Since mid-2014, the rising U.S. dollar has been a central theme in financial markets. Economic factors, combined with central bank policies in various countries, have increased the volatility in the currency markets during this time. This volatility has in turn affected the returns on non-U.S. investments for U.S. investors. U.S. investors can choose to hedge (that is, eliminate or reduce) foreign currency exposure in order to mitigate the impact on their investment returns. In this paper, we will focus on the reasons underlying the U.S. dollar's strength, currency impact on investment returns, and whether it makes sense over the long term to hedge foreign currency exposure in planned giving portfolios.
The Recent Surge of the U.S. Dollar
Rising about 20% since the middle of 2014, the value of the U.S. dollar — measured by the dollar index — has been well documented in the news. Exchange rate movements can have a considerable impact on non-U.S. investment returns. When investors buy non-U.S. securities, they gain exposure not only to the underlying assets, but also to the underlying currency. This means that movements in exchange rates can play a significant role in determining the ultimate performance of a non-U.S. investment.
Should an investor spend time predicting whether the U.S. dollar will move up or down against the base currency of a proposed investment, hedging currency exposures?
In addition to the costs involved with hedging strategies, we should keep in mind that forecasting exchange rates can be difficult, especially in the short run, since exchange rate movements reflect complex interactions among multiple forces. Exchange rates move in the direction suggested by economic fundamentals in the long run, but during shorter periods, their behavior is often chaotic and displays greater volatility than underlying fundamental economic variables may imply.
Since 1971, the dollar has moved in a cyclical fashion, with movements that have been both sizable and persistent over the short and medium term. Figure 1 demonstrates that the U.S. dollar has been trending much closer to its long-term historical average in the last two years.
Figure 1. The Recent Surge of the U.S. Dollar
Key Factors Driving Exchange Rates
There are several key factors that impact exchange rate movements. Assessing the different factors and their combined effect can make it difficult to predict short-term exchange rate movements with sufficient accuracy. Most studies in this area find that models that work well in one period often fail in others. In the table below, we highlight five well-recognized factors that can impact exchange rates.
Given these factors, the surge of the U.S. dollar since 2014 has been the result of several key drivers, including:
- Political stability and economic performance. A country's currency reflects in part how well the economy of that country is expected to perform relative to other countries. The U.S. economy has been setting the pace with stronger gross domestic product (GDP) growth rates compared to the rest of the developed world. During 2012 and 2013, we witnessed significantly slower growth in the Eurozone compared to the U.S. mainly due to concerns about Greece. Also, from a relative standpoint, the Chinese and Japanese economies have recently faced significant slowdowns. Better U.S. growth prospects have attracted capital inflows into U.S. markets, increasing the demand for U.S. dollars, and causing the value of the dollar to surge as a result.
- Divergent central bank policies. Given the continued comparative strength of the U.S. economy and the moderate inflation expectations, many investors expect the Federal Reserve to increase interest rates over the next 12 months. Globally however, other central banks remain committed to accommodative policies promoting low interest rates to encourage economic growth. Even though rates on short-term U.S. Treasuries are at historically low levels, they are currently higher than the U.K., German and Japanese sovereign notes. Currently, the two-year U.S. Treasury yield is +0.75% compared to the U.K.'s two-year at +0.14%, Germany's two-year at -0.62% and Japan's at -0.32%. This yield differential makes dollar-denominated assets more appealing to foreign investors that buy dollars to invest in the U.S., which in turn fuels the demand for the currency.
- Current Account Balance to GDP. The energy renaissance that the U.S is experiencing has made its economy more energy-independent and less reliant on oil imports from other countries. This in turn has caused a reduction in the U.S. current account-to-GDP measure, supporting a stronger U.S. dollar.
Impact of Exchange Rates on Investment Returns
When the U.S. dollar appreciates against a currency like the euro, investments denominated in euro lose value for a dollar-based investor. This affects the investment returns of a portfolio of European securities, since the U.S. investor would have to convert into dollars any income or sales proceeds from the European securities. Since the euro has lost value, the investment proceeds would buy fewer U.S. dollars, which ultimately would reduce the overall return of the European investment for a U.S. investor. Some investors therefore decide to reduce or completely eliminate currency risk by hedging the portfolio, or entering into financial contracts that protect against undesired movements in currencies.
Given the recent strength of the U.S. dollar, it is clear that a U.S. investor in unhedged, non-U.S. equities would see surprising underperformance after conversion back to U.S. dollars. To illustrate this, Figure 2 shows a comparison of developed international equity returns (MSCI EAFE) and emerging market equity (MSCI EMF) returns for 2015. The returns are presented in both local currency terms (so prior to currency conversion, or "unhedged") and in U.S. dollars (after conversion from local currency back to dollars, or "hedged").
Figure 2. Calendar Year 2015 Return Differences
You'll notice the significant impact that U.S. dollar appreciation had on both EAFE and EMF returns. EAFE returns dropped from 5.3% to -0.8% when converted from local currency to U.S. dollars. EMF returns dropped from -5.4% to -14.6% after conversion. Therefore, in an unhedged portfolio, international security returns for U.S. investors are enhanced when the U.S. dollar weakens and are hurt when the U.S. dollar strengthens.
Based upon recent experience, it might seem compelling to hedge against foreign currency exposures in a portfolio, as that would mitigate the negative impact that a strong U.S. dollar would have on portfolio returns for international assets. However, though this strategy would have been beneficial over the last few years while the dollar has appreciated, over the long term there have been many periods of time when the U.S. dollar has moved lower against other major currencies. Trying to predict currency movements over shorter periods of time has proven to be problematic, and has also resulted in costly mistakes for many investors.
Consistently forecasting short-term currency movements with accuracy is difficult. Although currency movements can substantially impact the returns of a portfolio investing in non-U.S. securities in the short term, these movements may tend to offset each other in the long run. As a result, many investors choose not to hedge their currency risks. Given the forecasting challenges, costs involved with hedging strategies and generally shorter-duration time periods for planned giving accounts, the BNY Mellon Wealth Management Planned Giving team chooses not to hedge currency exposure in planned giving portfolios. Our investment portfolios are therefore impacted by currency movements. Historically, during periods of strong dollar performance this “unhedged" approach has created a headwind for our non-U.S. investment returns, but, in other time periods, it has been beneficial. The reason we generally do not hedge is quite simple: building portfolios based upon predictions of short-term currency movements does not serve our clients' long-term interests.