Developed-market currency concern taking center stage

More institutions are taking cover as uncertainty surrounding the euro is putting developed-market currency risk at center stage of global investment portfolios, including equities strategies.

“Historically, equities managers have been less focused on the currency impact to the portfolios than fixed-income managers,” said Wayne Bowers, chief executive of asset management for Europe, Middle East and Africa, and Asia-Pacific at Northern Trust Global Investments Ltd.

“It’s all about risk, and currency risks are becoming more important to clients. Recent events have shown that equities managers do actually need significant understanding of the currency impact of the underlying assets,” said Mr. Bowers, who also is chief investment officer of international markets.

“The risks of a major negative event such as a hard default or a eurozone breakup have risen,” Adam Ryan, managing director within BlackRock Inc.’s Multi-Asset Client Solutions group, wrote in an e-mail. “Whilst these events are still not our central expectation, the fact that the risks have risen means that investors have had to focus much more on their exposure to eurozone assets.”

BlackRock is underweight eurozone assets such as equities and bonds, and also is actively hedging the euro versus other currencies to further protect investments in its diversified growth strategy, for which Mr. Ryan is the lead portfolio manager.

Weakness in the euro also has affected other currencies as investors flee to safe havens such as the Swiss franc, he said.

Equity managers are putting more emphasis on the impact of currency movements on the health of companies listed in that country, including earnings expectations.

For example, the upward trajectory of the Swiss franc this month hurt Swiss companies’ earnings. To stem the rise of the franc, the Swiss central bank imposed a 1.20 euro ceiling ($1.64) on the currency. The Swiss Market Index rose 4.36% on the day of the announcement.

“For years, globalization has meant that where a company was listed wasn’t relevant,” said James Harries, director of investments for global funds at Newton Investment Management Ltd.

The firm has about 47 billion pounds ($74 billion) in assets under management, about 57% of which is in global equity strategies.

“Now the underlying sovereign balance sheet is very important. If you invested in countries like Greece or Ireland, for example, you’d be in trouble as the markets lose confidence in the sovereign debt — even if the companies themselves may be attractive otherwise,” Mr. Harries said.

“Not only do you need to find well-balanced companies, but you also need to look at the country and, therefore, the denominated currency,” said Mr. Harries, who manages Newton’s Global Equity Income Fund.

Newton has increased the percentage of the euro exposure hedged versus the dollar within the $3.5 billion global fund, but Mr. Harries declined to specify the exact portion.

UNCERTAIN DIRECTION

The problems of the euro have proved particularly puzzling because “as a potential risk, it’s difficult to predict” which direction or shape the currency could take under different scenarios, said Matthew Roberts, an investment consultant at Towers Watson & Co.

“There is no contingency plan if the euro were to fail,” he said.

Tapan Datta, senior asset allocation specialist at Aon Hewitt, said that the euro has looked quite vulnerable in the past few months, and he is advising clients to be “fairly fully hedged,” typically between 50% and 70% of the euro exposure against both the dollar and the yen.

“We’ve become more negative on the euro,” Mr. Datta said

“All options [to solve the eurozone debt crisis] look unfeasible” in the long term, he said.

At one end of the scale are continued capital injection programs, which aren’t fiscally sustainable, consultants and managers said. At the other end is the worst-case scenario: a breakup of the euro, which consultants and managers still largely rule out.

In between those extremes are solutions that hinge on a tighter fiscal and economic union, eventually leading to the introduction of eurozone bonds. Even if such a proposal could muster enough political support and technical feasibility, there is no way to ensure that stronger economies won’t end up supporting weaker eurozone nations down the line.

If a change in the treaty that created the euro is required, the process could take years — time that policymakers can’t afford, observers said.

Another option is for troubled nations such as Greece to leave the shared currency, which would strengthen the euro. Germany and other economically strong nations also could decide to break away, which would severely weaken the euro, according to consultants and managers.

“The process for leaving [the eurozone] is massively complex, so it’s not likely that a country will make a deliberate decision to exit,” Mr. Datta said. “If it happens, it would happen under very extreme circumstances.”

For U.S. pension funds, a more globalized investment portfolio comes with more currency risks, which many have largely ignored until now, said Adam C. Tosh, managing director of investment solutions at Rogerscasey LLC.

“Although the currency effect is embedded within the return of the international asset, it is rarely reported or evaluated on a stand-alone basis. Because this currency purchase is often disregarded, its intrinsic risks are ignored,” Mr. Tosh wrote in a white paper published last month.

“The trend is to invest outside of the U.S.,” Mr. Tosh said. “If the assets invested outside of the U.S. is above 20% [of the portfolio], currency movements will have a real material impact.”

Since 2002, the MSCI Europe Australasia Far East Index has increased by 48% in U.S. dollar terms. Of that, about 43% came from foreign-currency appreciation against the dollar, according to data from Record Currency Management Ltd.

As of June 30, euro-denominated equities accounted for about 32% of the EAFE index.

If the U.S. dollar rises against the euro and other major currencies, a large chunk of that gain could be wiped out, said James Wood-Collins, chief executive of Record Currency Management.

The firm has $31.4 billion in nominal assets under management, about a third of which is sourced from U.S.-based institutions mostly investing in dynamic currency-hedging strategies.

‘KEY TOPIC’

“The euro is absolutely a key topic with all our clients right now. They want to know that we’ve thought through all the issues,” Mr. Wood-Collins said.

“It’s hard to determine the impact under the different scenarios that could happen. It’s not a one-way bet,” he said.

Several managers estimated that the euro already is overvalued compared with the U.S. dollar by as much as 20%.

“The [European Central Bank] is purchasing bonds in the market, which monetizes debt and puts more pressure on the euro,” said Francois Buclez, chief executive of Cube Capital U.K. Ltd.

The hedge fund of funds has about $1.2 billion in assets under management.

Mr. Buclez, whose firm runs an active overlay to boost returns on top of the underlying portfolio, said that Cube Capital has been running a tactical short euro position for a few months.

In addition to appearing overvalued versus other currencies, the euro’s downside risk also increases with the prospect that the ECB will lower interest rates if anemic growth continues in the eurozone, managers said.

“It’s not entirely clear which way the euro is heading,” Mr. Harries said. “It’s more likely to be weak than strong.”

Thao Hua is a reporter at sister publication Pensions & Investments.

Related Topics: ING Group