Key Takeaways
- After nearly a decade, currency markets are moving again with sharp increases in interest rates occurring in many nations. As 2022 progressed, the U.S. dollar became the flight-to-quality asset of choice.
- As we head toward the end of the year, investors are experiencing a heightened level of uncertainty, especially in the global equity markets. A neutral portfolio appears to be a prudent position for the time being.
- During 2023, the U.S. dollar may give back some of its 2022 gains, driven by one of two divergent possibilities: a rising appetite for risk or a focus on a deteriorating U.S. fiscal budget and current account deficits.
Transcript
Shannon Saccocia: Hello, and welcome to the Perspectives Podcast. I'm Shannon Saccocia, Chief Investment Officer at SVB Private, and I want to thank you for joining me today. On this podcast, we are going to discuss the dollar, where we go from here and the implications for investing outside of the U.S. in this environment.
With me to dig into this topic are Ivan Asensio, Head of FX Risk Advisory for Silicon Valley Bank, and Emmett Maguire, Head of Multi-Asset Research at SVB Private. Ivan and Emmett, how about a brief introduction of your background and roles here at SVB Financial? Emmett, I'll start with you.
Emmett Maguire: Thanks, Shannon. I'd be happy to give a brief introduction. My role here at SVB focuses on the ongoing management evolution and the investment strategy that we use to build multi-asset class portfolios for private wealth clients. Essentially, which asset classes we choose to use and the decisions we make as an investment team on how to best position ourselves within those asset classes. Since the mid-2000s, I've had similar roles at large brand-name banks, as well as more innovative boutique multi-family offices, all of which served as part of the foundation for the investment advice we give today.
Shannon Saccocia: Great. Thank you, Emmett. Ivan, how about you?
Ivan Asensio: Hi. Thanks for having me. I'm a part of the FX business. I'm responsible for working with our corporate and fund banking clients managing FX risk. So, that could mean an organic solution that does not involve derivatives all the way to derivatives, use execution, and then all the value-add around that. So that could be assistance with the accounting presentation of a derivative, optimizing hedge tenor, basically, whatever it takes to help our clients achieve their business objectives and take FX out of the equation. Thanks for having me. Great to be here.
Shannon Saccocia: Great. Well, thank you so much. And thanks again to both of you for being here. Let me set the stage a little bit in terms of the context of this conversation. Coming into 2022, we were clearly concerned about the inflationary pressure that existed in the United States as well as in the rest of the global economy. We had seen significant Central Bank intervention, particularly since March of 2020, and that affected the currency markets as well as the bond and equity markets.
One of the things that we were not anticipating, perhaps, was that inflation would not peak early on in the year as we had anticipated. We were really looking for inflation to peak from the consumer perspective in the March-April timeframe with the war in Ukraine as well as the continuation of zero COVID policy in China. We saw that inflationary scenario really push out to the point where perhaps we saw peak inflation in August, but it's a little too early to tell.
As part of that, we have continued to see restrictive Central Bank policy coming from the Fed, as well as other global central banks. And as a result, we've seen significant movement in the currency markets, which has implications not only for investing in local currency, but also investing for U.S. dollar investors. And so, I'm going to turn it over to my two colleagues here to talk a little bit about what we're seeing and what we should do about this changing environment for the global currency market. Ivan, if you don't mind, I'm going to start with you. Can you just provide our listeners with a summary of what's been happening this year in the currency markets broadly with that backdrop?
Ivan Asensio: Absolutely. To start, currencies are finally moving again, right? We went through a decade basically after the global financial crisis where currency volatilities were very muted, we had interest rate compression, we had very low levels of inflation, low level of volatility of inflation. But all of that now, sparked by the outbreak of inflation, has brought a lot of increased volatility in FX markets.
We're looking at intraday ranges now of 1% to 2%, right? Before over that period, 0.5%, you know, 9% to 10% over a given quarter. And over the last 12 months, you're looking at 20%, 25% movements in currency. So, volatility's up. And then directionally, the story is, a strong dollar, a much stronger dollar, a broad-base move in the dollar that's been quite imbalanced actually.
I'd say the bull run in the dollar began sometime around the start of 2021, but it's definitely accelerated over the last 12 months. A few factors have come together to propagate the rise in the dollar. First and foremost, you have higher interest rates. But it's not just the level of interest rates, it's the speed at which interest rates have risen. You'll recall that, just 12 months ago, two-year yields in the U.S. were 0.5%, right?
