Currency markets are one of the largest and most liquid in the world. Economic variables like interest rates, economic growth, inflation and productivity are some of the drivers of currency movements making predicting currency difficult.  Extreme fluctuations in currency can have a meaningful impact on client returns and can also impact the ability of fund managers that employ currency hedging to pay distributions in the future. This has been the case in more recent times for Australian investors.

In Australia, 2008 was a dismal year for investors. We saw a huge devaluation of the Aussie dollar against the US dollar from a high of 0.9794 on the 15th July to a low of 0.6013 on the 27th of October. This amounted to a 38% decline in just over 3 months. The chart below demonstrates just how large the fall was and how volatile currency markets can be.

The Australian dollar didn’t just drop against the US dollar (USD).  In the same period it fell 45% against the Yen and 22% against the Euro.  The reasons behind the drop were a combination of rapidly declining interest rates, the unwinding of the AUD YEN carry trade, the decline in both demand and prices for commodities and a ‘flight to safety’ to the USD.

How important is Currency?

Normally, small currency fluctuations over time are easily managed and would not typically have a material impact on investors’ funds and portfolios.  But large movements, such as the ones experienced in 2008, will have an impact.

This paper will discuss the two main effects of significant currency fluctuations:

• The cash flow effect, and
• The performance effect

The Cash Flow Effect

Many of the funds that are routinely used in portfolio construction use currency hedging to remove risk associated with the movement of the Australian dollar.  Funds that will typically be 100% hedged include international fixed interest funds, international property funds, some international equity funds and global listed infrastructure.

If a managed fund hedges out the effect of a fluctuating currency, then the usual mechanism for this is to use currency forward contracts. If forward contracts are in place in a portfolio then this is what happens:

The key part of the table above is the highlighted cell.  If the Australian dollar devalues, then the forward contract makes a loss which must be settled in cash.  In the normal course of events this is not a problem.  The manager simply settles out of cash in the portfolio or sells assets.  This settlement in cash becomes a problem when:

• The devaluation of the Australian dollar is very large over a short period so that a large amount of cash is needed; and
• Some or all of the assets in the portfolio are illiquid.

The other key part to understanding this problem is to appreciate the quantity of the cash needed.  Fund managers have sometimes needed to find enormous amounts of cash.  To illustrate, it’s best to work through an example.

Numerical Example – AUD against USD 3 month forward contract.

In a forward contract the following may occur:

• The Australian fund manager agrees to sell Australian dollars and buy USD today (T0) at the ‘spot’ rate (today’s transaction rate).
• The fund manager simultaneously agrees to reverse this, that is sell USD and buy AUD, in 3 months time (T90) at the forward rate.

The forward rate is calculated using the AUD/USD spot rate and the two risk-free interest rates for each currency. This is a 90 day example, where at T0 we sell AUD and buy USD, and at T90 we sell USD and buy AUD.

Note: We have selected values that were applicable in July 2008 for this example.

So the Australian fund manager has agreed to buy USD and sell AUD at 0.9379 in 3 months time.

At the forward date the transaction unwinds itself.  The profit/loss of the transaction is shown in the table.  For simplicity, we have used a USD amount of $1,000,000 at the end of the forward contract.

The calculation is simple. At the end of the forward contract the fund manager is selling USD 1m at the forward rate to get AUD (1,000,000/0.9379) = AUD $1,066,118.

If the fund manager doesn’t have USD1m to sell at the end of the contract because there have been no sales from a portfolio, then they also have to buy USD at spot.  If we use 0.6500 as the spot price, this would cost $1,000,000/0.6500 = AUD $1,538,461. That is, it costs $A 472,343 net to settle the contract. When the AUD goes from 0.9500 to 0.6500 in a three month period, then the currency forwards lose AUD $472,343 for every $1m hedged. This was the situation in 2008.

The table below shows the cash flows associated with unwinding the forward contract above (0.9379) at different T90 spot rates.

To repeat, in this example, which mimics the market in the 3rd quarter of 2008, a fund manager with a portfolio of fully hedged USD assets would have had to find almost half a million dollars in cash to settle every million dollars hedged through a currency forward.  A fund manager with a $1 billion portfolio would have had to pay out close to $500 million in cash to settle the contract.

Of course not all fund managers had fully hedged portfolios or 3 month forward contracts.  Many had longer dated forwards or some of their portfolios unhedged.

