After the 2008 financial crisis, investors might feel there are no safe havens left. However, in order to identify safe haven currencies, investors need to know the difference between statistical safe havens and valuation-based safe havens, explained Michael Lewis, vice-president, currency and absolute return, with CIBC Asset Management. He was a speaker at the 2015 Risk Management Conference in Muskoka held in August.
A statistical safe haven is a good place to start, he said. Looking at the correlation between the currency returns (versus the Canadian dollar) and local equities, the Japanese and U.S. currencies are statistical safe havens. The premise of looking at correlations is as simple as “a safe haven is as a safe haven does,” Lewis advised.
However, pre- and post-crisis data show that while some currencies remained as statistical safe havens (e.g., the Swiss franc and the South African rand), others changed significantly (e.g., the U.S dollar and the Euro).
So, while statistical relationships can be a starting point to identify safe havens, currency movements do not always play out as expected in practice, he explained. That’s why some investors are moving toward valuation-based safe havens, considering valuation and other factors to help predict returns. “If you have a currency that’s undervalued— or at least not overvalued—it is more likely to be safe.”
How to value currency
So how can you know if your “safe haven” is truly safe? There are two useful models for currency valuation, said Lewis:
Purchasing power parity: the law of one price, which assumes the cost is the same regardless of location; and
Balassa samuelson model: this model adjusts the cost based on a country’s productivity.
Since the U.S. dollar is particularly important to Canadian investors, careful consideration is required. While “most studies would show very clearly that the U.S. dollar is a safe haven, circumstances can change over time,” he argued. For this reason, Lewis advises partly hedging exposure to the U.S. currency, or taking an active approach to hedging.
When implementing a currency strategy, investors can go passive, active constrained or purely active (unconstrained). For those without a lot of resources to successfully manage a dynamic strategy, passive is a good option, said Lewis. Active constrained and purely active strategies typically involve higher management fees and transaction costs, but the profits may offset some of the negative cash flows related to hedging, he noted.
Furthermore, there’s a case to be made for a purely active approach, he added. “There is an argument that currency is a very strong, potentially diversifying source of alpha. As investors increase their exposure outside of Canada, an active approach to currency management can play a meaningful role to help improve the return to risk of their return seeking portfolio.”