A strengthening dollar will keep the smart money home

It was back in April that I wrote about how different national strategies in response to the financial crisis and recession might lead to increasing currency risk and advocated further investigation in to the potential benefits of introducing a currency hedging strategy. Four months on, we have seen a rally in equity markets of over 20%, the VIX has dropped by more than 30% to below 25, and forecast variance in developed markets has more than halved. There is a slowdown in the rate of increase in unemployment, people are talking about better than expected sales, and there seems to be a general belief that we are at the beginning of the end, as it were.


So how has all of this movement affected the distribution of risk in global equity portfolios? Consider the contribution of the three major areas of global risk and how they contribute to the overall risk of the MSCI World Index from the perspective of a USD-denominated investor. I have used the R-Squared Global Risk Model for this analysis; results are similar when generated using Barra and Northfield.

We can see from the chart above that the last 12 months have seen Currency Risk contribution increase far beyond that generated through Sector Risk, i.e., it is now more important to get your portfolios currency exposure right than to worry about your sector allocations.

Now consider the movements in the currency markets: the U.S. dollar has deteriorated ~7% against a trade-weighted basket of major currencies (source: JPMorgan & Co) with the Canadian Dollar (+13.4%) and sterling GBP (+7.6%) being the relative gainers. These are not small movements, and considering the above chart, the potential for a large correction is very real.

I therefore built a Stress Test looking at a 5% recovery in the Dollar and compared the impact on the S&P500 to the MSCI World. With the U.S. leading the world in consumption, it is not too surprising to see that the recovery of the dollar would be bad for equity markets in general, but it is interesting to see that the impact on the S&P500 is less than the MSCI World overall.

The overweighting of the S&P500 in Information Technology would have a negative relative effect with the strong Dollar affecting the returns of large exporters such as IBM, Apple, Microsoft, etc. The relative underweighting of the S&P 500 in Financial stocks (e.g., 14.9% vs FTSE 100 >21%) where through globalisation most have a large exposure to the U.S. (e.g., HSBC and Barclays), would generate a positive return, as would the Materials sector where the low exposure to commodities (all priced in USD) is a boon (i.e., no exposure to BHP Billiton, Rio Tinto, etc.)

Therefore, if the models are telling us that equity risk is predominantly a currency call and a strengthening in the dollar negatively impacts the S&P less than the rest of the world, then if I were a U.S. investor, there'd be no place like home.

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