What is the impact of currency on your portfolio?
By Mark Brighouse, Chief Investment Strategist
08 August, 2017
"There is no sphere of human thought in which it is easier to show superficial cleverness and the appearance of superior wisdom than in discussing questions of currency and exchange."
— Winston Churchill, House of Commons, 1949
Winston Churchill was ready to acknowledge that while many people will be prepared to offer views on the direction of exchange rates, in reality, very few will have superior views on the future of something that is so notoriously hard to predict.
With that in mind we prudently avoid the temptation to try and pick short term currency market moves in order to generate trading profits. Instead, we look at what currency exposure does to the risk of a portfolio and ask ourselves the most important question which is: what are the possible currency fluctuations we are comfortable with and how will the portfolio be affected?
The future revenues of companies can be very dependent on currency levels. A weaker currency boosts the revenue of exporters while making life much more difficult for importers, and vice versa. In our New Zealand portfolio, for example, a number of our companies have significant offshore operations and earnings so movements in the Kiwi dollar are very relevant.
Corporates typically protect against movements in currency in three different ways: hedging using an array of financial instruments, matching offshore assets against offshore liabilities (borrowing in the country/currency you are investing in) or by matching offshore revenues against offshore costs (shifting operating costs to the country/currency you receive your revenue in).
While the New Zealand dollar has been relatively stable against many of our trading partners over recent years (such as the Australian dollar or the euro) it has risen sharply against the British pound and US dollar.
The weakness in the British pound is related to their steps towards Brexit. After the June 2016 referendum the British pound slumped against most currencies resulting in the New Zealand dollar buying around 20% more in the UK. In the US, after some initial strength in the US dollar in the months following the Presidential election, the US dollar has weakened this year as a more realistic view has emerged of the challenges that President Trump faces in boosting growth in the US.
There isn't a clear New Zealand factor behind these exchange rate moves and in fact the outlook for low and stable interest rates here is a negative influence. For a long time the New Zealand dollar has been supported by our high interest rates. However, this attraction is fading.
We have been hedging against US dollar weakness but we believe that at current levels the risk reduction benefits are reduced. Any financial market volatility could mean share price weakness along with New Zealand dollar weakness so investors may find that some currency exposure gives a welcome offset to share price weakness.
There is potential for currencies to be volatile in future. If the polls are to be relied upon, the upcoming New Zealand election will be close and could deliver a range of outcomes. If there isn't a clear result and we see a protracted period of coalition negotiations, uncertainty may see the New Zealand dollar lose some of its recent strength and be more volatile.