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To hedge or not to hedge?

By: Russ Koesterich
Harvest Exchange
March 20, 2017

To hedge or not to hedge?

After another soft start to the year, the U.S. dollar has been strengthening in recent months. Increasing confidence in a less tentative Federal Reserve (Fed), coupled with higher interest rates, has pushed the dollar up roughly 2.5% from its February low (source: Bloomberg). To the extent the Fed is hiking more aggressively in an environment in which the Bank of Japan (BOF) and, potentially, the European Central Bank (ECB) remain in an easing mode, the dollar is likely to continue to find support.

A cheaper euro or yen provides a lift to Europe and Japan, which in general are more export driven than the more domestically oriented U.S. economy. The challenge is that what the dollar gives, it also takes away. Although European or Japanese companies become more competitive, for dollar-based investors the returns to these markets are reduced to the extent that the dollar rises against the euro and the yen.

Looking back on the last 20 years, this effect can be quite powerful. Take the relationship between U.S. and non-U.S. equity returns. For the U.S. I used the S&P 500, and for international developed markets, the MSCI World ex-U.S. Index. During the past 20 years, despite the headwind from a stronger dollar, U.S. equity markets outperform when the dollar is rising. The reason? When the dollar is rising, it boosts the return of the S&P 500 against the return from international markets that are denominated in euro, yen and other currencies. See the chart below.

<html><body><img alt="chart-unhedged" class="size-full wp-image-33823 alignnone" height="384" src="http://hvst.co/2mLQXTt" width="662"/></body></html>

This relationship is particularly strong during periods of market volatility, when the dollar is often appreciating the fastest. During these periods, not only is the dollar rising against most international currencies, but the U.S. is also outperforming as it is viewed as a relative ”safe harbor” compared to other markets. A good illustration of this phenomenon was the third quarter of 2008. The dollar, measured by the DXY Index, surged nearly 10% on panic buying. At the same time, while the U.S. market got hit, it still significantly outperformed the MSCI World ex-U.S. Index as investors sought the relative safety of U.S. assets.

The dollar and U.S. relative performance often move together during times of stress. However, under more normal market conditions a rising dollar can actually provide a bigger boost to international markets, if your currency exposure is hedged. Looking back over the past 20 years, the relationship between quarterly changes in the U.S. Dollar Index and the relative performance of the S&P 500 versus other developed markets inverts when the foreign currency component is hedged back to dollars. Under this strategy, the MSCI World ex-U.S. Index actually tends to outperform the S&P 500 when the dollar is appreciating. See the chart below.

<html><body><img alt="chart-hedged" class="size-full wp-image-33824 alignnone" height="384" src="http://hvst.co/2mLLbBe" width="662"/></body></html>

The lesson for investors is this: Although overseas markets offer opportunities, the currency effect can dominate, particularly in a rising dollar environment. Investors looking to take advantage of a stronger dollar by investing abroad should consider strategies that hedge at least some of the non-dollar exposure. In the absence of a hedge, betting against an appreciating currency may not be the best strategy.

Russ Koesterich, CFA, is Portfolio Manager for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

Investing involves risks, including possible loss of principal. International investing involves special risks including, but not limited to currency fluctuations, illiquidity and volatility. These risks may be heightened for investments in emerging markets. Past performance is no guarantee of future results. This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of March 2017 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results. ©2017 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners. RO-124869 http://hvst.co/2mkbtPa

Originally Published at: To hedge or not to hedge?