The piercing of the 7 U.S. Dollar/Chinese Yuan (USD/CNY) ceiling in the first week of August, and the subsequent labeling of China as a “currency manipulator” by the U.S. Treasury Department, prompted my colleague, Gabe Lembeck, CFA, to write a blog about currency dynamics and the potential implications of the trade-war-turning-currency-war.
It also stirred an internal discussion of currencies in the context of asset allocation and Balentine’s portfolio positioning. What is Balentine’s formal view on currencies? Do they represent their own asset class? If so, should Balentine have exposure to currencies within our allocation framework? We tackle these questions below by examining the validity of currencies as both standalone asset class and strategic investment.
Currencies as an Asset Class
Asset classes provide a relatively simple framework through which investors can group disparate parts of the capital markets together, simply, for analysis. Bundling in this manner allows investors to think about different securities as an abstract collection of risk premia, a measure by which an investment should outperform a risk-free asset in order to justify the degree of risk inherent in that investment.
Asset classes generally fall into one of two distinct categories—financial assets or real assets—and any difficulties in assignment are often indicative of the absence of true asset class status.
Financial assets derive value from a claim on future cash flows (e.g., stocks and bonds). On the other hand, real assets are tangible, physical goods with some intrinsic value beyond a simple contractual claim (e.g., infrastructure, timberland, and farmland). To illustrate the dichotomy, consider the art speculator and the currency speculator. The art buyer might purchase a painting hoping to profit from a rise in popularity of the artist. If the value of the piece were to decline substantially, the buyer might still gain some value from hanging the painting on the wall. Conversely, if the U.S. government were to lose all credibility overnight, the U.S. dollar, a financial asset, would become instantly worthless.
Further expounding the definition of an asset class, it is necessary that assets should be distinct from one another, both in features (e.g., seniority in the capital spectrum, regulatory treatment) and in market behavior.
Sub-asset classes, such as large-cap growth stocks vs. large-cap value stocks, while different in fundamental characteristics like price/earnings ratios, lack the idiosyncrasies necessary to be standalone asset classes. Both should behave relatively similarly in various market regimes or episodes, such as times of duress, economic expansion, or periods of high inflation, and both will likely behave differently from bonds during these same periods.
Two final considerations when discussing the legitimacy of asset classes are size and price (or return) history. Asset classes should have an extensive record of how they have performed through time, and the market for the asset should be sizeable; an aggregate value, or market capitalization, in the mere hundreds of millions of dollars with a three-to-five-year history can hardly be legitimized as an asset class.
For these reasons, it is perfectly sensible to consider currencies an asset class, as they:
Are dissimilar from other well-established asset classes, in both features and market behavior
Have reasonably long price histories, as most modern currencies have been in existence for several decades
The absence of any long-term risk premium does not preclude currencies from being considered an asset class, but, as we discuss next, it does omit currencies from consideration within Balentine portfolios.
Currencies as an Investable Asset Class
Having provided a broad definition of asset classes, and having posited that currencies satisfy most investors’ criteria for being deemed as such, we advance to a discussion of “investability.” Being an asset class is a necessary—but not sufficient—condition for strong consideration within an allocation framework. Balentine considers allocating only to those asset classes which contain risk premia that are:
Intuitive (i.e., Is the reason for return obvious?)
Pervasive (i.e., Has this premium been consistent through time? Is it found in multiple instruments?)
Accessible (i.e., Can this premium be readily accessed in a cheap and liquid fashion?)
Examples of such rewarded exposures include the inflation, interest rate, credit, and equity risk premia. Currencies, however, do not naturally exhibit a risk premium that warrants investment consideration; the return on currencies should be zero in the long term (unlike stocks and bonds), given that real exchange rates should converge to a natural equilibrium. Empirically, this absence of positive long-term returns appears to hold, as demonstrated in the following chart:
Furthermore, the potential to generate excess return by trading within a volatile asset class is insufficient to warrant an allocation. For example, active managers with some predictive skill might be able to capitalize on swings in asset class volatility. Balentine, however, prefers positive, long-term expected returns that are not solely reliant on such active management. Some might argue for the existence of a currency risk premium in the form of systematic plays like carry trades, which involve borrowing in a low-yielding currency, investing in a higher-yielding currency, and earning the spread. We consider such strategies to align more closely with alternative risk premia alongside factor exposures like value and momentum.
For Balentine to consider an asset investable in the absence of a natural risk premium, at the very least it should be able to play a predictable role within portfolios. For example, an asset class might be useful if it removes an unwanted exposure to a certain risk. Commodities, which also lack a “natural” risk premium, tend to behave in certain ways during various phases of the business cycle and can, therefore, act as an inflation hedge against demand-side shocks. Commodities remove a portion of the (perhaps) unwanted inflation risk premium within portfolios; as such, we consider them an investable asset class. And while certain safe-haven currencies, like the Japanese yen, tend to appreciate during risk-off environments, this behavior is only prevalent in a few currencies, is very difficult to time, and attempts to fill a defensive role which we believe is better occupied by sovereign bonds with a positive yield and greater duration.
Though currencies may meet the market’s definition of an asset class, they fail to meet Balentine’s standard for investable asset classes because they have no intuitive, pervasive, nor accessible risk premium and play no predictable role within portfolios.