Markets in Focus: Currency Risk Higher for Global Equity Investors

Currency volatility has disrupted global bond and equity markets since the Federal Reserve’s rate-hike cycle began in March 2022. Recent elections in India, Mexico and Europe, along with European Central Bank policy changes, have continued to stir currency movements. In this quarter’s edition of Markets in Focus, we examine the impact of shifting foreign exchange (FX) relationships on global equities, against a backdrop of continued rate uncertainty.

An overall stronger global equity market, but country-level returns varied

Global equities maintained an upward trajectory in Q2, posting a year-to-date return of 10% through June 2024,[1] but country-level equity returns were mixed. Chinese stocks rallied, while Japanese stocks — the first quarter’s performance leaders — pulled back. For international investors in Japan, the JPY’s decline against major currencies only deepened losses.

Chinese equities supported emerging markets’ returns in Q2


Data as of June 28, 2024. Quarterly returns for MSCI equity and fixed-income indexes are gross in USD. For 1-, 5- and 10-year performance data, please see MSCI’s end-of-day index data search. 

In contrast to equities, sovereign bonds continued to struggle over the quarter, down 5% for the six months ending in June, based on the performance of the MSCI Government Bond Index – Developed Markets.

Currency exposure has haunted USD-based investors since the start of rate hikes

We decomposed the excess returns of representative fixed-income and equity indexes using the MSCI multi-asset-class factor model from the perspective of a USD investor. We found that, since the start of 2022, for investors in foreign bonds, currency exposure has compounded the losses from term structure and spread effects.[2] And for investors in international equities, represented by the MSCI ACWI ex USA Investable Market Index (IMI), FX movements eroded all the gains from local equity markets.

As rates rose, currency impacts were on par with other sources of return

This exhibit shows the return contribution from currency, term structure, spread, equity market and other sources for the MSCI EUR Investment Grade Corporate Bond and MSCI Eurozone Government Bond Indexes, MSCI Government Bond Index - Developed Market (DM) and MSCI ACWI ex USA IMI for the period from Dec. 31, 2021, to June 28, 2024.
Data period from Dec. 31, 2021, through June 28, 2024. Returns are annualized and stated in excess of the three-month U.S. Treasury bill yield. We use the MSCI MAC Tier 4 factor model. Other sources include model residuals. We compare the MSCI EUR Investment Grade Corporate Bond and MSCI Eurozone Government Bond Indexes, MSCI Government Bond Index – Developed Market (DM) and MSCI ACWI ex USA IMI.

Hedging equities yielded favorable outcomes for USD investors

From January 2010 through June 2024, the USD strengthened against major currencies, supported by strong U.S. economic and corporate performance, international monetary-policy divergence and, longer term, the 2012 Eurozone crisis. Global investors — particularly non-USD investors — have increasingly adopted currency-hedging practices since the 2008 global financial crisis.[3]

USD-based investors who hedged their currency exposure over the last 14 years experienced lower risk and higher returns compared to unhedged investors, based on our index analysis. Hedging has not always reduced risk, however, and its impact on return has been regime dependent. For Japanese equities, hedging, both partially and fully, increased risk, as the following exhibit shows. This can be attributed to the unusual relationship between Japanese equities and the JPY-USD exchange rate.

Hedging Japanese equities historically increased risk

This exhibit is a scatter plot that shows the annualized risk and return for fully hedged, 50% hedged and unhedged investments in the Japan, Europe, UK and EM equity markets from Dec. 31, 2009, to June 28, 2024.
Data period from Dec. 31, 2009, to June 28, 2024. Annualized returns are gross in USD and reflect the unhedged, 50% hedged or fully hedged equity market. We applied the MSCI FX Hedge methodology for monthly or daily hedging, which is calculated as the difference between the notional cost of a forward FX contract versus the gain or loss on the spot exchange rate. The countries and regions are represented by the MSCI Japan, MSCI United Kingdom, MSCI Europe and MSCI Emerging Markets (EM) Indexes.

We used the MSCI Global Equity Factor Model to better understand the relationship between Japanese equities, using the MSCI Japan Index (USD), and the JPY. We also compared the relationships of the equity markets of India, Mexico and France with their respective base currencies. Since 2008, the rising equity markets in these three countries have tended to coincide with a rising USD.

Model-based correlations between currency and equity increased sharply in Japan

This exhibit plots the correlations from Dec. 31, 1997, to June 28, 2024, between the country’s returns in USD and the country’s currency for France, India, Japan and Mexico. Each country’s returns are proxied by the respective MSCI index.
Correlations are between the MSCI France, MSCI India, MSCI Japan and MSCI Mexico Indexes in USD and the country’s currency, based on the MSCI Next Generation Global Equity Risk Model from Dec. 31, 1997, through June 28, 2024. Correlations follow the framework used in determining risk contribution.

Japan was an exception. Since 2008, the equity market has been only weakly (and sometimes even negatively) correlated with the JPY-USD exchange rate. Importantly, our models show this relationship changed significantly in 2022. USD strength coincided with an upward-trending Japanese stock market. If this relationship were to persist, exposure to the JPY would increase, rather than decrease, total risk for USD-based investors in Japan, according to our model forecasts.

FX risk has risen for numerous home currencies

Lastly, we found that currency risk’s share of overall risk has increased across many home currencies, such as the JPY, EUR and CAD. JPY-based investors have been most affected by elevated volatilities and correlations, with currency accounting for 30% of risk for investments in single international equity markets, on average. CAD- and AUD-based investors have also experienced large swings in risk over the last two-and-a-half years.[4]

As market risk has fallen, currency risk has risen in many markets


Currency risk contribution based on home currency, MSCI indexes and the MSCI Global Equity Factor Model as of Dec. 31, 2021, and June 28, 2024.

One driver of these results is that market risk at the end of Q2 was considerably lower than in December 2021, just before the start of U.S. rate hikes. At that time, markets — and, hence, risk models — were still reflecting shocks related to the COVID-19 pandemic. As the market factor’s contribution to risk has fallen, other sources, currencies included, have assumed a larger share of portfolio risk.

Our models suggest that currency volatility has risen, along with higher equity-currency correlations, compared to two-and-a-half years ago. This development could have wider implications for equity and multi-asset risk management if the pattern were to persist.

The authors would like to thank Thomas Verbraken for his contribution to this blog post.

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