Unhedged Asian HNWIs taking a chance on dollar

The weaker dollar is boosting portfolio returns and discouraging high net worth individuals (HNWIs) in Asia from hedging their currency exposures. But it's a gutsy move that carries risks.

The US dollar was widely expected to strengthen against other major currencies in 2017 on expectations that the Federal Reserve would continue raising interest rates as the US economic outlook continued to firm, but those expectations were largely dashed as the greenback weakened. 

Based on the US Dollar Index, which measures the value of the dollar against a basket of major developed market currencies, the US currency fell by 10% in 2017. It has continued to decline in early 2018, dropping by another 3% in January, according to Bloomberg data. It's also depreciated against Asian currencies, not least the Chinese renminbi, which has powered to its strongest level since a surprise devaluation August 2015. 

As the dollar weakens, so the relative value of non-dollar denominated funds and assets increases. When investors think that this trend will continue, they tend not to hedge their different currency exposures because of the potential gains they could make from holding non-US dollar currency assets. 

“I often see clients not hedging,” Dominic Schnider, head of commodities and forex chief investment officer for Apac at UBS Wealth Management, told AsianInvestor. If an investor is bullish on regional currencies and positive on prospects for regional equity markets, they don’t see a reason to hedge their dollar currency exposure, he said.

Hedging is a risk-minimisation strategy that involves taking an offsetting position as a form of insurance against volatile asset prices. A forward contract is an example of a currency hedge, where the current exchange rate is locked in for a future currency transaction.

"Self-directed clients are often less systematic when managing currency risks and tend to take a more ad-hoc approach," Schnider said. "[But] having no systematic approach can lead to unnecessary currency exposure that might not be compensated adequately by returns."

While the reference currency for Asian investors tends to be the US dollar, they also tend to have significant exposure to regional and local currency assets.

“A weaker US dollar, therefore, translates into foreign currency gains for investors holding Asian assets,” Schnider said.

Emerging markets boost

Emerging markets, including Asia, generally benefit from a weaker dollar as dollar-denominated debt becomes cheaper to repay and global investors are more willing to shift capital from the US into riskier overseas assets.

So while the dollar was weak last year, the MSCI Emerging Markets index returned 37%, up from 11% returns in 2016.

“A weaker dollar is going to be great for Asian asset classes,” Jeik Sohn, investment director at UK asset manager M&G Investments, said. “2018 we think could broaden out as emerging markets are, on the whole, just on that early cycle in terms of their recovery. A weaker dollar definitely helps from a currency perspective and can boost returns,” he told AsianInvestor.

However, expectations of where the dollar will go over the rest of 2018 are mixed, and a continued weakening of the currency cannot be taken for granted.

Some experts such as Tuan Huynh, chief investment officer for Asia Pacific at Deutsche Bank Wealth Management, believe the US dollar could strengthen towards the end of the year after staying weak for most of the preceding months.

The euro rate is at 1.24 against the dollar and our outlook by the end of December 2018 is 1.15,” he told AsianInvestor. At press time the single European currency was trading at around $1.247.

Continued rate hikes by the Fed, as well as rising inflation driven partly by wage inflation, will reverse the weakening trend in the US dollar, he said. The Federal Reserve raised rates three times in 2017, lifting the overnight funds rate range to a still-low 1.25%-1.5%, and is broadly projecting another three small hikes in 2018.

Case for not hedging

At UBS WM the belief is that continued global economic growth, particularly in Europe, will supersede dollar-supportive factors such as rising US interest rates and US economic strength. In other words, relative strength elsewhere in the global economy could lead to the dollar being less strong than originally estimated.

“We do think the dollar is going to [continue to] weaken, and I think you can easily see somewhere close to another mid-single digit decline on the broad index level, meaning 3-5% down again from current levels,” UBS WM’s Schnider said.

He expects the euro rate to hit $1.30 in the next 12 months.

That’s the main reason why the Asia ex-Japan equities exposure is currently un-hedged on discretionary mandates at UBS, in order to benefit from Asian currency appreciation expectations, UBS WM’s Schnider said.

A discretionary mandate is where investment managers are authorised to manage investments on behalf of wealth investors.

“We do [advise] people not to hedge their currency risk at the moment here in Asia because we think Asian currencies are likely to appreciate across the board,” Schnider said.

FX volatility

It's a plucky call, though, given the volatile nature of foreign exchange markets.

As M&G’s Sohn put it: “There are so many different forces, it’s hard to say exactly what’s going to happen [to the dollar].” 

On the one hand, economic fundamentals in the US and interest rate differentials could strengthen the dollar, he said. But at the same time, continued global growth could see other currencies appreciate relative to the dollar.

Then there are the geopolitical issues that can occasionally flare up and drive capital seeking a safe haven to the dollar and the uncertain impact on currency markets of US trade policies, given US President Donald Trump's targeting of countries such as Germany and China with large trade surpluses.

Another unknown is the likely impact of recently agreed US corporate tax cuts on the huge pile of US corporate earnings sitting offshore, which could yet flow back to the US and lift the US currency, or, conversely, the reaction of Asian central banks if US Treasury bond prices start to slide as US inflation picks up, given the trillions of dollars of US Treasuries that they own. 

The risk for Asian HNWIs who do not hedge their dollar exposure is that if the dollar moves in the opposite direction and appreciates, then it will hurt their non-US dollar denominated asset returns.

As a result, Deutsche Bank WM’s Huynh said he recommends advisory clients either hedge their non-US dollar assets or implement a cross currency swap — where two parties exchange the principal and interest payments of loans denominated in different currencies — to hedge against foreign exchange volatility.