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You can hedge but not hide

The devaluation of the euro is regarded by many as a one-way street: if the US is a guide, then Europe’s QE 1 will be followed by QE 2 and QE 3 and if history is a guide, the devaluation may go on for many more months. So what should we do to prepare?


PA Europe
The global currency market is in turmoil. While the dollar has appreciated against all major currencies over the past six months, the euro has done the opposite. It has lost a staggering 20% of its value against the greenback since mid-August. It seems the eurozone is following the path of Japan, which saw its currency fall in value by almost a quarter from October 2012 to May 2013 (see chart 1).
So, what do fund selectors across Europe think of this currency turbulence, and how are they responding to it? “The last time I saw this kind of volatility on the currency market was after the introduction of the euro in 1999,” says Jaap Bouma, senior portfolio manager for the Amsterdam-based wealth manager Optimix. At that time, the dollar rose 34% in value between February 1999 and October 2000 – even more than its recent gains against the euro (see chart 2).

A dollar bet

Optimix is a top-down investor with an investment horizon of approximately 1.5 years. “But this market demands more short-term views and tactical position-taking,” Bouma says. On the currency front, his company has taken on some very strong views, mainly involving a bet on a strong dollar and a weak euro. “Since December, we have increased our exposure to non-euro currency by 40%,” he says. “We have close to half of our investments in dollars, and 6% in Norwegian and Danish krone.”
Optimix bought Norwegian government debt in January, motivated partly by its currency view that the Norwegian currency (which had been hit by the oil price slump) would recover against the euro in the subsequent months.
Bouma and his colleagues were not the only ones who found an attractive proposition in the krone. alt=''Tristan Delaunay, CEO of Athymis Gestion in Paris, had exposure to a Norwegian high-yield bond fund, which he sold when the oil price rout started. “But I decided to keep the krone, waiting for a rebound of the issuers and because I liked the currency,” he says. Their bet has paid off so far: since mid-January, the krone has all but recovered its earlier losses.

The view from Switzerland

While eurozone investors are seeing an attractive return potential in diversifying their currency exposure, investors with other base currencies approach the issue of a weak euro from a very different angle. The currency which has shot up the most against the euro this year is the Swiss franc. The unexpected decision by the Swiss central bank (SNB) in January to drop its currency ceiling of CHF1.20 per euro inflicted significant losses for Swiss investors who had not hedged their currency exposure.
Omar Gadsby, head of fixed incomefund selection for Credit Suisse’s private banking arm, says his
bank never took the currency ceiling for granted. “Our clients had most of their foreign bond exposure hedged to the franc [which is unusual for bond investors], so that was pretty fortunate for us,” he says. 
As a Switzerland-based investor, Gadsby (pictured right) was at the receiving end of the euro alt=''devaluation. But he takes a remarkably similar stance to eurozone investors Bouma and Delaunay, seeing it mainly as an opportunity. “Currency is a very interesting asset class at the moment, as we have seen significant overshooting in exchange rates,” he says.
“We are on a very strong dollar path now, indeed the strongest we have seen since 1999.” From a currency perspective, Swiss bond investors are in a sweet spot now. “We are in a unique environment, as the negative interest rates introduced by the SNB in January should depreciate the franc versus the dollar in the next six months. So we are recommending our clients now invest in a defensive dollar asset such as shortterm corporate bonds unhedged, so they have exposure to the dollar,” Gadsby explains.
However, to mitigate the strengthening of the franc, the SNB has introduced negative interest rates, complicating longer-term return prospects. “Swiss bond investors need to be particularly innovative in the current environment,” he says.
When we spoke to Omar in the first half of February, the Swiss franc traded at CHF0.92 to the dollar.
“We’ll see franc and the dollar at close to parity in six months, so that would be an 8% return, a great tactical bet,” he said back then. Now he is already halfway towards his aim, as the franc-dollar exchange rate stands at CHF0.96.
On a more general note, Gadsby believes the present volatility on the currency market makes active currency management indispensable for bond managers. “When I select my bond funds, I score them higher if they generate alpha from active currency management,” he says. “Funds that succeed in this are likely to achieve above average returns. Currency will be a major driver of returns in 2015, and currency overlay [outsourcing currency management to a specialist manager] will be an important contributor to bond fund performance.”

No gambling

While active currency management certainly offers attractive return potential for macro investors who do not shy away from taking on some extra currency risk, it is probably fair to say that the majority of European investors do not make currency bets. We asked the delegates at EIE’s event in Brussels in January whether they had recently been changing their allocation to the euro. Even though the currency had depreciated more than 10% versus the dollar in the six weeks prior to the event, 80% of delegates said this had not triggered them to change their currency exposure.
Tanja Wennonen-Kärnä (pictured right), a senior portfolio manager for Evli Bank in Helsinki, is one of those investors who prefers to stay clear of becoming embroiled in active currency allocation. The main reason for that is that most of her bank’s clients are very conservative, and have at least 50% of their assets invested in bonds. “We don’t want any currency risk in our bond portfolios, so we do not have a lot of exposure to non-eurozone assets,” she says.[image_library_tag c88b4e08-b7b4-44b7-bb57-b1e8d781378b 175×175 ” style=”width: 175px; height: 175px; float: right; margin: 10px;” title=”Wennonen-Karna,-Tanja_0314.jpg” ]
Her only exposure to foreign currency is in US equities, where she recently went underweight due to the high valuations of the asset class, and a little bit in emerging market stocks. Hedged share classes, which can be used to wipe out every possible currency risk, are not Wennonen- Kärnä’s cup of tea either though. “We invest in foreign currency because of the underlying investments, not because we have a view on the currency. There are so many factors influencing currencies anyway, it’s impossible to predict which way they will go in the short term.”

Base currency risk

Euro weakness might discourage conservative investors to take positions in other currencies, as they
feel they will meet their investment goals without having to take on additional currency risk.
However, many of these investors underestimate the consequences a weak base currency can have on their overall purchasing power, according to Tim Peeters, head of securities portfolios for Portolani in Belgium. “In the past, it was usually foreign currencies that were volatile and posed a threat to our returns because they were devaluating against our base currency,” he says. “But this is quickly changing and it’s the base currency [the euro] that is losing value because of the actions of the ECB.”
People who keep avoiding exposure to foreign currency therefore risk to lose purchasing power (see the interview with Peeters on page 7 and 8). One may or may not believe in the merits of active currency management, but history has shown that once currency volatility has taken off, it will probably take a while for markets to settle. There may be good reasons to be wary of taking an active position in this famously unpredictable area, but one thing is for certain: one way or another, currency matters.