Time to protect against currency risk?

The Australian dollar is trading at around a near three-year high of about US77.5 cents, even nudging reaching US80 cents last week, as world markets shrug off the dire economic impact of COVID-19 and the local currency follows commodity prices higher.

In Australia, an economic recovery is under way. Consumer spending has risen as COVID restrictions have been eased and the unemployment rate has fallen from its 2020 highs. Business and consumer confidence have lifted and commodity prices, iron ore in particular, have soared. Along with a generally weakening US dollar, this has helped push the Australian dollar higher.

“Our outlook for the Australian dollar continues to be positive with the possibility that it will test five-year highs of around US81.2 cents before the end of 2021,” says Felicity Thomas, senior private wealth adviser with Shaw and Partners.

Anthony Doyle, cross asset specialist at Fidelity International, says the local dollar is a risk-on currency, meaning it rises when the appetite for investment risk rises. As a result, it “has been positioned well to benefit from a revival in the global growth outlook, especially one led by China and parts of emerging market Asia,” Doyle says.

Among the big banks, National Australia Bank (ASX: NAB) is particularly bullish on the currency, expecting it to rise to US83 cents by December, a sharp rise from its 2020 low of around US58c in March.

Miguel Castillo, portfolio manager at American Century Investments, says Australia has been able to contain the spread of the COVID-19 virus more effectively than other developed countries and that has supported the view of a quicker local economic recovery in 2021.

“The currency has also benefited from a still nascent global manufacturing rebound which keeps gaining momentum as the vaccination effort gets under way,” says Castillo, who expects the currency to hit US80.5 cents this year.

Time to consider hedging

With the Australian dollar potentially headed even higher, some investors might want to hedge their offshore investments to avoid losing gains on international investments.  For each 10 per cent rise in the Australian dollar, the value of offshore investments falls by 10 per cent when converted to local currency. 

But is it too late for investors to hedge their exposure to a rising Australian dollar? Not necessarily, says Castillo.

“We are still in the early stages of the cycle and therefore the Australian dollar can continue to outperform other developed markets currencies,” he says.

“This can be especially relevant for investors with a high degree of exposure to US dollar … we have a higher expectation for more fiscal stimulus in the US than consensus. This, in combination with the ultra-accommodative policy from the US Federal Reserve, would set the stage for a weak US dollar cycle.”

Investor options on hedging

International equity funds often come in hedged and non-hedged funds version, providing investors with the choice on hedging.

“For instance, an investor may choose between a hedged currency fund, mitigating foreign exchange risks but the costs of the hedging mechanics will negatively impact returns,” says Fidelity’s Doyle. He says hedging may suit an investor who prefers less risk.

For investors with a greater risk appetite, or who expects currency fluctuations to be in their favour, “the investor will themselves assume the [currency] risk but in the knowledge that the lack of hedging mechanics and associated costs may lead to greater investment returns,” says Doyle.

Shaw and Partner’s Thomas says the benefit of investing in an unhedged managed fund is that when the Australian dollar weakens against the US dollar, “you would make a profit on the currency play. However, we usually recommend for a long-term investment if you are domiciled in Australia that you should choose a hedged version to mitigate the currency risk.”

On the other hand, some analysts say over the long term, currency risks even out—what goes up, must come down—and currency volatility is smoothed out. As a result, there could be less reason to hedge currency movements over the long term as compared to short-term investments as you could be cutting yourself off from the benefits when the Australian dollar falls. 

Most actively managed funds and ETFs charge management fees for hedged versions, but the differences in costs can magnify once you include transaction costs. Fidelity, for example, charges higher management fees for its Fidelity Hedged Global Equities Fund (13319) than the unhedged version of the fund, with total management and transactional costs 15 basis points greater than those on the Fidelity Global Equities Fund.

Another possible play

Another approach could be to invest in companies which benefit from a higher Australian dollar, which include businesses that consume US dollar denominated goods and services, or which benefit from an increased demand for foreign goods and services by Australian consumers.

“An example of the former might be retailers or certain health care providers, and the latter would be education, airlines and travel service providers, though obviously this would depend on international travel resuming,” says Fidelity’s Doyle.

Shaw and Partners’ Thomas picks up that theme. “The companies that benefit from a rising Australian dollar are consumer staples and consumer discretionary companies as importing of goods plays a large role in these businesses as it makes the purchasing of these products cheaper, which is then passed on to the consumer.  A few examples of companies in this space that will benefit are Woolworths (ASX: WOW), Coles (ASX: COL), JB Hi-Fi (ASX: JBH) and Harvey Norman (ASX: HVN),” she says.

 See also Morningstar Guide to International Investing