the intrinsic value of currencies. The ECB’s monetary policy stance poses a downside risk to the value of the euro over the next few years as the central bank continues to print money in large quantities.
Add to this the political dimension. If, for example, Marine Le Pen wins the French presidential elections in May, the euro will almost certainly take a plunge.
As a result, investors would do well to hedge their base currency risk and take a strategic allocation to major foreign currencies. Euro investors should have a strategic exposure of at least 10% to the dollar, add some yen and sterling and possibly some other currencies depending on their (expected) needs.
A larger tactical allocation to foreign currency is sometimes warranted. This was the case during the past couple of years, when euro-denominated investors should have added extra dollars to their portfolios as the Fed started tapering while the ECB did the inverse and started expanding its balance sheet.
For example, Tim Peeters, who co-authored this article, took a 35% tactical allocation to the dollar in 2014 and kept this in place until November 2016.
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