Shannon Saccocia: Right.
Ivan Asensio: I look at my screen today, and we're about 4.5%. I had to look back 30, 40 years, we haven't seen a rise in interest rates that sharp and that dramatic. For currency determination, right? So, it's the level of interest rates. It's the speed at which they moved, but it's really the widening interest rate differential that truly matters. So, this year, I mentioned the move in the dollar has been imbalanced, so the dollar has risen more versus the currencies governed by central banks that have had a tougher time raising interest rates.
Of course, I'm talking about Europe, I'm talking about the UK, right, where there's still an inflation problem, which would warrant higher interest rates, but the central banks that govern those currencies have a much tougher time raising interest rates. We had energy shock in Europe which has hurt households and economy and trade in the region. The UK has just dealt with a fiscal and subsequent pension crisis. So, very difficult environment to raise interest rates there.
And then there are some countries that are nowhere near raising interest rates. And I'm talking about Japan, Switzerland, for instance. Just today, we breached the 150 level in the Yen. It's interesting for a couple of reasons. We haven't seen that level since the early '90s, but it's particularly interesting because you mentioned intervention by central banks.
Bank of Japan actually intervened a couple of weeks ago to defend 146, and here we are at 150, right? So there’s definitely a lot going on. The dollar is strongest against those currencies that it holds a sizeable yield advantage over. The other pillar that's supporting the dollar strength is risk aversion, right? So historically investors have flocked to the dollar and other safe-haven assets.
This year, however, the dollar reigns supreme as the premier flight-to-quality asset of choice, right? The Yen, the Swiss Franc, historically safe-havens, gold, crypto have all disappointed. So, this year, it's really been the dollar. And, you know, it's been an interesting year, a lot going on, but it seems that you look around the world, the dollar is one of the only assets that's up on the year, actually.
Shannon Saccocia: Well, it's so interesting that you point to this decade where we had very little currency movement. If you think about CTAs, if you think about trend-following strategies, the ability to invest in currency as an investment opportunity, really, that was taken off the table for this decade prior to the pandemic.
And then you just talk about the velocity of the changes and how much these movements are happening intraday, not only in the currency market, but we're seeing that across all capital markets, just the span of outcomes that we're dealing with on a day-to-day basis. So, I think it's really interesting, to look at the currency markets with this different light, but I think it also creates some challenges in managingin managing balance sheets, but also in managing investments.
Ivan Asensio: Absolutely. Yes. Definitely.
Shannon Saccocia: So, I'm going to switch gears a little bit. Emmett, one of the things coming into this year, we were actually very optimistic about the opportunities in international developed equities. And given that incredible backdrop that Ivan just provided, you know, how has our view changed, and how much does the dollar impact our view?
Emmett Maguire: Yeah, I mean, I think Ivan did a great job of touching on some of the near-term and recent developments in markets that have really affected how we think about those international developed equities. So, putting a little bit of a different spin on it, if you look back to the late '70s and early '80s where you see the U.S. dollar skyrocket straight upwards relative to other currencies, we also had a high-inflation environment where the Fed was aggressively raising rates to combat that inflation. International equities suffered majorly in that time period, and they tend to do so in these environments, kind of throughout history as far back as we have data for.
So, given that, we've taken steps to kind of air back our international equity exposure, neutralize our weights towards the MSCI ACWI index from a global equity perspective, and really just acknowledge that the world changed this year, right? So, the future's always uncertain, but I think the level of uncertainty out there, particularly in equity markets, is definitely heightened going into the end of the year here. So, we've neutralized our stance, and we think that's the prudent move in portfolios today.
Shannon Saccocia: And, you know, how does that differ for emerging markets? We think about current account balances, and we think about the amount of dollar-denominated debt in the emerging market space. And, you know, if you look at that from equity perspective, we've seen, historically, wide swings in the performance of emerging markets depending on different environments. So, you know, how are we looking at that as we go into next year, putting aside some of the considerations about weaker production than anticipated in China? Is there kind of a structural challenge for emerging markets that's slightly different than international developed?
Emmett Maguire: Yeah, it's a great question. And it kind of varies country by country. So, theoretically, you'd think that the countries who are exporters would benefit from this scenario where the dollar buys more of their goods. But if you look back through history, it's kind of a mixed bag. And the EM index hasn't been around as long as the international developed equity indices. But really, there's only one full period to look at. That is the spring of 2008 through year-end 2016 where EM treaded water. And on a relative basis to developed international equities and U.S. equities, it trailed a bit, not significantly.
