With the USD projected to weaken further over the coming year, what factors should be taken into account when thinking about relative currency weightings in clients’ portfolios?
You wouldn’t allocate all of your capital to a single stock. Why would you do the same with a single currency? Diversified exposure to currencies – just like in equity or fixed income markets – can shield your portfolio from unforeseen risks and help you meet your investment goals.
We raise this now because as we scan client portfolios, even clients outside of the United States have far more U.S. dollar exposure than we feel is prudent for a global portfolio, particularly as we see the potential for the U.S. dollar to lose value going forward.
The case for a strong dollar has looked poor for a while due to the currency’s high valuation, Fed rate cuts that have eroded the greenback’s carry advantage, and the Fed’s renewed balance sheet expansion. In the wake of the Fed’s policy response to the COVID-19 recession, the U.S. now sports one of the lowest real policy rates among traditional reserve currencies, meaning on an inflation adjusted basis, overnight rates in the U.S. are as low or even lower than those in countries with negative nominal rates like the euro area, Japan or Switzerland.
As a safe-haven asset, the broad dollar rallied to its strongest level in over 25 years amid the height of the COVID crisis and related market turmoil; however, we believe this short-term strength will prove temporary. In addition to the dollar’s high valuation and now lower yields, cyclical risks appear to be easing and investor risk appetite is better supported, removing one of the last remaining pillars supporting U.S. dollar strength. As the global economy continues to recover and risk sentiment improves, we believe the dollar has further downside ahead.
This could have important ramifications for investors heavily overweight U.S. dollar exposure. The U.S. dollar tends to trend, pivoting from periods of persistent strength to persistent weakness. Over the past three dollar “cycles,” the broad-trade weighted dollar index has moved roughly 30 percent over a period of 4-6 years, on average. A realignment of the broad dollar’s valuation with historical averages could see the greenback as much as 20% weaker from current levels.
Dollar cycles tend to play out over a sustained period of time
If we are moving into a period of sustained U.S. dollar weakness, increased exposure to foreign currencies can protect against the dollar’s loss of purchasing power and provide a boost to returns on foreign investments.
In 2017, the broad trade-weighted U.S. dollar index declined 7%, with the dollar weakening nearly 15% against the euro. These moves provided an important tailwind to non-U.S. dollar investments. Over the course of 2017, the MSCI All-World ex-US equity index, in U.S. dollar terms, outperformed the S&P 500 by almost 500 basis points.
Even more starkly, over that same period, in local currency terms, the EURO STOXX 50 rose just 6% while the S&P 500 rallied nearly 20%. But for a U.S. client invested in the European stock index, the weakening of the dollar relative to the euro actually saw their Eurostoxx position outperform the S&P 500.
J.P. Morgan’s Long-term Capital Market Assumptions (LTCMAs) drive our strategic asset allocation across the asset management franchise. This year’s LTCMAs foresee the U.S. dollar weakening between 0.5% and 2% per year versus most major currencies over the long-term. Specifically, we project the U.S. dollar to weaken 22% vis-à-vis the euro and 17% versus the both the British pound and Japanese yen from current levels.
With little variation in the expected local currency equity market returns across the regions, the expected loss of value in the U.S. dollar could be the main source of performance differentiation for global investors going forward and provides a tailwind to the attractiveness of international markets to U.S. dollar based investors.
Assumptions for Selected Changes in Currency Exchange Rates vs. the USD
Whether because of the general prudence of FX diversification or given our specific outlook for the U.S. dollar, we recommend clients begin to consider whether they are truly matching their currency allocation with their long-term goals.
How much to diversify?
A common question from investors is, “What non-U.S. dollar allocation should I have?” The answer will be different for everyone but as a starting point, a balanced CIO portfolio with the Private Bank allocates about 65-70% of its FX-unhedged equity exposure to U.S. stocks. This is even with the portfolio’s current overweight to the U.S. and slight underweight to developed non-U.S. equity markets.
A globally balanced portfolio of U.S. and international stocks over the long-term has proven to produce better risk-adjusted returns with lower volatility than a U.S.-only portfolio. In other words, even for U.S.-dollar based investors, a U.S. dollar allocation well in excess of 70% looks too concentrated to us.
