Cutting Through the Currency Fog by Mark Phelps and Dev Chakrabarti, AllianceBernstein
With the euro sliding deeper against the dollar this week, equity investors have been getting nervous. But why is everyone so surprised when known currency fluctuations derail earnings? In our view, a sharper focus on company exposures can help create a “natural” currency hedge in global equity portfolios.
Currency is a big deal this year. Over the last six months, the US dollar has appreciated by 12% against a basket of major currencies on the back of a strengthening economy. And the euro has now slipped by more than 11% since the beginning of the year, with more likely to come following the launch of quantitative easing. Viewed together, the dollar-euro shift has been dramatic (Display).
Translating these trends into company-specific earnings forecasts often seems challenging. We think part of the reason is because of an overdependence on company reports. Companies don’t usually update the markets about how currency fluctuations will affect earnings. And sell-side analysts typically rely upon static exchange rate forecasts that don’t adapt in real time as currencies move.
Gaining Clarity on Currency
European investors will find this especially familiar. Since European companies have derived more revenue from outside their home markets than their US peers, (Display, left), currency has a bigger effect on performance—and has added a consistent element of uncertainty to the earnings season. In fact, we believe that greater currency exposure partly explains why European earnings estimates for companies of all sizes are more widely dispersed than estimates for their US peers (Display, right).
But currency confusion can be alleviated. Global investors can start by looking at Japan’s recent experience. The “Abenomics” plan launched 18 months ago was aimed at devaluing the yen, which inflated earnings and triggered a dramatic boost to the broad stock market.
Lessons from Japan
The playbook for investors was clear: take a short position on the currency and a long position on earnings. This was a winning combination as long as the market was being driven by artificial stimulus. But as the stimulus wears off, Japanese companies need to prove that they can grow earnings on their own. In our view, investors need to identify those companies that have sustainable growth potential—with or without monetary fuel—to generate reliable long-term returns.
This year, we believe Europe is likely to follow in Japan’s footsteps. The weaker currency will provide a welcome boost for companies with significant non-European sales. Earnings growth should benefit, especially since European profit margins are much lower than in the US, where profitability appears to have peaked, in our view. Yet it will probably take longer for the European stimulus to feed into economic growth, while the US economy is clearly doing much better this year.
Creating a “Natural” Hedge
These are complex dynamics for global equity investors. Many are already following Japan’s playbook, by piling into European stocks indiscriminately, via passive funds. We think that’s a short-sighted strategy.
Instead, we prefer to create a “natural” hedge for the current currency environment—without using derivatives or shorting. The idea is to increase exposure to a weaker euro and to stronger US economic growth at the same time through a stock-picking approach.
Focus on euro-area companies with significant business in the US. These companies should benefit twice—from both a weaker euro and a more resilient US economy. We look for companies that can deliver strong and sustainable growth potential in a longer-term revival of the European economy as well, and not because of stimulus. At the same time, US companies with higher-than-average international revenue should be scrutinized for their vulnerability to a strong dollar, even if their underlying fundamentals seem robust.
Being selective can be an effective antidote to currency hiccups. And the impact of exchange rates doesn’t have to be an unknown factor for individual companies. This year, it’s especially important to make sure that your portfolio manager is proactively assessing the impact of currency on portfolio holdings and adjusting equity positioning accordingly.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. AllianceBernstein Limited is authorized and regulated by the Financial Conduct Authority in the United Kingdom.
Mark Phelps is Chief Investment Officer of Concentrated Global Growth, and Dev Chakrabarti is a Senior Research Analyst and Portfolio Manager, both at AllianceBernstein.