PMC Weekly Review - January 20, 2017

A Macro View – Handling Currency Hedging in International Equity Investing in 2017

Over the past three years, international equity not only trailed US equity by significant margins, but registered a negative total return. From 12/31/2013 to 12/31/2016, the MSCI EAFE Index (the proxy for international equity), had a total return of -3.1% versus +29.0% for the S&P 500 Index (the proxy for US equity), a whopping 3,200 basis points of underperformance. Most of the underperformance can be attributed to the strong dollar, which jumped more than 27% during the past three years versus the world’s other major currencies, as measured by the dollar index (DXY). For investors with a contrarian mindset, 2017 may be a good time to take a stab at international equity. However, it is important to handle the currency hedge appropriately and treat the various regions/countries differently.

The Eurozone is the largest common currency region/country in the MSCI EAFE Index, with approximately 32% of the index weighting. Although the common currency, the euro, fell 24% versus the dollar over the past three years, it did not boost the region’s economy. The euro was created mainly to facilitate trading among countries within the Eurozone, and its devaluation versus the dollar does not matter a lot. For the Eurozone’s equity market, the rule of thumb is basically a stronger economy, a stronger stock market, and a stronger currency. Aggressive US investors should “double down” and invest in the Eurozone without currency hedging, potentially benefiting from both a higher stock market and a higher euro, as they generally go hand in hand. Conservative US investors, on the other hand, should invest in the Eurozone with currency hedging, to avoid the “double whammy” of both a lower stock market and a lower euro.

Japan is the second largest common currency region/country in the MSCI EAFE Index, with approximately 24% of the index weighting. In contrast to the Eurozone, the rule of thumb for Japan is basically “bad news is good news”—the weaker the economy, the lower the currency, and the higher the stock market. Japan’s stock market is dominated by exporters, especially those exporting to the US, such as car makers, and thus a lower yen versus the dollar is critical. For a US investor, either aggressive or conservative, currency hedging is almost “mandatory” for investing in Japan; otherwise, gains from the stock market will be offset by losses from currency translation. 

Lastly, the United Kingdom (UK) is the third largest common currency region/country in the MSCI EAFE Index, with approximately 18% of the index weighting. The UK has become a wild card since the Brexit vote on June 23, 2016. Whereas sterling declined as much as the euro versus the dollar over the past three years, most of the damage was done after the Brexit vote, as sterling nosedived 17% versus the dollar between then and year-end. However, the UK stock market, as measured by the FTSE 100 Index, jumped nearly 15% (in sterling), more than double the S&P 500 Index’s 7% gain. Although this looks much like Japan’s situation (lower currency, higher stock market), it is very much a knee-jerk reaction. The UK’s economy is very different from Japan’s, as it does not rely heavily on exports, much less exports to the US. The UK’s postBrexit vote situation is still very fluid, and has many uncertainties. The rule of thumb in this situation is generally no currency hedge, as the stock market itself, especially a quite mature and efficient one like the UK’s (probably second only to the US’s), will reflect and adjust to the sudden changes naturally, and thus the extra cost for a currency hedge is not warranted during the transition time. 

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Investments in smaller companies carry greater risk than is customarily associated with larger companies for various reasons such as volatility of earnings and prospects, higher failure rates, and limited markets, product lines or financial resources. Investing overseas involves special risks, including the volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. Income (bond) securities are subject to interest rate risk, which is the risk that debt securities in a portfolio will decline in value because of increases in market interest rates. Exchange Traded Funds (ETFs) are subject to risks similar to those of stocks, such as market risk. Investing in ETFs may bear indirect fees and expenses charged by ETFs in addition to its direct fees and expenses, as well as indirectly bearing the principal risks of those ETFs. ETFs may trade at a discount to their net asset value and are subject to the market fluctuations of their underlying investments. Investing in commodities can be volatile and can suffer from periods of prolonged decline in value and may not be suitable for all investors. Index Performance is presented for illustrative purposes only and does not represent the performance of any specific investment product or portfolio. An investment cannot be made directly into an index.

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