We're currently living through the second data point, and EME is definitely behind U.S. equity by about a handful percentage points. So, it's hard to say, but we're taking the same stance. We're going to neutralize our exposure relative to MSCI ACWI with emerging market equities because it does happen to be a country-by-country phenomena. But we do partner with active managers in that particular part of the world, which we think they can take advantage of, not only company selection, but also country selection, positioning themselves to out-perform on a forward-looking basis.
Shannon Saccocia: Great. I think that's incredibly helpful. And one of the comments that I continue to hear, not only from the managers that we partner with but from our clients, is that just as developed economies are not all the same, the opportunities, prospects, and risk for different countries in emerging markets is perhaps even more divergent as they have a wide variety of constraints in terms of, are they importers of commodities, or what is the strength of their domestic economy? What is the strength of their current account?
I think that it becomes incredibly more important in this space to be able to select not only the country but also the underlying companies that have some insulation versus these more macroeconomic concerns.
Ivan, you touched on this a couple of minutes ago, but with this increased volatility, if you will, in currency, how are you looking at managing currency risk for clients? And I would say perhaps it's become a bit more challenging, but also potentially an opportunity for us to create a lot of value for clients in this environment.
Ivan Asensio: Yeah, absolutely. And it varies for us by type of client. So, there's basically three stratas that I can talk about. So, we cover tech and life science companies, many of whom by a margin of three to one actually, so it's a wide margin, that are not yet generating significant revenue overseas, which means that foreign operations have to be funded with dollars. Raising dollars – dollars go out to fund the operations.
And you mentioned opportunity. Yeah, a strong dollar actually creates a tailwind for these companies as dollars are sold for more euros, more pounds, more Pesos. And then this is extending runways. This is minimizing burn at a time, right, where, you know, the industry is faced with a tougher fundraising environment, which is, you know... it's a tailwind.
Many of these clients have looked to us for hedging solutions as a way to monetize these gains and position for the next round of funding. Now, on the flip side, we do have a strata of clients in our corporate banking division, which is made up of later-stage public companies, where, in fact, there are established overseas revenues. So a stronger dollar does present a headwind as revenues and profits are translated back to dollars or repatriated back to dollars.
They're worth less in dollar terms. Now, in the past, so pre-COVID times, these higher growth companies that we bank were able to absorb some degree of depreciation in their currencies because you have high growth, right, so you take an enterprise software company, right? That's, if you're growing at 100% and FX vol is 10%, then that's a little easier to absorb, okay?
But we are in a new environment, right? There's more focus on unit economics, more focus on reigning in cost. So we're seeing a lot of these clients come in and seek assistance with putting in on hedging strategies to protect their business results and fundamentals.
And then finally, a last strata, which is extremely important, and it overlaps with the space that you guys talk to in the investment space, which is we bank the investors, the venture and private equity funds who are invested overseas and are facing material impact to their investment returns in dollars. Of course, we can't paint them all with the same brush.
You've got venture funds that generally don't focus on hedging too much, right? Because when you're in venture, your exit is unknown. You know, whether the investment will pay off or not, that's unknown. Hedging is not big in that space. But then when we get to the private equity space, especially credit funds where visibility of cash flows is better, then, obviously, hedging is an important element of the strategy. There's some very interesting dynamics at play right now in this environment.
So, number one, because U.S. interest rates have increased versus rates in, you know, Europe, rates in Japan, then the carry, right, is favorable to sell Euro, sell Yen, and back-buy dollars. In fact, to be clear, you may not love the level of the Yen, but you get 4% to 5% of that back because selling Yen forward generates an additional boost from the carry. Number two, we've seen quite a sharp rise in looking at options as a way to get some flexibility.
So, when you're down 10%, 20% on currency, locking into forwards can be a very tough value proposition. So, we're seeing more interest and activity around options use to be able to protect future cash flows. But basically, bottom line with regard to currency in the investment space is that our clients tell us that currencies, at the end of the day, don't determine hedging decisions. In fact, you know, significant investment over the years has gone into India, for example.
