Jason Daw:
Hello and welcome to Macro Minutes. During each episode, we will be joined by RBC Capital Markets experts to provide high conviction insights on the latest developments in financial markets and the global economy. Please listen to the end of this recording for important disclosures.
Hello everyone, and thank you for joining this edition of Macro Minutes called Pivot Time. We're recording at 10 A.M. Eastern time on June the 10th. And the backdrop is that U.S. policy uncertainty is sky-high. Global investors own a lot of U.S. assets, mostly UN unhedged currency exposure. And the natural implication is that the collision of this large exposure and elevated uncertainty could have a large impact on global capital flows, asset markets, and currency hedging activity.
It's a broad topic, it has critical implications for investors of all stripes, and it's particularly fertile ground for currency specialists. So in this spirit, to unpack these complex topics, I'm joined today by Elsa Lignos and Richard Cochinos. So to kick it off, I guess over to Elsa first. And I guess as some background, the desirability of U.S. assets has ebbed and flowed based on cyclical factors. But the size, depth, return prospects and stability of U.S. policymaking has led to a structural increase in capital flows to the U.S. over time. And I guess the question is, have we ever seen a comparable shock to sentiment towards U.S. assets in recent history? And how big of a deal is the current situation in your opinion?
Elsa Lignos :
So I think there are two ways to look at this. Part of this is the shock of the new Trump Administration and investors having to question things which were previously thought unquestionable. We'll get onto that in a sec, but it's also worth setting the stage in terms of the starting point.
Over the last several years, there has been a long-term overweight position building up in the U.S. Part of it is capital inflows and part of it is valuation. So the fact is U.S. assets have in general, outperformed rest of the world. I can take the EUR area as an example of that. If I look back to the start of 2013, when the EUR area first started running a current account surplus, overall European held portfolio investment assets in the U.S. were sitting around 1.8 trillion, fluctuating somewhere just under the 2 trillion Euro mark. As of the end of last year, they were sitting at north of 7 trillion. And the EUR area may be an extreme example of this, but that's replicated across the world. And the fact is that heading into this shock, we started from a position where almost all foreign investors were heavily overweight U.S. assets.
Now, on top of that, you lay in the unpredictability, the unconventionality of the current Trump Administration. And I can see why it does feel in many ways, an unprecedented shock. So Richard, this is a great moment to bring you into the conversation. As the newest member of the macro strategy team here at RBC, and as somebody who was most recently on the buy side in a portfolio management role for the last five years, can you run us through how you look at foreign holdings of U.S. dollar assets? And what is happening to currency risk in global asset management portfolios?
Richard Cochinos:
Right. Thanks very much for that, Elsa. In short, the answer is 41 trillion U.S. dollars, give or take, plus or minus one to 2 trillion, which is our 5% margin of error. Now, how we arrive at that, we aggregate the assets under management of the 500 largest asset managers globally and the 100 largest sovereign wealth funds, pension funds, OCO funds to build a map of where these non-U.S. portfolios are managed. Now, if you exclude the U.S. from those total assets under management, we're talking about 74 and a half trillion is managed outside of the United States, which if we assume a 55% asset allocation to the U.S., that's how we arrive at our $41 trillion. We further break down this by country of origin for the portfolio. It's probably too much to go into this call, but ultimately your top three is Europe, Canada, and China.
Elsa Lignos :
And so, what's been happening on the currency risk of those global portfolios?
Richard Cochinos:
That's a great question. How has the risk changed? Now the short answer, it's gone up and it's specifically gone up for currency management. We built a simple global multi-asset portfolio of 50% stocks and 50% fixed income. And we tracked its risk in a post COVID world. Now, we did this with a VAR decomposition and we also looked at it from the perspective of a U.S. based manager, a European based manager, a Japanese manager, a Swiss manager, a UK manager, an Australian manager, and a Canadian based manager. For PMs outside of the U.S. foreign exchange contribution to overall risk or overall portfolio volatility has gone up with some of it doubling its contribution in the past three quarters. And for some countries or where those manager are based, it's the highest that it's been since 2021. Now, if you think about this, this is the risk adjusted return. FX or currency contribution to the risk side of that equation has gone up.
