There is always a development in the global asset markets that has the potential to captivate a large share of the headlines. To me, one of the most interesting stories of late is taking place with respect to currencies.
Japan’s newly elected prime minister, Shinzo Abe, is engaging in a relentless attack on the strength of the yen against other currencies, and the market seems to believe that he is serious, since the yen is actually declining in value, most notably as measured against the U.S. dollar.
I said in a previous blog that Abe has a large “bazooka” in his pocket and he is not afraid to use it if the currency markets shift toward supporting a stronger yen or the Bank of Japan (BOJ) does not follow a set of policy prescriptions that have the potential to weaken the yen’s value against other currencies. Abe’s rhetoric thus far has been very effective in getting the yen to weaken, and as a result a number of investors have embraced currency hedged investments for Japanese equities, as they see the weaker yen directly benefiting Japan’s exporters.
Japan may be the only country in the world that’s currently exhibiting such a clear and sharply negative relationship between the returns of its currency and the returns of its equity markets—such that while the yen has been one of the weakest currencies, its equity markets have been among the strongest in the world.1
All this is not to say that Japan is the only country whose currency value against other major currencies should be in question. There is a recession in Europe—and the countries on the periphery still exhibit very slow economic growth or even contraction, with many structural and competitive imbalances yet to be fully corrected.
Last year, flows to European equities were substantial,2 as bargain-hunting investors concluded that European stocks were attractively priced, even with all the uncertainty surrounding the economy.
Practically all the investments went into funds that assume European currency risks. Do these investors believe the euro is structurally better positioned than the U.S. dollar? I believe both the euro and the U.S. dollar have their fair share of potential weaknesses. Ultimately, the situation begs the question: Should investors trying to capture the relatively low prices of European stocks take on additional euro risk—namely positioning themselves so that their investments may decline from a weakening euro compared to the U.S. dollar—in doing so?
It is widely understood that currency performance can add significant volatility to international equity returns, but the difficult question regards whether investors receive compensation, i.e., a potential increase in their returns, for taking on this additional risk. In some cases, depending upon both the market and the period in question, equity market returns and currency returns can exhibit correlations that are sharply negative—as we are currently witnessing in Japan.3 In fact, in the 1990s the European currencies had negative correlations between their returns measured in U.S. dollars and the MSCI EMU Local Currency Index.
There was a nearly 10-year stretch (from September 30, 1992, to May 31, 2001) where the European currencies represented in the MSCI EMU Local Currency Index declined more than 40% on a cumulative basis, but the index returned 19.81% a year.4 The European stocks represented in this index reacted much like many of the Japanese stocks represented in the MSCI Japan Local Currency Index are reacting today.