Hedge or Not? Dollar Volatility Renews the Question | American Funds

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Hedge or Not? Questioning Dollar Volatility

Key Takeaways

  • The dollar’s recent weakness could be the start of a multi-year currency reversal.
  • Equity exposure through currency-hedged vehicles may prove detrimental for international and global equity investors if the dollar’s weakness continues.
  • Currency-hedged strategies could subtract a meaningful portion of total return.

The dollar’s multi-year strength appears to be winding down — a warning to advisors that hedging strategies that have worked for so long could not only lose their effectiveness, but actually hurt returns the next few years.

Currency effects can make a big difference in returns, which means hedging at the wrong time can subtract significant portions of international equity returns. Recent history highlights how investors who hedge currency risk with international equities miss out on a significant boost to returns during dollar weakness. During the 2005 to 2008 period, the most recent extended period international stocks outpaced U.S. stocks, annualized currency returns reached 3.2%, which was more than a third of the total annualized return during the period, as shown in the chart below. 


 

International Equities Get an Extra Boost From a Weak Dollar

The longest periods that international stocks have outpaced U.S. stocks:

LI26-Chart1

Sources: Capital Group, MSCI, RIMES, S&P 500. Data represents rolling three-year returns in local currency of MSCI EAFE Index vs. the S&P 500 Index through 5/31/17.

Currency hedging may have been beneficial during the past few years as the dollar strengthened. But we suggest the environment has changed and not adjusting hedges could end up being costly.

 

Hedging Currency Risk Can Cap Upside Potential

With the dollar at a possible inflection point, it’s an important time to appreciate just how much of total returns during periods of international equity strength come from currency effects. Capital Group research shows how dollar hedging has been counterproductive during periods of strong results for international stocks. During the past three instances that international equities outpaced U.S. markets during an extended period of time, anywhere between 36% and 63% of annualized returns came from currency returns. This is a large portion of returns to potentially give up if the dollar continues to weaken.

“Investors risk leaving on the table a meaningful portion of total return by investing in these hedged strategies,” says Capital Group investment specialist Marc Nabi. “Historically, a significant portion of total return from international and global equity has accrued from the currency portion.”

 

What the Dollar’s Summer Move Tells Investors About the Future

Many of the factors that powered the remarkable run for the dollar — planted by years of sluggish growth and political uncertainty in Europe, deflationary pressures in Japan and weak emerging-markets economies — appear to be coming to an end.

Our research suggests this could be just the beginning of dollar weakness since past history shows currency cycles have generally lasted for five to eight years. Our currency analyst believes we are in a multi-year period of gradual dollar weakness after an extended era of dollar strength that lasted from early 2011 to late 2016. “The dollar really rallied hard in 2014, but now I am getting greater conviction that the dollar has peaked and will weaken over the next two to three years,” says Capital Group currency analyst Jens Søndergaard. “As long as the global economy picks up and the Fed is cautious about interest rate hikes, this should be conducive for international equities with greater non-U.S. revenue exposure.”

 

Factors Are Piling Up Against the Dollar

Why would the dollar weaken from here? There are several factors.

Skepticism is increasing that the new U.S. administration can make good on the agenda it initially outlined, namely loosening financial regulations, pushing through business-friendly tax cuts and rolling out a major infrastructure program. Moreover, senior U.S. officials are expressing a desire to devalue the dollar — a bluntness not seen in past administrations.

On another front, there is growing belief the global economy is in the midst of a broad-based recovery, moving in lockstep for the first time since the 2008 financial crisis. Europe finally appears to be turning the corner.

“The global economy is doing well and investor sentiment is improving, which is quite a departure from last year when everyone was worried about China, Brexit and negative interest rates,” says Capital Group portfolio manager Lisa Thompson. “It’s not just the U.S. anymore, it’s Japan, Europe and a number of emerging markets where we are seeing better economic growth, rising consumer spending and signs of higher inflation.”

 

International Equities Staging Comeback

The hedging issue aside, there are indications international stocks could again be attractive after years of underperformance. Already, a weakening dollar and a global recovery are boosting international portfolios. Both European stocks and emerging markets have generated solid returns after years of lackluster results.

There could be more upside: “The long-term devaluation of currencies such as the yen, the euro and pound against the dollar has made many European and Japanese firms more competitive relative to their U.S. counterparts. European and Japanese companies are starting to see higher dollar sales. This takes time to work through companies’ income statements, and operating leverage will vary, but as the dollar has stopped rising, this headwind is slowly turning into a tailwind and we should see this come through in earnings,” said Marc.

Furthermore, valuations overseas are appealing and becoming hard to ignore. U.S. stocks have outpaced their European counterparts for more than eight years creating a lopsided valuation. Our general strategy of investing in global companies on local exchanges — and not hedging — means that investors are positioned to take advantage of any strong local returns, while not giving up currency gains when the dollar is weakening. There may be a call for limited currency hedging in equity funds during periods of dollar strength, but in our experience currency impacts may offset each other in the long run and extensive hedging is therefore not worth the cost.


 

MSCI Europe Index vs MSCI USA Index

The longest periods that international stocks have outpaced U.S. stocks:

LI26 Chart2

Sources: MSCI, Thomson Reuters as of 5/31/17.

“If the dollar really has turned and we are in the early innings of the next eight- to 10-year dollar bear market, this could drive big, relative returns for non-U.S. equities since they are so much cheaper at current valuations,” says Paul Benjamin, an equity investment analyst at Capital Group.

Capital Group Global and International Strategies

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Investing outside the United States involves risks, such as currency fluctuations, periods of illiquidity and price volatility, as more fully described in the prospectus. These risks may be heightened in connection with investments in developing countries. 

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