Within a global asset allocation portfolio, substantial currency exposures may emerge as a result of investment instruments denominated in local currency, such as foreign stocks or bonds. These exposures represent both a source of risk and, potentially, a distinct opportunity set for rewards. Either situation argues for active currency management.
As discussed in our most recent GMAG monthly update, in early December we moved to a neutral positioning in the U.S. dollar after several years of being overweight. In other words, while in the past we have hedged part of our foreign currency exposures, we have recently scaled back those hedges, taking us to an aggregate foreign currency position more in line with our benchmark.
Within this neutral stance, however, we are favoring some currencies over others. In particular, in the last couple of months we have increased our exposure to the Japanese yen from 3% to an approximate current weight of 8%, which represents our largest foreign currency position. This equates to roughly an overweight of 3.5% versus the benchmark (see Exhibit 1 and Exhibit 2).
Sources: OppenheimerFunds, Bloomberg, 2/11/16. The Fund’s benchmark consists of 60% MSCI ACWI/40% Barclays Global Aggregate Bond Hedged USD. The MSCI ACWI is a free float-adjusted market-capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The Barclays Global Aggregate Bond Hedged USD is an index comprised of several other Barclays indices that measure fixed income performance of regions around the world while hedging the currency back to the U.S. dollar. Indices are unmanaged and cannot be purchased directly by investors. Past performance does not guarantee future results.
As illustrated in Exhibit 1, over the course of 2015 our underlying investments in foreign stocks generated a Japanese yen exposure of 3%. This represented an underweight position versus the benchmark, which we actively decided to maintain. In late November, however, our global macro views led us to revisit this stance and we rapidly transitioned into an overweight position via currency overlay.
Sources: OppenheimerFunds, Bloomberg, 2/11/16. Active weight represents the difference between the Fund’s allocation weight and its benchmark’s.
What has led us to this substantial increase in exposure?
In our opinion, despite the recent cut by the Bank of Japan to negative interest rates, the Japanese yen is currently supported by several tailwinds, contributing to its strength year-to-date:
- Favorable valuations: After depreciating nearly 40% versus the U.S. dollar in the last three years, the yen is now one of the cheapest developed market currencies on a purchasing power parity basis (PPP);
- Energy importer: Japan is one of the single largest beneficiaries around the world from the dramatic fall in energy prices;
- External surplus: Japan is rapidly regaining its status as one of the largest current account surplus countries, going from 0% of GDP in mid-2014 to currently 3%, and it is projected to reach 4%-5% as a result of lower energy import costs and favorable currency valuations.
- Defensive/“safe haven” behavior: As a result of its international creditor status, the yen behaves as a counter-cyclical currency, with a tendency to hold its value, or even appreciate, in times of global risk aversion. Therefore, as a result of our cautious global allocation stance, the Japanese yen represents another vehicle in our portfolio to express such defensive views.
The Bank of Japan will certainly become more vocal, expressing discomfort with recent appreciation. In our opinion, this will introduce more volatility and uncertainty in foreign exchange markets, with another round of “currency wars” likely in the near future. However, we believe that the four tailwinds we mentioned above are strong enough to negate any significant impacts of the Bank of Japan’s efforts to devalue the yen.
We believe active currency management is a key component of a diversified global asset allocation process. Whether foreign exchange is seen as a source of risk or return, it requires a dedicated analysis and investment process.
Mutual funds are subject to market risk and volatility. Shares may gain or lose value.
Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes, regulatory and geopolitical risks. Emerging and developing market investments may be especially volatile. Eurozone investments may be subject to volatility and liquidity issues.
These views represent the opinions of the portfolio manager(s) of OppenheimerFunds, Inc. and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.