Currency Domination: The US Election, Currency Effects, and Portfolio Risk
Both the US election and the Brexit vote flummoxed even the most seasoned political pundits and surprised the markets. It resulted in significant volatility, specifically for currency exchange rates. The markets widely anticipated the Federal Reserve Bank’s rate hike in December, but they reacted when Federal Chair Janet Yellen communicated a more bullish economic outlook after the decision. All of these events seemed to have been positive for the dollar and US stock markets, which during the so-called “Trump rally” posted all-time highs while the oil price shot up. Government bond values, on the other hand, fell sharply over concerns about increased government spending and inflation.
I am on Axioma’s Applied Research team, and we track trends in market and portfolio risk and their impact on a multi-asset class risk portfolio in the weekly Multi-Asset Class Risk Monitor. Through our research, we observed that this particular combination of market movements led to a surprising conclusion – that US equities showed one of the lowest risk contributions in a global multi-asset class portfolio compared with their market value weight.
Unpacking this, we found that the main reason for this was that the strong gains of the dollar versus its major rivals had made it appear as if non-USD assets were losing money (despite sometimes healthy gains in their local currency), while the US equity market soared. The result was a strong preference for domestic stocks from a US investor’s point of view, both in terms of risk and return. However, this finding turned out to be only true when the portfolio was denominated in US dollars and no currency-hedging was applied. After varying the base currency of the analysis, we could observe significant changes in portfolio risk, both in terms of overall volatility as well as risk decomposition. You can learn more about our findings here.