FX Trumps Correlation: How currency effects dominated portfolio risk in the aftermath of the US election
Author: Christoph V. Schon, CFA, CIPM, Executive Director of Applied Research
2016 was a turbulent year for financial markets. A number of unexpected outcomes of major political events caused significant volatility, in particular for currency exchange rates. The most notable surprises were the Brexit vote in June and the result of the US presidential election in November. The rate hike by the Federal Reserve Bank in December was widely anticipated, but markets still showed a significant reaction to a more bullish economic outlook communicated by Fed Chair Janet Yellen after the decision. This particular combination of market movements led to the slightly unintuitive conclusion that US equities showed one of the lowest risk contributions in a global multi-asset class portfolio compared with their market value weight. More detailed analysis revealed that the main reason for this was that the strong gains of the dollar versus its major rivals had made it appear as if non-USD assets were losing money (despite sometimes healthy gains in their local currency), while the US equity market soared. This resulted in a strong preference for domestic stocks from a US investor’s point of view, both in terms risk and return. In this paper, we will explore how the risk decomposition changes when we alter the base currency of the portfolio or apply implicit currency hedging in our Axioma Risk tool.