Measuring The Potential Impact of Global Trade Slowdown
My name name is Chris Martin, Product Manager at Omega Point, and I’m excited to take the Factor Spotlight helm from Omer over the next two weeks.
Today, we’ll begin a series of posts on the extreme recent performance of a factor that is most heavily linked to global trade: Exchange Rate Sensitivity. We’ll also provide our weekly market and factor update.
Defining Exchange Rate Sensitivity
Exchange Rate Sensitivity is a factor that captures a company's risk associated with its revenue generation in foreign countries given constant fluctuations in exchange rates. Exchange Rate Sensitivity is calculated by regressing local market asset returns against the returns of a currency basket, in this case the International Monetary Fund’s Special Drawing Right (SDR) basket. SDR currencies from the top 5 exporting currencies in the world, which currently consists of the following currencies at the following weights:
From the perspective of a USD based investor, assets whose returns have higher positive sensitivities to fluctuations in the FX markets will have a positive exposure to Exchange Rate Sensitivity. Assets whose returns have lower and even negative sensitivities to fluctuations in the FX markets will have negative exposure to Exchange Rate Sensitivity.
We can connect these exposures to our intuition about how FX rates influence markets by thinking as a US based investor.
Who benefits during strong dollar: (companies with positive exposures to Exchange Rate Sensitivity)
- Foreign companies that do business in US
- US companies that rely on importing goods/materials from foreign countries
Who gets hurt during strong dollar: (negative exposure)
- US Companies that do business in foreign countries
- Exporters get paid less in terms of their own base currency
Generally when the US dollar strengthens, US companies that rely on imports benefit as goods cost less in terms of USD to purchase, and US companies that rely on exports can suffer given goods cost more in the local currency reducing demand. Generally when the US dollar weakens, US companies that rely on imports are hurt as goods cost more in terms of USD to purchase, and US companies that rely on exports benefit as goods are less expensive increasing demand. We can therefore think of Exchange Rate Sensitivity as the ‘import/export revenue/cost of goods risk’ factor.
Cumulative Performance (4/9/2019 - 4/9/2020, AXWW4-MH model)
On March 18th, Exchange Rate Sensitivity was up over 1%, and fell over 2% in the next 10 days. It hit a trough of -0.95% on March 27th, popped back up to near-0 on April 4th, and then immediately gapped down to -0.93%, where it sits today. On a normalized basis, we can see how profound this recent move was, as the factor now sits at -4.45 standard deviations below the mean after plumbing the depths towards a full 5 standard deviations below the mean on March 31.
Now let’s compare the cumulative return chart to USD/SDR over the previous year (courtesy of XE.com):
Here, we see that the factor return of Exchange Rate Sensitivity is correlated with the relative strength of USD. When USD strengthens relative to the SDR, the factor return for Exchange Rate Sensitivity is generally positive, and when USD weakens the factor return is generally negative.
The big changes in USD strength relative to US equity asset returns can also cause similarly sized changes in Exchange Rate Sensitivity asset exposures. While Exchange Rate Sensitivity has traditionally been a relatively low volatility factor, recent times are showing it may end up capturing a “fiscal policy” phenomenon.
The drops in Exchange Rate Sensitivity (and the USD/SDR) began on March 19th, when rumors of Fed intervention began swirling. The big drop happened on March 23rd, when the Fed announcement unlimited Quantitative Easing, which caused the USD to depreciate and thus the Exchange Rate Sensitivity factor to drop. Trump signed $2T stimulus on 3/27, which actually caused the USD to rally back for a short stint, until this week where we saw further USD depreciation.
What will the future of this factor be given the Coronavirus pandemic and the financial accommodations now in play? Will companies start to rely less on complex international supply chains and implicitly reduce their FX risk? What currency will win the stimulus arms race by staying strongest relative to the rest of the world? Exchange Rate Sensitivity is an interesting factor to keep your eyes on during this unprecedented time of fiscal expansion and supply chain breakdown. Next week we will continue our analysis at a company and sector level, to help investors identify unwanted risks and alpha opportunities.
US & Global Market Summary
US Market: 4/03/20 - 4/09/20
- The market enjoyed a colossal rally in a truncated week of trading, as the mantra “Don’t fight the Fed” rang true. Stocks had their best week in nearly a half-century, as the Fed announced several additional measures to prop up the economy, including $2.3T in loans.
- At the same time, we received another shocking job report, with initial jobless claims for the week of 3/29-4/4 jumping another 6.6 million, bringing the three week total to 16 million.
- The US is now home to the world’s deadliest Coronavirus outbreak, as cases exceeded 500,000 domestically and US fatalities neared 20,000. The global death toll also reached 100,000 worldwide.
- OPEC+ negotiation efforts were throttled as Mexico became the last holdout on agreeing to participate in the 10% cut in worldwide production.
Factor Update: Axioma US Equity Risk Model (AXUS4-MH)
- Earnings Yield - another proxy for Value - was the week’s biggest winner, as it vaulted up over one full standard deviation after seeing a big positive move the week prior.
- Market Sensitivity saw a 1+ standard deviation move as well, continuing its sharp rebound from a 3/18 trough of -3.45 SD below the mean as investors bought up high-beta assets in the market rally.
- Value continued to recover from being nearly 3 SD below the mean in Feb, exiting Oversold territory as it headed back towards the mean.
- Volatility also left Oversold space as risk-on was back in vogue this week.
- Medium-Term Momentum tumbled to -0.83 SD below the mean as it closes in on an Oversold designation.
- Size continued to fall from a peak of +3.2 SD above the mean on 3/18, and is still an Overbought factor.
- The ongoing weakness in Profitability took it down to a still-stratospheric +3.34 SD above the mean (recent peak was +6.47 SD above the mean on 3/20).
- US Total Risk (using the Russell 3000 as proxy) increased by 1.41%.
Factor Update: Axioma Worldwide Equity Risk Model (AXWW4-MH)
- Market Sensitivity surged out of Oversold by 1.31 standard deviations as the market rallied throughout the week.
- Volatility also saw a big +1 SD move, exiting Oversold territory as risk assets were bid up worldwide.
- Value also continued to recovery internationally, losing its Oversold label at the end of last week.
- Earnings Yield continued to head deeper into Extremely Overbought space, now sitting at +2.56 SD above the mean.
- Profitability saw a slight decline, but nothing compared to what’s happened to what it’s seen in the US.
- Size continued to revert, falling to +2.52 SD above the mean and retaining its Extremely Overbought label.
- Global Risk (using the ACWI as proxy) moved up by a little over a percentage point.