This year, the strong dollar has worsened international asset returns for U.S. investors. Chris discusses whether that means it makes sense to hedge currencies going forward.
"To hedge or not to hedge?" That is the question many investors are asking this year, given the dollar's rally, which has eaten away at returns of international exposures for U.S. investors who did not hedge that currency impact.
For example, the MSCI Emerging Markets Index is down around 12% this year (as of 9/11/08, according to Bloomberg). However, the MSCI Emerging Markets 100% USD Hedged Index is down less than half of this number with a -5.9% return.
In short, 2018 has underscored that currency exposure matters when investing internationally. For U.S. investors, if the dollar gets stronger, that exchange rate translates into lower returns for the international holdings. If the dollar gets weaker, the opposite occurs, boosting returns. Given that the U.S. dollar on a trade-weighted basis is up more than 5% year to date against a basket of developed and emerging markets currencies, the currency move has impacted portfolios.
For emerging markets, large currency moves this year detracted from the performance of international indexes, a sharp contrast to the persistent rally in 2017 amidst a backdrop of little volatility. The Federal Reserve's interest rate hikes in the U.S. have contributed to the tightening of global financial conditions. This, coupled with rising trade tensions, has influenced a broad unloading of emerging market currencies. Chart 1 highlights how nearly all emerging and frontier markets' currencies are down against the stronger dollar this year.
Where we go from here?
Looking ahead, the outlook for the U.S. dollar is dependent on fundamental economic growth as well geopolitical considerations. The dollar bulls continue to look for above-trend U.S. growth to support higher interest rates relative to the eurozone, Japan, and China supporting the USD. Worries over escalating trade tensions could also prompt a risk-off move and flight to quality, which would also support the USD.
On the other hand, the dollar bears point to the fact that global growth ex-U.S. is stabilizing after decelerating in the first half of the year. Stronger international growth and a rebound in risk appetite would likely push the USD lower similar to the 2017 experience.
To hedge or not to hedge
Given the sell-off in foreign currencies against the dollar, US-based investors have benefited from hedging the currency effect this year. But that doesn't mean it will going forward. When considering whether to implement a hedging strategy, it is important to keep three factors in mind.
First, foreign exchange markets are some of the most liquid markets in the world. Their responsiveness to changes in geopolitical risks, economic data, and monetary policy has tended to occur more rapidly than other asset classes. This makes currencies some of the most difficult assets to forecast, and potentially, should not be a major consideration for long-term investors.
Second, developed market currencies tend to weaken after a strong rally - i.e. "mean-revert" - in the long run, so betting on a continued multi-year move higher in the U.S. dollar may be difficult.
Third, as my colleagues in the BlackRock Investment Institute have noted, over the long run, currencies are more of a portfolio risk to manage, rather than an opportunity to boost returns. Hedging an international exposure where there is a long-term correlation between the local equity market and moves in the home country's currency can lead to long-term portfolio diversification. Although the positive correlation means that the assets move in tandem, it can be a key tool in mitigating downside risk. This is intuitive, as it diversifies the source of risk and return. Conversely, in a market with a negative equity to FX correlation, the relationship between the two assets is already diversifying.
In short, investors looking abroad need to consider the impact of currencies in the international portion of their investment portfolios across both stocks and bonds. With the rise of currency-hedged ETFs, investors now have the tools to express their view.
Funds to consider
HEEM - iShares Currency Hedged MSCI Emerging Markets ETF
HEFA - iShares Currency Hedged MSCI EAFE ETF
HEZU - iShares Currency Hedged MSCI EMU ETF
HAWX - iShares Currency Hedged MSCI ACWI ex U.S. ETF
This post originally appeared on the BlackRock Blog.