What do investors with international assets do now the NZ dollar is rising? AMP Henderson investment strategist Paul Dyer provides some advice.
Monday, April 22nd 2002, 10:30PM
by Paul Dyer
The increasing global investment exposure of New Zealand investors has led to an increased level of interest in the outlook for the $NZ. This is particularly the case right now. While the collapse in the $NZ over the past few years has concerned many, for the economy it has been a godsend. The impact of last year’s global downturn on New Zealand was barely perceptible, largely because of the offsetting stimulus of a low NZ$. It has also helped protect investors with offshore exposure from the slump in global equity markets (at 44c, the NZ$/US$ cross remains around 10% below the level of two years ago).
The big concern now is that if the $NZ was to rebound it would cut into any recovery in global equity markets. This leads to the obvious question – should investors consider reducing their exposure to foreign currency by either hedging some (or all) of their international equity investments back to $NZ (where possible), investing in fully hedged international equity funds (where available), or reducing their offshore allocations generally?
The case to reduce foreign currency exposure
Given the significance of this decision it is important to carefully consider the pros and cons of reducing foreign currency exposure. In favour of hedging/reducing foreign currency exposure are the following points:
Firstly, the $NZ remains very undervalued. An important measure is New Zealand’s Real Exchange Rate (RER), defined as a trade weighted basket of currencies adjusted for relative inflation at home and abroad. It can loosely be thought of as a measure of the competitiveness of New Zealand producers (a lower exchange rate implies greater competitiveness).
New Zealand’s Real Exchange Rate, 1963-2002
Currently the NZ$ is at similar levels to previous troughs, such as those following the 1991 recession, the 1984 20% devaluation and that of the early 1970s. This is not the whole story – the continual balance of payments deficit and worsening investment income balance probably necessitate a downwards trend in the RER. The difficulty is separating this trend from shorter term influences. However it does suggest that near term downside risk is limited. It is quite possible that a rising NZ$ could offset any benefits from stronger world sharemarkets in the near future.
Secondly, the $NZ should benefit from the cyclical upswing in global growth. As a rough rule, falls in the value of the $NZ tend to precede, or be associated with, falling global growth, and vice versa. This reflects the fact that New Zealand’s exports, like Australia’s, are still heavily exposed to the commodity price cycle. This explains the fall in the $NZ in 1997 to 1998 (global growth fell with the Asian crisis), the rally in 1999 (as global growth recovered) and the more recent fall.
Thirdly, local economic conditions are supportive. In the current cycle the RBNZ is at the forefront of tightening, being the only central bank to have already raised rates twice. Others have tightened once (e.g. Canada, Sweden) or else are contemplating when to begin (e.g. Australia, the US). The New Zealand economy is relatively buoyant. The housing market is in full flood, fuelled by strong immigration and low interest rates. These factors favour the NZ$ in two ways. Firstly, the RBNZ will continue to tighten, with perhaps a further 1% to be added to interest rates over the next year, underpinning the currency. Second, the rising gap between local and foreign interest rates encourages investors to hold NZ$ assets. For example, with NZ interest rates currently around 3% above those in the United States, a fixed interest investor would require the NZ$/US$ exchange rate to depreciate from its current level of 44c to around 42.7c to merely break even. The short term odds are clearly that the dollar does better than this.
For all these reasons the near term case for favouring the "kiwi" looks strong.
The case to retain some foreign currency
Arguments for retaining some foreign currency exposure include the following.
Firstly, from a purely strategic point of view it should be noted that much of the diversification benefits of investing in global equities derives from diversifying currency exposure away from the $NZ. Hedging back to $NZ necessarily reduces these diversification benefits. This is largely why international equity portfolios are usually left unhedged. Further, most investors are also consumers, and will spend a portion of their consumption on imported goods and services. Holding some foreign currency assets helps hedge the risk as local currency prices of these goods and services fluctuate with the exchange rate.
Secondly, holding some foreign currency helps diversify the risk associated with holding NZ$ growth assets. In general, periods of rising NZ$ tend to be associated with good performance of the NZ economy and sharemarket. The point is that holding some foreign currency tends to offset some of the risk of holding local assets, and vice versa.
Thirdly, while it may seem reasonable to expect a recovery in the $NZ over the next year or so, the difficulty in currency forecasting should not be underestimated. J.K. Galbraith once commented that there are two kinds of forecasters: "those who don’t know…and those who don’t know they don’t know." While I might take issue with this (naturally!), one area where it is harder to deny is in relation to the $NZ. In recent years NZ forecasters have consitently predicted a rising NZ$ - and been continually wrong. The difficulty in exchange rate forecasting stems from the lack of any empirically reliable theoretical model for what determines the appropriate level of exchange rates. Finance textbooks are in broad agreement as to how appropriate interest rates, bond yields and even share prices are determined. There is no such agreement with respect to currencies. In fact numerous theories abound, for example, relative price levels between countries, relative interest rates, trade flows, capital flows, commodity prices (in relation to the $NZ). The failure of each of these to work reliably leaves a massive space for investor sentiment to push the $NZ and other currencies to extremes.
Fourthly, there is nothing to indicate that the long-term downswing in the value of the $NZ (from $US1.35 in 1970 to $US0.44 now) is over. While New Zealand’s inflation rate is now in line with that of the rest of the world, New Zealand’s external accounts remain a problem. This dictates a continual shift of resources back towards exporting sectors. A lower NZ$ is a key price signal in achieving this.
NZ$/US$ 1963-2002: A Clear Trend
Finally, it is worth noting that many investors are already 'long (ie have bought) the $NZ. This suggests a strong risk of disappointment if the $NZ fails to recover – in other words, downside risk if these long positions are unwound.
What to do?
Drawing these considerations together suggests the following:
Investors who are prepared to take a long-term view and don’t have any confidence in short-term currency forecasts should not alter their investment strategy. The key considerations if you wish to take a long term passive approach are to select a sensible level of foreign currency exposure and then to maintain it irrespective of future developments.
For those with a shorter-term perspective (or a very high exposure to global equities) there is a case to consider reducing their foreign currency exposure where possible. Perhaps the best way to do this is to allocate a portion of their international equity exposure to a hedged international equity fund (where this option is available). However, given the longer-term strategic benefits of being unhedged and the inherent risks in currency forecasting, it is hard to justify having all of your investments in NZ$. In general, we believe having 30-40% of your investments in foreign currency is a sensible benchmark. This might be reduced at present due to the short term outlook, but we would retain at least half this amount.
Finally, it is a mistake to think of all foreign currencies as equal. Diversification between foreign currencies is as important as diversification everywhere else within your portfolio. The US$ has risen against most currencies in recent years. It is far less obvious that the NZ$ is "undervalued" against the Euro, Yen or A$.
Finally, it is worth bearing in mind that most fund managers do actively manage the hedging of their international equity funds.
Paul Dyer is the head of investment strategy at AMP Henderson Global Investors
