While Your Current FX Hedging Strategy May Have Served You Well Thus Far, Will It Work As Well Should There Be a Global Slowdown?


There has been much talk of a slowdown in global growth over the past few months, and people have even been using the R word of late. Memories of the Great Recession of 2008/2009 loom large in the market’s collective psyche, and so when groups such as the IMF and the World Bank cut their growth forecasts (which both did in January), the market gets concerned (Chart 1). As risk managers we are always asking ourselves: how should we advise our clients to prepare for changing forward-looking risks? In this case, as we will discuss below, an increased risk of global slowdown brings with it added risk to those with currency exposures in both the potential impact on returns and on liquidity, so a prudent manager should add optionality to their hedging strategy in order to hedge both of these key risks.

Chart 1: Global Growth (Historical and Projected)

 

 

 

 

 

 

 

 

 

 

 

What will be the cause of the next global slowdown?

 

The Global Financial Crisis had a very specific cause: debt levels and the housing market. Given that there was only one real factor to monitor, it was clear what was happening, and the impact was very sharp and deep. Contrasting that to typical market slowdowns and recessions, it’s much more common that there are multiple factors contributing to a reduction in GDP. Aggregating this information is more difficult and open to interpretation. As a result, the slowdown is usually more incipient, and gathers steam over a longer period of time than the 2008/2009 recession.
As the chart below shows, while monetary tightening, like we’ve seen in the US, has historically been a big contributor in the majority of previous slowdowns, numerous other factors were also involved.

 

 

 

 

 

 

 

Looking at various economies in light of the factors listed in the chart, it’s evident that some of these are playing out in some countries, even while the economic data looks generally strong. Canada, Sweden and Australia have seen significant cooling of their previously frothy housing markets, EM countries such as Turkey and Argentina are experiencing the impacts of previous financial excesses, and trade wars are causing concern over their impact on external demand for countries such as China and Germany. The cause of the next global slowdown (if we’re not there already) will be far more difficult to pinpoint, so we will likely be well in a slowing trend before the market really gets on board.

 

 

Are we experiencing a global slowdown?

 

As Chart 3 below shows, there are many data points that suggest that we are already seeing a contraction in the global economy.

 

 

 

 

 

 

 

 

 

 

 

 

Markets are concerned but not yet reacting in any meaningful way to this global slowdown risk. Looking at the equity markets, we saw a selloff across the board in late 2018, but have since seen a recovery in virtually all markets, indicative of a complacent market.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

What should a prudent currency risk manager do in this scenario?

 

That question is one we are asked a lot these days, and our answer is always the same:
1. make certain your risks are well understood in terms of their potential impact to your projected returns / EBITDA as well as their potential impact on liquidity;
2. make certain you have hedges in place to mitigate the risk, but add optionality into your hedging strategy to ensure you don’t get hurt by liquidity impacts, should your hedges go offside. There are ways to hedge both the downside risk to FX as well as the liquidity risks, and in times of high uncertainty and low implied volatility (which is exactly where we are today), it is prudent to cover off both of these risks.

 

 

As an example of how currency risk rises during times of market stress, we look at the US Dollar in terms of the reaction to a recession. The general thesis holds that as risks rise there is a flight to safety, and therefore the USD will appreciate in times of recession. As we see in chart 7 below, back in 2008/2009 we did indeed see a flight to the USD at the onset of the recession (green oval), but then saw the USD give up almost all of those gains in 2009 as the recession gained momentum (red oval). Grated this is only a single incident, but what it shows us is that what is really experienced is an increase in volatility with big moves, and the associated added risk for portfolio managers with currency exposure.

 

 

 

 

 

 

 

 

 

 

 

 

We recommend that our clients take the time to review their exposures, and consider adding optionality to their hedging strategy to mitigate against the risk of the increased currency volatility that will accompany an extended period global economic slowing, should this actually happen.

 

 

 



 

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