Cutting Through the Currency Fog

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Mark Phelps (pictured), CIO of Concentrated Global Growth and Dev Chakrabarti, Senior Research Analyst and Portfolio Manager at AB, argue that a sharper focus on company exposures can help create a “natural” currency hedge in global equity portfolios.

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?

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).

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.