Effect on Portfolio

There are several potential effects on a portfolio, depending on how it is structured:

• When there is a cash loss from currency forwards, there is also a matching upward valuation in the assets.  The value of the fund does not change.  The difficulty is that the portfolio value is paper profit and the payment of cash is a real payment.
• Assets may have to be sold to settle the forward contract.  In a ‘hybrid’ portfolio that has both liquid and illiquid assets, this might alter the proportions of each.  The fund might become overweight in illiquid assets.  Most funds have limits around the proportions of each.
• The cash that needs to be paid may use up the existing liquidity in the fund, including the normal cash buffer that is used for redemptions and any accumulated income.
• The forward loss may be accounted for as a trading loss.  Income flowing into the fund will be set against the loss and not paid out as distributions.
• The fund, if it is able, may have to borrow to fund the cash settlement.  Income coming into the fund would then go to paying off the loan.

Where there has been the extraordinary circumstances of both market illiquidity in property and fixed interest, coupled with the enormous fall in the Australian dollar, it is not surprising that there have been some funds that have had to alter the redemption schedule or distribution practice due, at least in part, to the effects of the negative cash flow on the currency forward contract.

The Performance Effect

You have seen from the example above the possible scale of the effect of extreme currency movements.  Of course not all funds are fully hedged. International equity funds or those funds that are perceived more liquid behaved differently to the cases we have discussed above:

• International equity funds are liquid.  If cash is needed the manager simply has to sell assets.
• International equity funds can range from fully hedged to fully unhedged. Typically, most would not hedge more than 50%. There are both passive currency managers and active currency managers. The focus for international equity funds is not just the cash flow effect in very volatile markets – it is the currency effect throughout all market cycles.  An appendix has been attached to the back of the paper highlighting the different approaches adopted by ‘International Equity’ managers on the Lonsec approved list.

In summary, it is important to be aware of the effects of currency movements along with asset sector movements. Even skilled equity fund managers find predicting the direction and size of exchange rate moves difficult, therefore using currency as a source of alpha can be fraught with danger. In many cases the currency effects swamp the underlying market effects and, as we have seen, can also lead to changes in redemption and distribution policies for some Funds.

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• Strong returns by listed property companies during the month were mainly driven by positive momentum in most global equity markets.
• The prospect of further quantitative easing in the US would be beneficial to property companies. Asset valuations would improve because the lower risk-free rate tends to cause capitalisation rates to have adownward bias.
• We continue to hold a positive bias to the North American and Asia-Pacific regions and a cautious stance towards property companies in Europe, which we expect to continue to lag despite the outperformance during the September quarter.

Market Review

Strong returns were generated by property companies during the quarter in virtually all major geographies. European property companies generated the highest total returns, up more than 18%, based in part on the positive response to bank stress tests in July followed by Basel III pronouncements in September, both of which were deemed to be less stringent than expected. Property companies have benefited from lower bond yields, which have improved the yield spread versus fixed-income alternatives as well as improving earnings prospects.

Macro-economic news continues to drive sentiment

Macro-economic news continues to confound investors who are seeking smooth, sustainable trends. Economic releases have been inconsistent as they appear to vacillate. As an example, US existing home sales plunged 27% in July from a month earlier to an 11-year low as demand was pushed forward from the anticipated expiration of the first-time home buyer’s tax credit, only to rebound 7.6% in August to a seasonally adjusted annual rate of 4.13 million sales.

While up nicely from the 3.84 million annualized rate in July, this remains 19 percent below the 5.10 million-unit pace in August 2009 (so good news at first glance turns out to be mixed).

One clear theme for the quarter, however, was the consistently benign nature of the review of European banks. European bank stress tests, released on July 23, were less stringent than expected as only seven of the 91 banks tested failed. Separately, the Basel III rules announced in September were more accommodating than expected as banks will have the better part of a decade to meet the new requirements. This measure has provided relief for European banks as well as industries deemed to be capital users, including property companies. Equities rallied globally on this news.

Language from the US Federal Reserve Bank (the Fed) in September indicating that it’s open to further quantitative easing also contributed to the rally during the quarter. Taken with economic growth in the Asia-Pacific (ex-Japan) region which remains robust, the case for a continued global economic recovery appears to remain intact.