You know, you go to India because India has twice as many internet users than we have people. You don't go there because you expect that strong inflows are going to subsequently turn into a rise in the rupee. In fact, you could love an investment there, but you're not going to love the rupee. The currency is a completely different animal value proposition. And you asked the question about emerging markets in general. You know, if the time horizon that we're talking about here is a three to five, six-year holding period, currencies or countries that have higher persistent inflation, right? Just not including the current bout, but I'm talking Brazil, I'm talking India, Mexico, Turkey, South Africa Indonesia, and so on, you should expect currencies to weaken over this longer period of time. Ultimately higher persistent inflation is going to hurt the relative value of a currency. And I think our investors, they appreciate the fact that you don't have to love a currency to love the investment prospects in a particular country.
Shannon Saccocia: That's a great point, and one that, I think, when we think about inflation, we are grappling with perhaps the first bout of inflation for the developed economies since the '70s, but emerging markets have certainly been dealing with their fair share of inflation for this entire period.
Ivan Ascensio: That's right.
Shannon Saccocia: So, that's a great segue, Emmett. You know, one of the things that we've been hearing a lot more about is the suggestion that we should be investing in hedged currency strategies. And how do we respond to that, especially given some of the comments that Ivan has shared?
Emmett Maguire: Yeah, it's an absolutely valid question. And there's a variety of ways to frame someone's thinking around this particular topic, but I'll focus on two major points. The first one is that it’s it's really quite difficult in practice to hedge out 100% of someone's currency exposure in a multi-asset class portfolio. Just think about companies alone or equity exposure alone, these companies increasingly compete in that global marketplace where their revenues are exposed to multiple currencies outside of the one that may be domiciled in. Second, over the long term, it tends to even out, right?
So, if you think about an asset class like international developed equities, that tends to get hurt by a rising dollar. It also benefits when the dollar struggles. And these things tend to play out over time with cycles like a lot of things in markets do. So, it's really one of the bigger reasons why we leverage multiple asset classes when we're building a portfolio for a client. That's just to increase their odds of success, achieving whatever the goal is that they have for their personal wealth, but also to smooth the ride to that end destination.
Shannon Saccocia: Great. Ivan, we just have a couple of minutes left here, and so I'd love for you to just briefly grab your crystal ball. And I know I'm asked to do this all the time, so I'm going to put you on the spot to do the same. 2023, what's your outlook for some of the major currencies that you've mentioned on this call today?
Ivan Ascensio: Yeah,. So, consensus says that the dollar should weaken back up in 2023 or give up some of the gains that we've seen over the last 12, 18 months. We discourage our clients from managing risk according to consensus. By the way, what do you think consensus said at the end of 2021 about 2022 before, right? The dollar should weaken. So, yeah, consensus is definitely very difficult to forecast what's happening.
We do know a few things, however. That a recovery next year of stock markets and risk appetite should, at a minimum, slow down the pace of dollar appreciation, right? So, one of the pillars of dollar strength that I talked about. The other pillar obviously is rate hikes, the pushing up of yields. So, reaching a terminal Fed funds rate should also slow down the dollar and the rise in the dollar. At that point, however, we're not going to be focused on, well, what is the aftermath from all the central bank activity?
You know, did we in fact engineer a successful soft landing, or do we have a hard landing and potential global recession on our hands? So, I think that we will start to focus then on growth employment and then currency determination. We'll go back to...you know, 2023 is the year of the fundamentals. So, I think we'll go back to looking at things like trade and current account deficits, overdependence on importing commodities as opposed to exporting commodities to the extent that there could be still some commodity price pressures.
And then budget deficits, that's involved. The situation that occurred in the UK, right, is that sort of a foreshadowing about something that, a way that U.S. debt can be perceived here in the U.S., right? So, potentially, that could be the case. And yeah, so I think, you know, on the margin, I think that the dollar should give up some of those gains. But whether it's going to be anchored by, again, that good news, that risk appetite is back, right, which would be a reversal of what we saw this year, or will it be focused on deteriorating fiscal budget and current account deficits? Looking at now focused on the U.S., it remains to be seen.
Shannon Saccocia: Thank you so much. And thank you to both Emmett and Ivan for joining me today, and thank you to all of you for listening in. We'll keep digging into topics that impact your financial future, so tweet me @shannonsaccocia if there's something you'd like us to cover in a future podcast.
You can also read our latest perspectives on the markets, the economy, financial planning, and perhaps where we go from here by visiting the link on this podcast page. Be sure to subscribe to "SVB Private Perspectives" on Apple Podcasts, Spotify or wherever you prefer to listen. And I look forward to coming to you again next month. Thank you.
