Currency's return opportunity for today's macro investor

Most professional asset allocators today attach below-average return expectations to traditional asset classes across the capital spectrum. Relative to their historical averages, equity valuations are high and bond yields remain low.

This unfavorable outlook for conventional investment categories magnifies the pressures many investors feel, as the risk of failing to reach a particular return objective continues to rise. Even more concerning, without strong prospective return potential from mainstream markets, the risk of losing money increases.

At First Quadrant, we're paying particular attention to global policy uncertainty readings, variables that can tell us something about:

• The expected return on risk assets: If policy uncertainty rises, then the premium investors require to hold risky investments typically goes up, too.
• The likelihood of recurring market shocks, positive as well as negative: When policy uncertainty is high, policy proposals or actual changes happen with greater frequency and have the potential to induce short-term dislocations or sudden shifts in the valuations of different asset classes and investment instruments.
• The potential for major shifts in economic growth and inflation: Policy uncertainty typically indicates a greater potential for changes in asset prices, correlations, and risks.

Today, we face an unusually high level of uncertainty around major domestic and international policy positions that have prevailed since the fall of the Berlin Wall, increasing global trade liberalization and associated deflationary pressures across the developed world, and, more recently, since the 2008 global financial crisis, the trend toward ever-looser monetary policy and tighter bank capital and regulatory financial standards.

Shifts in any of these established policies can lead to relative value investment opportunities, particularly across currencies, as changes in these global policy forces have a tendency to affect foreign exchange markets in a major way.

Investors who manage international equity portfolios must consider currency in the context of risk management of those exposures. Many focus on currency as a hedging vehicle, perhaps because they conceptualize currency only as a zero-sum game. However, the very nature of currency markets can also work in their favor: Active managers often attribute a lack of opportunity to a lack of dispersion among markets, but this isn't true of the currency market today.

Global macro and fixed-income managers have long included currency with the explicit intention of augmenting returns. Indeed, the return-generation potential of international bond and macro managers is often driven predominantly by their underlying currency views. Moreover, macro risks have been increasingly relevant in the current environment as central bank divergence, policy shifts, and macro-centered event risk move currency markets. We believe this will continue, if not increase, as countries embark on increasingly different economic paths, creating macro dispersion and opportunities for currency investors.

Currencies are almost perfectly constructed to provide views on relative movements; by definition, you must sell one currency to buy another, and vice versa. It's difficult to find similar ways to express macro views in other assets, which is why currencies tend to provide a powerful source of uncorrelated and potentially diversifying exposures to a portfolio.

Currency managers as a group—using the Barclay Currency Traders Index as a proxy—have been able to provide differentiated returns with low correlations to other assets over the long term, and an active currency program may serve as an effective complement to other strategies commonly found in investor portfolios over time. Especially right now, an absolute return-oriented currency investment may provide genuine diversification potential at a time when diversification is so desperately needed.