With earnings season well underway, we’ve been hard at work on our quarterly currency impact report. So far, we’ve seen two new currencies consistently surprising companies: the Australian dollar (AUD) and the Indian rupee (INR). Both of these currencies experienced more volatility than normal in the second quarter, with the AUD down 10.8% and the INR down 11.1% against the U.S. dollar.
Many clients when we first engage with them are focused on managing currency risk on 5-8 currencies that they think are their largest exposures. These currencies are the “biggies” that come up every earnings season – euro, British pound, Canadian dollar, Japanese yen. Many times, these new clients are not focused on smaller, less visible exposures – like the Aussie dollar or Indian rupee – that, as it turns out, can actually have more risk.
No one was talking about the Aussie dollar or rupee at the beginning of the quarter, so it’s easy to think that these currencies came from nowhere to impact companies’ earnings per share. But in reality, companies that manage exposure across all of their currency pairs have visibility into all of their exposure – on all currencies, big and small, highly visible and less so.
The treasurer of a leading Internet service company explains the concept: “A lot of large moves in very small currencies can hurt you as much as small moves in very large currencies in terms of your exposure to those currencies. When currencies move as much as they have, as it turns out a lot of those small currencies will add up to a large amount.” When an organization isn’t focused on smaller, less visible exposures, when those currencies move, it can create surprise impacts like the kind companies saw from the Aussie dollar and the rupee in the second quarter.
Managing currency exposure across all of your currency pairs is what we call the portfolio approach. Companies that manage currency risk well adopt the portfolio approach to become currency agnostic – they manage currency risk so that any impact is immaterial, regardless of which currencies move and to what extent. It could be the yen one month, the Venezuelan bolivar the next, and the peso the next; currency agnostic companies, like the one quoted above, identify and manage exposures across all of their currency pairs.
Aussie dollar omen
The Aussie dollar’s 10.8% fall in the second quarter was largely the result of fears about upcoming Australian federal elections. That’s water under the bridge now, but it demonstrates how politics can impact currency volatility. Uncertainty about the political climate and economy in general can lead to currency devaluation as traders look for safer currencies to hold their cash in.
For those same reasons, as we look forward to national elections in Germany in September, we expect greater levels of euro volatility. But here, the stakes are much higher than in Australia: the outcome of the German election has potentially enormous ramifications for the fate of the euro zone and certainly the value of the euro. As I write this post, the euro has been trading around 1.33 to the U.S. dollar, but some forecasts still have it falling to 1.26 (another 5% drop, with potentially a lot of volatility in between).
The rupee took a similar-sized tumble as the Aussie dollar did in the second quarter, falling 11.1% against the dollar. There are a number of reasons behind the rupee’s weakening:
- BRIC struggles – India is the next BRIC domino to fall as the country struggles to sustain domestic growth and compete internationally (Brazil had a similar crisis that began in Q1)
- Military worries – India’s state-run banks are selling rupees and buying U.S. dollars to meet the government’s defense needs in an increasingly polarized region
- Investor flight – foreign investment has been exiting Indian markets as outsourcing to India has begun losing popularity
- National deficit – the country’s current account deficit stood at a record 4.8 percent in the fiscal year that ended in March
So what can you do to prevent a currency surprise from the Aussie dollar or Indian rupee or whatever the surprising currency happens to be next quarter? The answer is not to add AUD and INR to your list of 5-8 currencies to manage. Companies that are keeping currency impacts to less than $.01 of EPS are currency agnostic, managing risk across all of their currency pairs.
Stay tuned for our Q2 Currency Impact Report where you’ll get all the details on how currency volatility impacted multinationals in the second quarter.