Jason Daw:
Okay. So very interesting, Richard. So from a big picture standpoint, what's the number one determinant that we would need to see for there to be increased hedging and possibly capital flow mobility?
Richard Cochinos:
Another good question. I hope it's okay, I'm going to give you two. First is, what is the cost to hedge? And second, what is the need to hedge? Both of these are going to affect your portfolio's total risk adjusted return, which is the way to think about it. Either as cost drop or risk increases or both, generally we'll see an increase in capital mobility which FX markets reflect. Now, Jason, turning to you and given Canada's proximity to the U.S. market, what has been the trend in Canadian holdings of U.S. assets given their large footprint? And what have the pensions been up to?
Jason Daw:
Yeah, Richard. So, there's been an explosion of Canadian investment in U.S. assets over the past 15 years. And to put it in context, back in 2010, holdings of U.S. assets by individuals, businesses, private asset managers of pension funds, that was 1 trillion. And now we're at almost six and a half trillion. And around 50% of those holdings are financial assets like stocks and bonds. The remaining amounts, mostly fixed investments and a residual portion in items like bank deposits.
Now the pension industry, it's large in Canada. And its size, growth capacity, diversification needs, and investment return angles, these have all necessitated an increasing portion of total holdings being outside of Canada. And when you look back to 2000, domestic listed assets, so stocks and bonds, they represented around 70% of pension holdings compared to only about 40% now.
Elsa Lignos :
So going forward, Jason, how do you think that domestic versus foreign asset allocation mix could change?
Jason Daw:
Indeed, Elsa. So going forward, all eyes are on this industry and what they do with their domestic versus foreign asset allocation mix. And there's really two aspects to consider here. One is the flow aspect and one is the stock aspect. And it is a complicated balancing act. From a pure investment return perspective, that's decidedly in favor of maintaining the status quo that we've been seeing. But it's not difficult to imagine that asset allocators are more conscious and discerning about their domestic versus U.S. investment choices. And of course in that discussion, pensions can shift from the U.S. to non-Canadian markets as well, especially Europe, which probably has the second most capacity outside the U.S. So, it's not just the U.S. versus Canada decision.
But looking at it from a flow perspective, I would say that the bar would be probably low to adjusting allocations when new money comes in to a fund. And the higher bar would be changing the stock of existing investments. So, active selling of U.S. assets and bringing those proceeds back to Canada. And ultimately pension funds, they're going to need to balance the trade-offs across many competing factors in their investment strategy. And it's unclear which direction or how quickly this will proceed, but it's definitely worth monitoring these medium-term trends given the size of the industry.
Elsa Lignos :
So Richard, zooming out again and thinking more generally about FX hedge ratios, we don't often get hard data on them. Where we do have some hard data, we can see that they have been rising over the last six months. I'm thinking specifically about Japan and the lifers. But more generally, how do you see the shift happening in FX hedge ratios? What magnitudes are we talking about and which currencies could be the most impacted?
Richard Cochinos:
Well, I tend to agree, absolutely, without a doubt, hedge ratios are going to be rising. Now, if we go back to the portfolios we talked about earlier, that 74 and a half trillion dollars, which is managed outside of the U.S., foreign exchange FX currencies, it's generally considered uncompensated risk. So, the practice is hedge out as much as you can and how much is practical or cost-effective.
Now so for magnitudes that we're talking about, let's be conservative and assume something like 5%. And if we assume the asset allocation to U.S. is 55% of that, 74 and a half trillion, 5% rise in the hedging of dollar assets leads us to a greater than $2 trillion selling or dollar hedging order flow. Those are the numbers that really start to matter.
