Investment Insights: Revisiting currency risk

For all the talk of the dollar being dethroned this year in 2023, the greenback has continued to reign supreme as the higher for longer U.S. rates narrative takes hold and sends Treasury yields surging.

With U.S. growth resilient and rates higher for longer in the face of persistent inflation, the dollar has benefited from a favourable growth and yield differential relative to the rest of the world.

U.S. Treasury yields have soared with the 10-year now at a 16-year high and the two-year inching ever closer to that milestone. The result: the U.S. dollar has soared to its highest level since November 2022 against a basket of currencies.

For Australian investors, currency plays an important role in determining the eventual returns of their offshore investment.

In that context, let’s look at the performance of U.S. stock market so far in 2023. If you’re an Australia based investor who thinks about the world in Australian dollars, the S&P 500 has delivered an impressive 18%. Meanwhile, U.S. investors are just about hanging on to double digit returns of 11% as hopes of a soft landing have dissipated.

That’s a big difference and it’s entirely linked to the fact that when investing overseas, your return is a function of both the changes in that foreign market and the movement in the underlying market’s currency versus your own.

When an Australian investor buys U.S. equities, they have to sell their Australian dollars for U.S. dollars and then use those U.S. dollars to buy U.S. stocks.

When the investor goes to sell their investment, they need to reverse those steps, selling U.S. dollars and buying the Australian dollars back. In this way, the investor is ultimately exposed to fluctuations in the value of the Australian dollar.

Under those dynamics, a weaker Aussie versus the greenback this year in 2023 has played into the hands of the Australian investors who bought U.S. equities as it has offset some of the drawdowns in the U.S.  As such, unhedged AUD returns have been the clear winner so far this year.

However, AUD weakness may now be close to reaching an extreme. Remember, currency pair performance is often a function of growth and yield differentials.

When it comes to the USDAUD, The U.S.’s better-than-expected growth, supported by higher wages and a strong labour market, explains much of U.S. dollar’s strength. On the flip side, growth in China, Australia’s largest trading partner and the biggest consumer of its minerals, has disappointed this year, with little prospect of major policy support. This has weighed on growth in Australia, particularly in the resources and tourism markets.

Similarly, the Fed’s determination to move historically fast to tame inflation has put a spotlight on the RBA’s decision to pause in the middle of Australia’s hiking cycle. Australia’s inflation remains amongst the highest in the developed world, and if you look at real yields versus nominal yields, it’s clear that we still have some way to go compared to the U.S.

Any sign that the U.S. economy is not as robust as investors think, or that China’s economy can reverse a sluggish 2023 in the last quarter could help keep U.S. dollar strength in check.

On top of this, Australia’s still-high food costs as well as a persistent housing shortage, couple with an expected surge in immigration has the potential to fan inflation further. That may mean that the RBA’s 4 percentage points of increases since May last year could still be “underdone”.

Any consequent narrowing in yield differentials between the U.S. and Australia could leave the door open for a stronger Aussie dollar.

With the risks here now looking more evenly balanced and the AUDUSD testing its recent valuation limits, iShares flow suggests that Australian investors believe that is high time to hedge (again!).

When the USDAUD was last at these levels (in November 2022), our hedged S&P500 exposure experienced a significant uptick in demand – no surprise when you consider that hedging has paid off when the Aussie dollar strengthens.

Having fared better than their hedged counterparts year-to-date, unhedged investors may well hedge at least some of their currency risk. They can lock in the positive performance offset provided by the currency YTD and begin to shift some of their U.S. equity allocation into AUD hedged exposures.