“Quality currencies” can potentially diversify against growth risk

The Invesco Fixed Income team explores the idea of "quality currencies", examining currency strategies and their benefits for investors.

Jun 7, 2017 | Invesco Fixed Income

“Quality currencies” versus government bonds
Investments in stocks, bonds and other assets have historically delivered healthy returns over long time horizons. An investor in the Standard and Poor’s 500 Index over the past 40 years, for example, could have turned USD1000 into nearly USD75,000 over the period.Why then, at times, does investing seem so difficult?

We think there are two reasons. First, markets are volatile and investors do not always have the benefit of long time horizons to smooth out market ups and downs. Second, it is difficult to diversify portfolios away from growth. In other words, most assets that offer attractive return profiles (so-called “risky assets”) are driven by the same underlying factor: growth. Historically, government bonds have been considered to be one of the most effective diversifiers against growth. Government bonds have typically performed well when risky assets, like stocks, have performed poorly. However, this negative correlation cannot be relied upon; there have also been periods when stocks and bonds both performed poorly.

For this reason, Invesco Fixed Income (IFI) believes it makes sense to consider alternative diversifiers to growth. We believe “quality currencies” are a viable alternative. We have observed that adding “quality currencies” to credit portfolios can potentially help investors protect against growth-related risk.

What is a “quality currency”?
We consider “quality currencies” to be those that are likely to offer a good “store of value.” This means we could expect quality currencies to maintain their purchasing power during times of stress. From an investor’s standpoint, a foreign currency’s value is defined by both its nominal and real (inflation-adjusted) purchasing power.

For example, if goods prices are rising faster at home than abroad, the foreign currency should appreciate to maintain the same nominal purchasing power in both locations. This is the idea behind the well accepted and empirically researched theory of purchasing power parity (PPP). The real purchasing power of foreign currencies can also vary. A stable empirical relationship has been shown to exist since the 1950s in which countries with higher rates of productivity have tended to enjoy stronger real exchange rates.2

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1 Source: Bloomberg L.P., investment between March 31, 1977 and March 31, 2017. Assumes reinvested dividends.
2 Source: Obstfeld, Maurice and Rogoff, Kenneth, Foundation of International Macroeconomics, MIT Press, 1996.