Just as important as deciding how much U.S. dollar vs. non-U.S. dollar exposure to maintain is what the composition of the non-dollar exposure should be.
In practice, the most appropriate benchmark allocation will vary depending on each client’s home currency, strategic goals, investment portfolio and risk tolerance. For example, a strategic FX allocation for a U.S. dollar-based client with a global, diversified investment portfolio, second home in Europe and plans to invest in a London-based business might look something along the lines of 70% USD, 20% EUR, 10% GBP. If that client also owns a business in Australia or plans to retire in New Zealand, then some allocation to those currencies in their strategic benchmark would be key.
Because each client’s FX benchmark by definition needs to be personalized and customized, here are some of the ways we recommend engaging with clients in order to help them arrive at a currency allocation that fits their needs.
What currencies do you need to maintain your lifestyle and meet your long-term goals?
Do you plan to send your child to school in London? You’ll need British pounds for that. Do you live in New York but maintain a home or yacht or other asset in Europe? You’ll need both U.S. dollars and euros. Where do you plan to retire? Let’s make sure you have exposure to all the currencies you need to meet your long-term goals, and in the amount that best suits your situation.
What currencies are you already exposed to at present?
Think about your assets holistically, not just those held with J.P. Morgan; does the currency allocation of your current assets match the currency allocation of your likely liabilities according to your long-term plans? What assets are currently in your investment portfolio?
What are potential benchmarks for me to consider?
For most U.S. dollar based clients, their wealth and long-term goals will require exposure to only a few currencies – for example, the 70% USD, 20% EUR, 10% GBP benchmark proposed above. And indeed, for U.S. investors with only U.S. exposures and liabilities, a diversified FX portfolio may not be suitable. But like CIO’s more diverse allocation, there are a number of other, more diversified strategic FX benchmarks we recommend as a starting point for client conversations, along with why clients might seek to match their currency allocation to them:
- COFER-based: Given the similar horizons and objectives of global reserve managers and high net-worth individuals (liquidity, safety and return), using the currency allocation of central bank reserve managers is a reasonable starting point for many clients.
- Equity market based: An equity market-capitalization based benchmark, for clients focused on investing in global equities.
- Real-estate market based: For clients focused on investing in global real estate, a real-estate based benchmark could be appropriate.
- GDP-based: For clients expecting to spend a decent portion of their assets on goods and services in the medium-to-long term, a GDP based benchmark diversifies the portfolio in line with the production of goods and services globally.
Possible FX Benchmarks for Clients
What jumps out to us is that relative to any of these benchmarks, USD-based investors are generally overweight U.S. dollar assets. We recommend clients engage with their J.P. Morgan team about the right currency allocation for them.
The next installment in this paper series will cover how we can work with clients to appropriately, methodically and efficiently shift their FX exposure to their selected benchmark.
Definitions of Indices and Terms
The MSCI All-World ex-US equity index captures large and mid cap representation across 22 of 23 Developed Markets (DM) countries excluding the United States. With 987 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.
US Fed Trade Weighted Real Broad Dollar Index, also known as the broad index, is a measure of the value of the United States dollar relative to other world currencies. It is a trade weighted index that improves on the older U.S. Dollar Index by using more currencies and the updating the weights yearly
The EURO STOXX 50 Index, Europe's leading blue-chip index for the Eurozone, provides a blue-chip representation of supersector leaders in the Eurozone. The index covers 50 stocks from 12 Eurozone countries. The Index is licensed to financial institutions to serve as underlying index for a wide range of investment products such as Exchange Traded Funds (ETF), Futures and Options and structured products.
Standard and Poor's 500 Index (S&P 500) is a capitalization-weighted index of 500 stocks. The index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The index was developed with a base level of 10 for the 1941-43 base period.
All market and economic data as of July 20, 2020 and sourced from J.P. Morgan Private Bank unless otherwise stated.
Opinions, estimates, and investment strategies and views expressed in this document constitute judgment of the Foreign Exchange, Commodities, and Rates Group based market conditions as of the date identified and are subject to change without notice.