- Currency risk remains high as other factor-block risks have fallen
- US Dollar’s strength leads to outsized returns for the Exchange-Rate Sensitivity style factor
- US Exchange Rate Sensitivities by sector are opposite in sign from their non-US counterparts
Currency risk remains high as other factor-block risks have fallen
Most developed market currencies remain at or very near the low end of their 12-month return range versus the US dollar, and correspondingly at the high end of their 12-month volatility range. Predicted volatility has increased for almost every individual developed markets currency over the past two months, and the median risk-model correlation between currencies has also increased. As a result, although country and style risk for the STOXX® Global 1800 Index have fallen over the past few weeks, currency risk has remained relatively high and is likely to be a driving force behind the active risk in a portfolio that makes currency bets.
See chart from various Developed Markets Risk Monitors as of September 2, 2022:
US Dollar’s strength leads to outsized returns for the Exchange-Rate Sensitivity style factor
The strength of the US dollar was related to the 1.9% return to the US Exchange Rate Sensitivity style factor over the past three months. This return is the highest three-month return since 2008, and more than two standard deviations (based on the predicted factor volatility from the US fundamental medium-horizon model) above the long-term average at the beginning of the period. Exchange Rate Sensitivity measures the relationship between a stock’s price and the return of its base currency relative to a basket of currencies. A positive exposure means that the stock rises along with its currency, and a positive return suggests that those names, likely importers, fared better than their exporter counterparts. This factor’s return is usually much closer to zero, and therefore not necessarily noticed by investors, but in the current quarter it may have had a larger-than-expected impact on active returns. In addition, the factor tends to be toward the low end of volatilities of model factors.
At the same time, the pound’s weakness meant that Exchange Rate Sensitivity according to the UK model returned -3.5% over the past three months, three standard deviations below the long-term average return. The factor’s returns in the European, Asia ex-Japan, Australian, Developed Markets ex-US and Emerging Markets models were all negative, although well within a two-standard deviation range so they do not appear overly outsized. This wide range of factor outcomes also suggests that a model user may be better off using a model that corresponds most closely to the investment mandate, to better capture the nuances of individual market behavior.
See chart from US Equity Risk Monitor as of September 2, 2022:
US Exchange Rate Sensitivities by sector are opposite in sign from their non-US counterparts
For those paying more attention to Exchange Rate Sensitivity (ERS), note that sector exposures to the factor vary widely. The range of ERS exposures for the US is not quite as large as it is for Market Sensitivity, but Consumer Staples has a positive ERS exposure to the factor of 0.5, while Financials and Materials are both quite negatively exposed.
Outside the US, in contrast, the Materials sector in aggregate is positively influenced by home-currency increases and Consumer Staples has a negative exposure. Non-US Financials have positive ERS loadings on average, while Health Care sports a negative exposure. Again, we view this as evidence that to best capture the risk of a particular factor, a local model is best.