Foreign currency actions and currency risk (1/4)

There are certain myths about foreign currency equities that can lead us to make mistakes with far-reaching consequences. These clichés come from a time not so long ago when

• growth to finance public deficits
• equities outperformed all conventional assets
• company fundamentals dictated share prices, not politics.

In those days, investing in foreign equities was seemingly no more risky over the long term than in local currency. States were solid, their budgets equally so, and their currencies held up proudly. Or almost.

With this in mind, let's imagine that in 2004 we decided to invest in the shares making up the leading American index, the Dow Jones. On the face of it, despite the "little hitch" in the middle, it was a good idea: in the end, the index made almost 15% in gains, compared with just 3,53% for its Swiss counterpart, the SMI. Not to mention the fact that the American index is far less volatile.

But that's where the picture ends, because during the same period, the currency of Dow Jones stocks fluctuated considerably against that of the SMI. 15% of gains turned into a loss of over 11%, due to a 26% drop in the USD/CHF pair.

But why would we invest in the Dow without giving it much thought? Because there are three myths in the financial community that can distort our view of reality:

• the myth of the all-powerful course
• the myth of a return to equilibrium (purchasing power parity)
• the myth that currencies are less volatile than equities

In the stock market, price is everything. So much so that you forget what currency you're invested in. Worse still, on many financial sites, you're given the price, but no currency. Or it's hidden away, tiny in a corner. It could be carrots, potatoes, it would all be the same. Give it a try, it's worth it. The problem is that, without being careful, you end up comparing, as above, things that have almost nothing to do with each other. Not a great way to make an investment decision.

The second point isn't so bad either. It is commonly accepted in the economic world that currencies fluctuate around a sort of magic equilibrium point, which some call the purchasing power parity. A sort of sophisticated Big Mac Index. We've been talking about it ever since speculation on the CHF began and the Swiss National Bank had to roll up its sleeves. For the EUR/CHF, this parity would be 1.35 and for the dollar 1.05.

If currencies do indeed fluctuate around this point, it too varies over time. In 1975, the USD/CHF parity was 2.67! So, in addition to the cyclical and speculative risks to currencies, there is also a structural risk. The CHF is strengthening over the long term, as a safe-haven asset, while other currencies are weakening thanks to the expansionary monetary and fiscal policies of their central banks and governments. We may therefore have to wait a long time for a hypothetical return to this equilibrium point. The graph below clearly illustrates the dollar's structural weakness since the 2000s.

The final cliché is that currencies are less volatile than equities. With this volatility, equities would be more profitable over the long term, reducing the proportion of currency risk. It's true that the USD/CHF pair has traditionally been less volatile in the short term than the equity market (even if between 2010 and 2011 there were extraordinary speculative movements in the CHF). Over the long term, however, the extremes on the USD/CHF are equivalent in proportion to the SMI.

The paradisiacal situation we initially described has gradually deteriorated since the 2000s, with the bursting of the Internet bubble, and then went off at a tangent in 2008 with the subprime and fiscal crises. The dollar crumbled with the FED's expansive monetary policy (QE 1 & 2), while the Swiss franc enjoyed safe-haven status, at least until the SNB intervened in August this year. From the beginning of January to the beginning of August 2011, the CHF even gained more against the dollar than "king" gold itself!

Clearly, the SNB is not going to be able to weaken the CHF ad vitam eternam. So, what to do with these sad facts? Invest solely in domestic equities? Not necessarily. In our next article of the various solutions available to us.