Common valuation measures give mixed results

The most common valuation approach, purchasing power parity, provides mixed results for the Swiss franc. Using data from the SNB the overall level of the franc does not appear expensive compared to a broad basket of currencies as the low level of Swiss inflation has maintained the purchasing power of the franc even as the nominal exchange rate has risen dramatically over recent decades. Ensuring accurate measurement of inflation trends is important when looking at such long time periods. Our research therefore focuses on ensuring that we have appropriate and comparable measures included in our proprietary models.

When we look at comparisons of the franc against individual currencies we find some signs of overvaluation against the euro, little difference from long-run averages against the US dollar and some evidence that the franc is actually cheap against a basket of smaller commodity-sensitive currencies.

Income levels in Switzerland have been high for many decades and our research has shown a relationship between higher levels of per capita income and higher price levels, casting further doubt on the significance of the high price of a burger or a coffee from the perspective of a currency investor.

SNB EFFECTIVE EXCHANGE RATE INDICES, DIFFERENCE FROM MEDIAN 
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Source: Swiss National Bank as of 31.01.2019.

Current account dynamics remain a positive for the currency

When we assess currency valuation we examine balance of payments dynamics as an important cross check on purchasing power parity, to see whether a currency that appears expensive is behaving like an expensive currency.

The SNB argues the level of the Swiss current account is distorted by certain activities, such as commodity trading, that occur mostly in foreign currency. Our research has indeed shown that it is the changes in the current account that are more important for currency markets than the absolute levels due to a variety of measurement issues. However, Switzerland has run a large and stable current account surplus, with no sign that the exchange rate appreciation a few years ago has reduced the competitiveness of Swiss industry, despite trade in goods typically being most sensitive to exchange rate valuations. Our quantitative assessment of the current account dynamics suggests future appreciation pressure, not depreciation pressure.

The high cost of carry is an issue

Rather than the valuation, the key issue we see with holding the franc is the high cost of carry that comes from paying around 0.75%1 on Swiss deposits while also missing out on rates of around 2.7%¹ on US dollar cash. This interest rate difference is around multi decade wides even as inflation rates have converged, with the difference averaging little more than 1% per year recently.

With little sign that the SNB is likely to change course away from highly accommodative policy, the cumulative effect of this real carry over a period of five years would require the franc to appreciate 12% in real terms simply to break even, taking the franc to levels that truly would appear expensive.
BALANCE OF PAYMENTS, % GDP
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Source: Bloomberg as of 30.09.2018


Currency Management

Since our first segregated currency overlay mandate funded in 1989, J.P Morgan Currency Group has grown to manage a total of USD 361 billion in bespoke currency strategies. Our clients include governments, pension funds, insurance clients and fund providers. Based in London, the team consists of 20 people dedicated exclusively to currency management with an average of over 15 years of investment experience.

We offer a range of hedging solutions for managing currency risk as well as a tailored optimal hedge ratio analysis:

  • Passive currency hedging serves to reduce the currency volatility from the underlying international assets. It is a simple, low cost solution designed to achieve the correct balance between minimizing tracking error, effectively controlling transaction costs and efficiently managing cash flows.
  • Dynamic ‘intelligent’ currency hedging aims to reduce currency volatility from the underlying international assets and add long-term value over the strategic benchmark. A proprietary valuation framework is used to assess whether a currency looks cheap or expensive relative to the base currency and the hedging strategy is adjusted accordingly.
  • Active ‘Alpha’ currency overlay strategy offers clients’ passive currency hedging, if required, combined with an active investment process to deliver excess returns relative to the currency benchmark. Our approach is to build a global currency portfolio combining the output of fundamental models and incorporating the qualitative views of our strategy team.