Investors looking for alternatives to standard strategies could do well to consider allocating active exposure to currencies, says Paul Lambert, portfolio manager with Insight Investment. He notes that investing in currency strategies can help diversify portfolio returns while also offering a potential hedge against periods of volatility.
On the question of diversification, Lambert points out how Insight’s currency strategy has tended to generate an income stream that does not correlate with equity returns, bond returns, or emerging market returns in either bonds or equities. The same can be said for the strategy’s returns versus other macro funds or indeed the returns of most currency indices.
Significantly—and unlike other strategies that offer diversification benefits—it also manages to achieve this while not “locking in” investors over the long term.
Says Lambert, “Other approaches, such as private equity or real estate, tend to be illiquid. Generally, this isn’t the case for currency. The beauty of currency—especially if you avoid the more niche areas of the market—is how freely it’s traded. Even in periods of heightened duress, we’re able to rapidly open and close positions in response to events. In that sense it’s fairly unique in offering both very good liquidity and a lack of correlation with other asset classes.”
The lack of correlation with other markets goes further, however. In Lambert’s words, “As a currency manager we don’t really care which direction markets are traveling—whether equities are rallying or bonds are falling, for instance. Because currency is always a long/short strategy, it tends to have very limited directional bias versus other asset classes.”
THE VOLATILITY RESPONSE
In addition to diversification and liquidity characteristics, currency investing can also offer a hedge against wider market volatility. This is potentially the case in the current economic climate where Lambert notes there has been a “growth wobble” accompanied by spikes of volatility in recent months as some of the more positive trends—such as increased corporate profits—begin to retreat. Investors are now worried that central banks have “run out of ammunition” to boost growth, but they are also concerned about deflation as oil prices and other commodities continue to slump in response to oversupply.
One of the root causes for this current lack of confidence, according to Lambert, is the lackluster pace of the recovery, which is weaker than post-recession recoveries in 1957, 1973, 1980, 1990, 2001 and 2007 (see chart below). Taking an analogy from physics, he notes how Hooke’s Law would suggest an equal and opposite reaction for any downturn: that the bigger the recession, the bigger the bounceback. “But with this recovery that’s not been the case,” he says. “This time something’s different.”
While this may be a concern for equity and bond investors, the increased volatility accompanying investor uncertainty can actually be helpful for a currency strategy, says Lambert. “For us,” he says, “volatility is not the enemy. If anything, it actually widens the range of opportunities to express views on developments in the wider world. Currency strategies can offer a simple and transparent way of gaining a broad exposure to global markets—but without the need to invest directly in the underlying assets. It has historically worked well during periods of increased volatility and as such we believe it could be beneficial in hedging against future market turmoil.”
INVESTING IN THE REAL WORLD
But how does investing in currencies work in practice? Currencies are affected by a vast array of factors ranging from the economic cycle, to central bank policy, to commodity prices to business confidence. By investing in currency pairs, a manager can take a specific view of how they expect these wider political or economic trends to play out in real life.
If one has a particular view on oil, for example, a potential strategy may be to go long or short on the Russian ruble, the Canadian dollar, the Mexican peso or the Norwegian krone, all of which are correlated to changes in the price of crude. In metals and mining, the Australian dollar or the Chilean peso might offer a proxy for changes in supply and demand and pricing for coal and iron or copper, respectively. In soft commodities, the New Zealand dollar can act as a proxy for dairy pricing, while the South African rand often mirrors changes in precious metals pricing, particularly platinum. More generally, a “risk-off” environment can benefit “established” currencies such as the U.S. dollar, the euro and the Japanese yen versus other currencies.
Says Lambert, “In emerging markets, for example, we saw a fairly broad currency sell-off in 2015 because of the slowdown in China and the knock-on effect this had on commodity-producing countries. Elsewhere, the actions of central banks and their influence on interest rate cycles often offer huge scope to express a view through currency trades.”
This was the case in the latter half of 2015, for example, when the Federal Reserve’s decision to raise interest rates contrasted with generally looser policy in the rest of the world and in Europe in particular. Lambert says, “We believed expectations of a Fed rate rise would push the dollar higher versus the euro.” As such, he believed there was opportunity to short the European currency versus the dollar.
Economic data from the U.S. has recently been firmer than that of its main trading partners, having suffered a setback over the first quarter. It seems policy divergence is once again back on the agenda and dollar strength is likely to prove to be an increasingly important theme over the year ahead while the rest of the world is still beset by economic headwinds. However, caution is appropriate. While the Fed is currently expected to hike rates this summer in response to stronger data, any stumble will produce strong countertrends and the narrative will change once again. Lambert believes that investors are adapting to potential changes to central bank policy dynamics. “Market expectations have been reset and we are likely to see trading in ranges punctuated by breakouts,” he says.
Looking forward, Lambert believes this means other currency crosses and pairs may prove far more compelling in the near term. He concludes, “The recent bounce in commodity markets and an improvement in sentiment towards emerging market assets puts commodity-linked and EM currencies back in the spotlight.”