- Long-term macroeconomic effects of the pandemic remain hard to assess
- Currency hedging programmes should be structured to generate positive cash flow over the long run
- Disregarding emerging market currencies ignores typically 25% of a portfolio’s foreign exchange exposure, and the contribution to risk is even higher
For many investors, the crisis calls to mind the Black Monday stock market crash of 1987 or the 2008-2009 Global Financial Crisis (GFC). Indeed, the spike in volatility seen in March 2020 was last seen during the GFC, and in 1987 before that. Exhibit 1 shows the realised volatility of the equity markets using daily returns of the Dow Jones index going back more than 100 years.
Indeed, over the last 30 years, the volatility seen in March 2020 was matched only during the GFC and on Black Monday itself, when the Dow Jones fell by more than 20% in one day. Prior to that, similar levels of volatility had not been seen since the Great Depression.
We know already that the COVID-19 pandemic will have severe implications for the economy: the unemployment rate in the US is likely to exceed 20%. But it is difficult to gauge its medium to long-term macroeconomic effects.
History shows effects of pandemics to be long-lasting
A recent paper by the Federal Reserve Bank of San Francisco looks at the macroeconomic impact of the last 12 major pandemics, starting with the Black Death of 1347. It concludes that the consequences last long, not months, but multiple decades. A major caveat is that the Black Death and other pandemics affected the majority of the population below age 60, so this time could be different.
What is clear is that the range of possible outcomes is extremely large—there are no more ‘Black Swans’. No future event should come as a surprise as we know only that little is known about the current pandemic at this stage. Data from China has been met with scepticism in the West, and fatality rates vastly differ among different countries (Germany and Italy, as one comparison).
What does this mean for the foreign exchange market?
The US dollar typically benefits in periods of global recessions, so over the medium term, it is likely to remain well supported. But Exhibit 2 suggests that US dollar bulls need to be cautious. The current bull market started during the GFC – more than 10 years ago –and is the longest in history, the previous bull markets lasting about seven years (from 1980 to 1987, and from 1995 to 2002).
The current crisis has highlighted the advantage of hedging foreign currency exposures as the US dollar surged in Q1 2020. Positive cash flow generated from hedging was certainly beneficial as liquidity was much needed in March.
But passive hedging alone will likely generate significant negative cash flows when the dollar bull market ends. Exhibit 3 illustrates that between 2000 and 2007, the cumulative negative cash flow would have been as high as 40%, forcing investors to sell international assets to cover the losses on currency forwards.
Indeed, when experiencing this significant negative cash flow, some US institutional investors who used passive hedging liquidated their passive hedging programmes at the worst possible time as the dollar bottomed in 2007 after locking in significant losses on short foreign currency forwards.
Hedging should aim to outperform passive hedging and no hedging
Any hedging programme should be structured to generate positive cash flow over the long run. There should be two objectives: outperforming passive hedging, but also outperforming zero (no hedging).
Only outperforming passive hedging could still lead to significant negative cash flows in periods of dollar weakness, so the emphasis on generating positive cash flow (beating a zero benchmark) is important.
Many hedging programmes have been implemented only against developed market currencies. This is perhaps due to a perception that emerging market (EM) currencies appreciate over the long run and therefore hedging will be costly, especially considering the higher interest rates in those countries. However, exhibit 4 illustrates that high-yielding EM currencies fell against the US dollar after the GFC, impacting long-term investors.
Furthermore, the coronavirus may hit EM countries especially hard. For many, the crisis compounds the blows of domestic outbreaks, declining global demand and fewer capital inflows. Importantly, disregarding EM currencies ignores typically 25% of a portfolio’s foreign exchange exposure, and the contribution to risk is even higher than that.
To conclude, currency risk has long bedevilled investors, who have been faced with many opinions and recommendations as to how and whether they should ever hedge their exposure. The coronavirus crisis highlights once again the importance of hedging currency exposures in institutional portfolios. And while much of the impact of the pandemic is difficult to gauge, one thing is sure: its effects are unlikely to be short-lived.
 “Longer-Run Economic Consequences of Pandemics” by Òscar Jordà et al. at https://www.frbsf.org/economic-research/files/wp2020-09.pdf
economist and coordinator of COVID-19 research.
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients.
The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.
Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).
Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.