Challenging conventional investor wisdom
As we approach what is potentially the end of the current economic cycle, we assess whether 'safe haven' currencies really do protect you in a downturn.
Having recently re-watched 'The Big Short', it reminded me of how dangerous it can be to rely on conventional wisdom ("It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so”). In that light, as we potentially approach the end of the current economic cycle, we are writing a series of blogs testing the veracity of some of this nous. We begin by assessing whether 'safe haven' currencies really do protect you in a downturn.
“The Japanese yen and the Swiss franc rally in times of trouble” is a statement made by many investment professionals, encouraging investors not to hedge their exposure to these currencies as it provides a tail hedge. What drives this assertion?
Current account surplus/deficit
A key reason cited for yen and franc strength is the tendency of Japan and Switzerland to have current account surpluses (e.g. they export more than they import). Nations with current account surpluses effectively act as creditors to the rest of the world, providing debt to finance investments in current account-deficit nations. In a downturn, investment levels generally fall, putting downward pressure on the currencies of nations with current account deficits. The UK tends to run a current account deficit, which is why sterling is often cited as a currency that weakens in the event of a downturn.
Nations with current account surpluses also tend to have lower interest rates than their current account deficit peers. This makes it optically very attractive to borrow money in these currencies to finance projects in other currencies. For example, the previous owners of the Gherkin tower in London borrowed at low interest rates in francs to purchase the sterling-denominated asset. While this initially worked well, the owners ran into trouble when the franc rallied against sterling during and after the global financial crisis. This forced them to put the Gherkin up for sale so they could pay back their Swiss denominated loan. This, along with other investors who had made the same trade, further exacerbated the demand for francs, putting upward pressure on the currency.
The third cited reason is that investors have bought into the previous two and therefore rush to hold safe haven currencies when there is a market downturn. Similar to Pavlov’s dogs, who salivate when the meat handlers come into the room even if they do not have meat, investor demand for so-called "safe haven" currencies increases in a downturn creating a self-fulfilling prophesy.
Does the data back the theory?
At a high level, yes! Looking in aggregate at trade weighted currency performance during the five main crises since '93 (namely the Asia crisis in 1997, the Russian default in 1998, the dot.com crisis, the global financial crisis and euro sovereign debt crisis), sterling has fallen c.10% while the Swiss franc and Japanese yen have appreciated by 55% and 86% respectively. This pattern can be quite clearly seen during the financial crisis below, where yen and Swiss franc rallied strongly and pound sterling weakened.
Time to fill your boots then?
Unfortunately the mantra of no free lunch still applies, and there are a number of reasons why this relationship wouldn’t hold. What can cause these relationships to break down?
Valuation and positioning
The poor performance of sterling during the financial crisis can give a misleading impression of the strength of the relationship between a downturn and pound weakness. One must remember at this time valuations also looked stretched (sterling was significantly overvalued to the US dollar going into the financial crisis on a relative purchasing power parity basis at $2 to the pound) creating a perfect storm for sterling when the crisis hit. The chart below shows currency moves in the dot.com bubble. In this episode, sterling was broadly flat. What stands out most is the poor performance of the yen. While still running a current account surplus, this weakness was, at least in part, driven by the 35% appreciation of the yen over the previous two years and the excessively bullish sentiment beforehand. This made a challenging environment for the currency to rally further, even as the dot.com crisis hit.
One currency that consistently breaks the rules above is the US dollar. Similar to the UK the US tends to run a current account deficit but historically the US dollar has been much more resilient to market corrections, appreciating 25% during the five main crisis since '93. A key driver of this is the US dollar status as the international reserve currency and that it purchases imports in its own currency. This status and the ‘exorbitant privilege’ it provides, gives the US dollar a similar safe haven status, despite it not having the same fundamentals as other currencies.
So what does that mean for my portfolio?
In short, currency is a useful tool in protecting against downside scenarios but is not without its risks. We advocate that investors typically should not fully hedge their overseas currency exposure (particularly if they are sterling based) as it provides both diversification benefits and hedging in tail scenarios. However it is important to remain cognisant of the wider macro-economic backdrop and currency valuations. Remember, housing market bonds had never defaulted until they did — spectacularly.