Major currency moves happen relatively often and 2016 may be a year of major currency moves given diverging central bank policies.
In the past, stock market reactions to currency moves have tended to be sharp and in the same direction as the currency, but the recoveries were swift.
Hedging currency exposure may make sense when investing in developed international stock markets in 2016, but investors have had little to fear from the short-lived dips in the stock market due to currency devaluations.
Last week was a big one for the currency markets. After a move by China in August to allow its currency to float more freely, the International Monetary Fund (IMF) announced on December 1 that the Chinese currency would be joining the US dollar, euro, Japanese yen, and British pound to make up its Special Drawing Rights (SDR) basket. On that day, the dollar rose to an 11-year high. On Thursday, December 3, the euro began a two-day gain of about 2% versus the SDR basket in response to the European Central Bank being less aggressive than expected in adding more stimulus to the European economy.
Currency moves have become big news for investors and there may be more to come in 2016. The diverging policies between central banks in Europe and Japan and those of the United States and the United Kingdom where we may see interest rate hikes in 2016 may further weaken the euro and yen while the dollar and pound may grow stronger. In addition, some have argued for a greater risk of a major devaluation of China’s currency now that China has achieved its goal with the IMF.
What do devaluations mean for stock markets?
Recent history reminds us that even relatively small moves in currencies can trigger major impacts on global stock markets. China’s devaluation back in August of just under 3%, which some market participants at the time feared signaled a deeper slowdown in China’s economy, prompted indexes from many countries including the S&P 500 and the Hang Seng to fall over 10% in the following weeks. However, a longer look back at the history of currency moves tell us that while markets can react sharply, markets also tend to fully rebound quickly.
Major currency moves and the stock market
Results based on Charles Schwab study of 15 years of moves among eight major trade currencies and their impact on the stock market in those countries, measured in US dollars.
Source: Charles Schwab, Factset data as of 12/4/2015.
Major currency moves happen relatively often - Over the past 15 years, there were 34 occasions when one of the top eight currencies used in international trade (see chart below) moved by 3% or more up or down versus the IMF’s SDR basket of currencies. That’s about two per year, on average. Those 34 major currency movements were divided equally between devaluations (currency fell) and revaluations (currency rose).
Top eight global trade currencies
Currencies used by value of international trade payments
Source: SWIFT data as of October 2015.
Stocks move in same direction as the currency – During those major currency movements of 3% or more, the currency and the stock market of a country moved in the same direction 88% of the time (stock performance measured in US dollars with most of the stock market move exclusive of the change in currency value). In other words, stocks fell most of the time when the currency was devalued and stocks typically rose when the currency was revalued higher.
Stock market moves were sharp - The median stock market decline following the 3% or more devaluations among the eight countries studied was -9.6% (measured in US dollars). The declines were sharp and typically took place all on the day of the devaluation.
Stock market recoveries were swift – Fortunately, stock markets recovered the losses associated with currency devaluations fairly quickly. The median period was only 23 days for the stock market index in that country to rebound to the 5-day average that preceded the devaluation. Stocks fully recovered in every one of the devaluations studied.
What should an investor do to protect from currency devaluations?
Hedging currency exposure may make sense when investing in developed international stock markets when seeking to lower portfolio volatility and offset the drag from a rising dollar on foreign-sourced gains in 2016. Many investment products offer hedged currency exposure.
The currency moves we expect in 2016 are likely to be similar to those seen over the past 15 years. A more defensive portfolio posture hasn’t proven necessary in the past. Investors have had little to fear beyond the short-lived dips in the stock market from currency devaluations.