The implications of potential quantitative easing

Probably the most important recent event during the quarter was the change in language from the Fed’s rate-setting Federal Open Market Committee. The Committee in its September statement made it clear that further quantitative easing is a possibility as it stated that it “is prepared to provide additional accommodation if needed to support the economic recovery.”

As background, quantitative easing has typically been in the form of the Fed expanding its balance sheet by purchasing Treasuries and potentially mortgage-backed securities in the market in an effort to reduce these “reference rates” for a variety of fixed income instruments.

The ultimate goal is to reduce the cost of private sector borrowing in order to spur economic growth. The impact on real estate companies is generally very positive both with respect to asset valuations as well as cash flow.

Asset valuations are improved since a lower risk-free rate tends to cause capitalisation rates to have a downward bias, which causes the value of an in-place cash flow to rise.

Cap rates decrease since investors are able to afford to pay more for a given level of earnings while maintaining the same spread to the cost of capital (which has gone down because debt costs have come down and possibly the cost of equity, too).

Cash flows tend to improve as the cost of borrowing becomes cheaper.

External growth (acquisitions/development) also tends to pencil out more easily as the overall cost of capital goes down.

Taken together or even separately, quantitative easing is clearly very beneficial to real estate companies.

While the Fed has not engaged in another round of quantitative easing, it has made it clear that it is ready and able to engage if and when needed. This would be positive for real estate stocks.

Low rates and high spreads improved real estate valuations

Talk of quantitative easing and fears of recession are likely to keep interest rates low in the near term. As stated previously, yield spreads for real estate companies versus fixed-income alternatives remain attractive. Even with the rally in real estate stocks in September, implied cap rates generally represent significant positive spreads to local bond yields.

For investors who expect a continuation of low yields and low returns, it is logical that real estate values have been going up and may continue to do so. In the US, the implied real estate yield on REITs is 6.5%, which implies a spread at the end of September of 90 basis points to the 5.6% yield on Baa corporate bonds (the longest duration corporate bond composite of 25-30 year paper). This remains above the
average spread, which according to data compiled by Green Street Advisors has averaged 80 basis points since 1994.

Green Street Advisors has also estimated that commercial property values in the US have risen by 25% in the last 12 months and almost 30% from the trough values in May 2009. Values are still more than 20% below the peak levels reached in late 2007.

Other markets have followed a similar trend. The following table shows real estate yields (i.e., cap rates) implied by current REIT pricing around the world, as well as the NAV premium or discount, which reflects our estimate of implied pricing versus prevailing private market valuations for comparable real estate portfolios. We currently estimate that global listed property stocks trade, on a market cap weighted average basis, at a 3% discount to private market real estate values.

Third quarter earnings season is upon us

Third quarter earnings reports should evidence continued improvement as we expect many of the themes seen during 2Q10 to continue to play out:

1. improving property fundamentals;
2. wide-open access to debt and equity capital at competitive costs;
3. increasing transaction volumes and;
4. firming property transaction yields.

If anything, we expect the “new news” to be that yields have room to compress further as a result of bond yields, which have headed lower over the past few months and the Fed which has made it clear that it would like to keep yields low over the foreseeable future.

Property companies will continue to be able to reduce their cost of capital via a lower cost of debt as refinancing improves the prospects for positive spread investing. We expect low yields to continue to underpin property values.

OUTLOOK

Improving fundamentals portend positive earnings growth in 2011

We believe real estate companies will be able to deliver modest growth in earnings in the current environment. We look for a global weighted average growth rate for property company earnings of 7% in 2011. In the meantime, the unusually wide spreads between real estate yields and bond yields suggest that real estate assets are still attractively valued. If yields remain low, then real estate values if anything are likely to improve.

The path forward

We continue to retain the view we had at the beginning of the year, but with a few caveats. We continue to hold a positive bias to the North American and Asia-Pacific regions and a cautious stance towards property companies in Europe, which we expect to continue to lag despite the outperformance during the quarter.

By property type, we remain overweight sectors which stand to benefit from an economic recovery, including the shorter lease length hotel and apartment sectors as well as certain office markets in the Asia Pacific region. We remain underweight property types which react more slowly to economic recovery including healthcare and most office markets in North America and Europe.

Our outlook remains predicated on the assumption of gradual but steady global economic growth.

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