Global currency fluctuations and offshore investments

Johannesburg - In comparison to global gross domestic product (GDP), global trade has grown exponentially over the past two centuries, according to Neil Verster, portfolio manager at Novare Investments.

Foreign exchange represents the largest asset class globally when measured by daily turnover.
 
"The volatility observed in forex markets is a function of the intricate and fluid relationships between socio-political and economic factors across countries. Another layer of complexity is that an exchange rate is a relative measure," explains Verster.

"It considers not only the unit measure of value - currency - within one country with respect to another, but also how the market views that same measure relative to all other trading currencies."
 
Taking currency movements into consideration should form an integral part of the decision-making process for almost any investor looking to invest offshore, he says.

Some reasons to invest offshore:

- To diversify one’s investment portfolio;

- Taking advantage of opportunities that are not available in the local market;

- Saving for a holiday.
 
"A key aspect to consider is your investment horizon. Research suggests that attempting to consistently and accurately predict short-term fluctuations in exchange rates are a nearly impossible task. Over the longer term, fundamental drivers of any given country’s currency tend to provide better guidance on future movements than that seen in the short-term," says Verster.

Currency volatility could, therefore, create opportunities to invest for the longer term as the market over or under reacts in any given scenario. The erratic fluctuations observed in certain currencies do, however, make an exact forecast – even over the longer term – a challenge.

"Irrespective of whether this variability arises from the local or foreign currency, it directly translates into volatile local currency mark-to-market values. This, in turn, introduces drawdown risk to a given portfolio as well as the potential for upside gain. Derivatives such as currency forwards, options or swaps could be used to alter the risk-return profile of a position, depending on the desired outcome," says Verster.
 
Being aware of the currency exposure in an offshore investment is highly recommended. It should be considered within the context of an investor’s entire portfolio and not as an isolated allocation.

"As with any investment, currency movements could move against or in favour of an investor. The return from these movements could often be greater than the loss suffered or appreciation realised from an underlying position," explains Verster.

In local currency terms, for example, an investor who has taken a position in US equities might have seen the US dollar value of his or her equities decrease by 3% over a period. The rand, however, might have weakened by 10%, which effectively means that the investor has preserved capital in rand terms. The reverse would be true if the rand strengthened relative to the dollar over that period.

Source of earnings
 
"South African investors are well aware of the so-called rand hedge shares listed on the JSE. Consider the scenario where a South African investor takes a position in a London-listed Sterling based share with operations based and earnings streams being generated primarily in the US. This dual layer of exchange rate movement could further complicate an investment thesis," cautions Verster.

"Investors should, therefore, consider the source of earnings in the underlying securities that they are invested in, not just the base currency of their holding."
 
Countries across the globe employ various exchange rate regimes. The spectrum ranges from making use of the same currency (Monetary Union) to that of a floating exchange rate regime where demand and supply forces in forex markets determine the price of one currency relative to others.

"Emerging and developed market exchange rates could prove to be volatile, particularly when global markets are in turmoil. When a country runs a persistent current account deficit it results in a dependence on foreign capital flows which directly affects the exchange rate. Whilst not always the case, many emerging markets are often dependent on foreign sources of capital," says Verster.

"This could make these countries’ exchange rates sensitive to how foreigners perceive the health of these states and consequently their future investment returns."

Developed markets are, however, not immune to exchange rate volatility. The Swiss National Bank’s abrupt abandoning of the euro-franc peg in January of 2015 saw significant swings in the Swiss franc, which caught many investors off-guard.

Potential volatility
 
"This potential volatility should not be a reason to avoid investing offshore. Arguably, it creates even more of a case to do so. In the absence of direct or indirect offshore exposure, an investor would have exposure to only his local currency. Even though day-to-day costs are priced in local currency terms, any goods that are imported tend to increase as the home currency depreciates," says Verster.

"Even though a South African could argue that none of his future expenses will be in euros, the price of a German imported vehicle is more than likely a function of the rand-euro exchange rate. If the investor had exposure to euros while the rand depreciated, he might have been better able to absorb the rand increase in vehicle prices."
 
When considering exchange rate volatility, there is no single piece of advice that is perfectly applicable to every individual or institution, emphasises Verster.

"There are, however, guidelines which one should bear in mind, such as the purpose of investing offshore, the investment time horizon, the base and foreign currencies and the longer term prospects of each. Being aware of these aspects will better enable investors to make informed decisions and achieve their investment objectives," he says.