FX Effects
Key Takeaways
Due to the limited local investment options and concentration risk, we need to look globally to diversify effectively. By doing so, we become exposed to two factors of return:
The return of the underlying stock or bond in their local currencies.
The total return of the investment which include changes in the exchange rates between the SGD and the local currencies that those stocks or bonds are held in.
A weakening SGD will contribute to our returns and a strengthening SGD detracts from returns. Your outcome will depend mainly on these relationships amongst others.
Overall, FX considerations are very important for bonds and other safer instruments such as structured deposits, compared to equity strategies — as FX volatility can quickly destroy stable albeit lower returns.
The function of economic forecasting is to make astrology look respectable.
— John Kenneth Galbraith
The news on Fri 12 Apr 2024 recently reported that the MAS is keeping the SGD on an appreciating path to help combat inflation. However, just two weeks earlier, the news also quoted analysts predicting that our currency was likely to weaken as they expected the central bank to ease. Such a quick about turn again showcases the perils of forecasting.
There are many factors that affect currency and a myriad of reasons why policy makers would want to weaken or strengthen the local currency. An important consideration is its effect on the GDP, in particular the essential import/export sector of our country. Latest data from SingStat indicates that Asia (in particular China) is the largest trading partner for Singapore — and by a large margin. This is followed by the US, and then Europe. As such, the direction of where our currency goes may not be that apparent, as policymakers would need to juggle its effects vs Chinese Yuan, ASEAN currencies, Euro, and USD, as it could all lead to broader implications for our economy.
Singapore’s various import/export relationships can be seen in the graphs below:
However, such currency effects sometimes may be less apparent for your investments. This is because we tend to look at the headline returns without converting back to our home currency. Because the Singapore market is limited in terms of depth and exposure, we need to look globally to diversify effectively and to receive returns from around the world.
When we buy foreign stocks and bonds, we become exposed to two sources of return. First, we receive the return of the underlying stock or bond in their local currencies. Second, the total return of the investment, this includes changes in the exchange rates between the SGD and the local currencies that those stocks or bonds are held in.
A weakening SGD will contribute to our returns (i.e. you can get more SGD for a unit of foreign currency than before). In contrast, a strengthening SGD detracts from returns (i.e. you can get fewer dollars than before). Over the long term, the SGD has appreciated versus quite a number of the major currencies worldwide — so investments held in those currencies, could result with lower returns than expected.
However, SGD does not experience a straight line appreciation year after year and there can be a lot of variation between the return of global stocks in USD or global stocks in SGD based on different time periods.
For instance, the SGD investor would have missed out a lot of returns from the 70s to the 90s — due to the appreciation of the SGD vs USD. Investing in global stocks in SGD would have grown your S$1 to just under S$6, but in USD it would have grown to nearly US$12 (shown in the chart above).
However the story over roughly the last decade has been quite different. The diagram above shows that global stocks in SGD have actually performed better than global stocks in USD. Your outcome and the FX effects on your investments will depend on which period you are invested in.
In aggregate, whilst currency effects may have been a drag over the very long-term, we see that there are periods where the currency effect helps. Isolating the currency effect by calculating the difference between three-year annualised returns in USD and SGD and presenting it on a rolling basis, the diagram below shows instances where the FX effects are beneficial to your investments.
A good question would then be, “Should I hedge my overseas investments — especially those in currencies I am most exposed to?”
As usual, there are a few things to consider. First, a hedged strategy effectively adds a bet on SGD versus other currencies. Since currency movements are unpredictable, this is like making a random bet. Sometimes, the hedge will help returns, and other times, it will hurt. We must also realise that currency hedging is not free.
A hedge does not really benefit equity strategies but it is very important for bonds and other instruments such as structured deposits — this is because their volatilities are much lower than the movement of currencies. As such, if you have foreign currency exposure in these types of “safer” instruments it may end up being riskier than expected, due to the exposure to FX movements. At the moment a popular trade is to borrow in JPY or CHF, as the interest rates are low, and to invest in other areas. However, be mindful of not only the cost involved, but also how the currency conversion could affect you.
In line with our investment philosophy, the reason we globally diversify is so that your total portfolio returns rely less on any single investment, region, or currency. Regardless of which outperforms over a period, you’ll always have returns. While these returns may not always be the best, it’s more important that they are not the worst. For more information on currency effects and how we efficiently mitigate it within our portfolios, come and chat with us.
