Switching our US exposure to be currency unhedged

Investing in international markets can provide diversification benefits and access to sectors not available domestically, particularly given the Australian market’s sector concentration to Financials. However, like everything in life this comes at a cost and that is the introduction of currency risk to actual returns. This is because the return enjoyed by a local Australian investor on investments made in offshore securities will include both the performance of the underlying investment (e.g. the S&P500 Index) in their local currency (in this case US dollar (US$)); and the movement of the Australian dollar (A$) relative to the foreign currency (i.e. the US$).

For an Australian investor, when the A$ strengthens against the foreign currency in which the underlying international investment is denominated, then the return on the investment will be lower when converted back to A$. Conversely, if the A$ depreciates then the return on the international investment in A$ terms will increase.

Currency movements can thus have positive or negative impacts on the local currency returns investors enjoy on international investments, so it is important to consider potential changes in foreign exchange rates.

Looking specifically at the A$ relative to the US$, at current levels the local currency is trading broadly around fair value when measured on a purchasing power parity (PPP) basis. In simple terms the PPP looks at the purchasing power of one currency compared to another, what can you buy with a particular amount of money in each country. While this measure is useful as a longer term gauge of value, in the short to medium term it is however less useful as the A$ does swing around the PPP fair value level.

Source: AMP Capital, ABS, RBA

Over time periods more relevant to most investors, the A$ has tended to be driven primarily by two factors; commodity prices and interest rates relative to the rest of the world. In recent months, the local currency has however been remarkably resilient despite narrowing yield differentials on government bonds, diverging monetary policies and falling commodity prices.

Source: IFM Investors, Bloomberg, RBA

Over the past 12 months the US Fed has been hiking official rates while the RBA has held rates steady. Should this divergence of monetary policy continue for an extended period of time then official rates will eventually ‘invert’ i.e. US rates will be higher than those in Australia. This inversion may even occur with shorter dated bond yields that tend to be sensitive to monetary policy actions.

Current positioning by FX traders in the A$ also leaves it vulnerable to a change in sentiment, especially if we experience a period of heightened risk aversion, because the majority are positioned for an increase in the local currency over the short term.

Against these risks of a lower A$, stronger global growth which typically benefits more cyclical currencies like the A$ is an upside risk, and broad-based US$ strength may turn out to be more muted than expected should the U.S. Congress and the Trump administration fail to agree on a fiscal stimulus platform.

On balance, we are of the view that the greater risk for the A$ is to the downside and hence have switched our US exposure to the iShares S&P 500 ETF (IVV), funded by the sale of the iShares S&P 500 AUD Hedged ETF (IHVV). The underlying companies invested in are the same, the only difference is that IVV is not hedged into the A$ and so performance is impacted by currency fluctuations – a weaker A$ will add to the returns of the underlying ETF and given our views this is the exposure we want for investors.

This article is written from the perspective of global economic analysis. This article does not provide any recommendation on any particular foreign exchange contracts. Elston only invests in funds denominated in A$ and does not hedge currency exposures directly. The funds we invest in manage the currency risk within the fund and describe this in their Product Disclosure Statement, a copy of which can be provided on request.

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