The coronavirus pandemic has hit the U.S. dollar hard, disrupting a dynamic that Canadian pension funds have taken advantage of for years.
Unhedged exposure to the U.S. dollar has been a boon for Canadian pensions as they’ve reaped the extra returns from the favourable conversion of asset income back into Canadian currency. But the outlook for the U.S. dollar is looking sketchier than it has for some time, says Aaron Hurd, senior portfolio manager at State Street Global Advisors.
“You just had a nine-year Canadian dollar bear market and the U.S. dollar added enormous tailwinds to performance on a trend basis. On top of that, you have the nice — albeit temporary — diversification during little shocks like December 2018, to some extent, but mostly with March, where you go from $1.34 to $1.47 in a matter of weeks, as equities collapsed. So that’s obviously great diversification.”
While the nearly decade-long cycle was positive for Canadian investors, the next nine might not be so kind, he says. “Given the size of the U.S. component for the majority of Canadian institutional portfolios, if you’re giving up, we would expect upwards of two to three per cent a year on the currency over the next five years, that’s a significant drag on your overall portfolio return.”
Historically, the U.S. dollar’s strength has proven quite cyclical, notes Hurd, swinging anywhere between 30 and 40 per cent over seven- to 10-year spurts. With most now expecting the U.S. to require a longer recovery period from the economic impacts of the pandemic, as well as a contentious election expected in November, there’s no end in sight for the pressure the currency’s under.
Going forward, many factors — pandemic-related or otherwise — will rattle equity markets, says Hurd. “In those isolated shocks, you do enjoy some diversification benefits. The problem with using unhedged U.S. dollars as a way to mitigate or diversify equity risk is that it’s a very expensive way to do that, for a couple of reasons. One is, it’s very temporary. Most institutional investors are very long horizon and that protection works for a month or two and then immediately reverses. . . .
“And, on average, over the long-term, Canadian investors are paid to hedge. Canada’s a small economy; it’s interest rates tend to be slightly higher than U.S. interest rates. So you get paid to hedge over time and you give that up if you go unhedged for the diversification.
“Right now, we’re fresh off the period where that diversification helped. . . . And we’re coming to the end of a nine-year period where just the trend returns from being unhedged were amazing. So this is going to be very easy for Canadian investors to underestimate.”