Now, as you know, all hedging approaches are different by client and by the underlying asset exposure. But if we look at these big pools globally, the Euro area, the UK, Japan, Canada, Switzerland, these are all the areas that they kind of rise to the top of the net where we're going to likely see some hedging interest. Notionally, Europe is the largest stock of assets at 8 trillion. UK has 3 trillion, Japan and Canada just under 3 trillion.
But another part of this hedging to consider is the cost. The larger the negative, the forward carry is the less hedging you can actually afford to do. And the final part is liquidity of currency that you're hedging back to. As an example, let's take sterling, which has roughly half the liquidity of the European Euro. You sell the same amount of dollars into both Euro and sterling, the impact on sterling would be about two times that of Euro.
So, what we can do is we filtered the average daily turnover for these currencies that we were looking at where we found these pools of capital externally. And then we basically limited your hedging to the average daily turnover. Once you do that, Canada becomes very interesting. Because not only is it a large pool of assets, but has significantly less liquidity than Euro and sterling and Japan, for instance.
So like I said, the large pools of the capital, they're in Europe, they're in Canada, they're in the UK, they're in Japan. But once you kind of take currency liquidity into account, the ones that tend to matter in the G10, Canada, Norway, Switzerland, all potentially could actually see dollar weakness versus them. Jason, what are some of the possible implications for fixed income in Canadian markets if home bias started to rise?
Jason Daw:
So any of the monies that stay at home or come back from an active asset allocation shift, they could have outsized impacts on Canadian asset markets. At least in fixed income, that could go a long way to absorbing the elevated supply that's coming to the market over the next year. And that supply is only going to grow if the proposed fiscal measures from the government are enacted. And it would disproportionately impact the long end of the curve, because this is where the pensions typically traffic in their investment decisions, so stuff like tens and thirties. Probably lead to a flatter yield curve than otherwise. And it could also reduce some of the downward pressure on swap spreads from heavy issuance and alleviate some of the expected upward pressure on Canada-U.S. cross-market spreads. So Elsa, to wrap up the discussion, is there anything that we can conclude from the price action over the last few months?
Elsa Lignos :
So what's interesting is that to pick up on a point made earlier by Richard, we haven't actually seen the cost of hedging shift materially so far. So yes, we've seen some increase in hedge ratios, and that's evidenced by the Japanese data I cited earlier. But we're at the very early stages of what's likely to be a multi-month, multi-quarter process.
If I think about the cost of hedging, what's really going to shift that is the fed's starting to cut rates. On our forecast, we're looking for around 150 basis points of cuts over the next year. And as that happens, we expect that we'll accelerate the process of increasing hedge ratios. So coming back to your question around the price action in the last few months, part of this is very early stages, a bit of speculative positioning ahead of that longer-term trend that's likely to take place.
But the other thing that's worth highlighting is the shift in the way the dollar has been performing relative to other asset classes. And I'm thinking here specifically equities. Dollar CAD stands out to me the most. Historically, Dollar CAD has always had the strong inverse correlation to equity returns. Such that a lot of Canadian investors were motivated to leave their U.S. equity holdings unhedged because the currency almost acted as a natural hedge. Over the last few months, that's no longer the case. And actually now if you look at Dollar CAD's correlation to equities, it's pretty much insignificant. Eurodollar has already flipped its correlation such that Euro is the relative safe haven.
If you extend that over time, I think it actually reinforces this expectation for hedging behavior to shift more materially, more fundamentally. And so for me, I'm watching this price action very closely, very carefully. Because the longer that this breakdown in correlations persists between the dollar and equities, particularly for those more traditional risk proxies like the Canadian dollar, the more likely you are to see a change in the incentives around hedging. And therefore leads to potentially some pretty significant longer-term adjustments in hedge ratios.
Jason Daw:
Thank you, Elsa and Richard. The insights were extremely helpful. And thank you to our listeners for joining today. And hopefully the content can help guide your investment decisions. Now, there's a lot of moving parts, some of them very complex, and a lot of data to monitor regarding this potentially significant mega trend. So if you would like more information, please reach out to us directly or via your sales contact. Or visit RBC Insight to read our content.
Speaker 4:
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