World headlines Dueling central banks Dave Napalo, head of FX Risk Management for Wells Fargo, discusses the impact of the collapse of oil prices on the world economy, the broader implications of the strong U.S. dollar, and debt in the emerging world. Read article
Dueling central banks
As 2014 concluded, World Headlines focused on the impact that a collapse of oil prices was having on the world economy. Since then, as oil has stabilized at lower price levels, market attention has shifted once again to more general macroeconomic themes, particularly with respect to central bank policies within the two dominant economies of the world, the United States and the Eurozone. While the U.S. wrapped up its program of quantitative easing at the end of 2014, the European Central Bank (ECB) began a program of its own in the first quarter of 2015. These counter-cyclical measures have in turn led to a significant realignment of the dollar versus the euro (USD/EUR) trading relationship, and more generally, a profound effect on global economic trends as the result of an appreciating dollar.
While a trend of a declining EUR had been in place since May of 2014, the pace of depreciation accelerated in 2015. The EUR began the year at a value of $1.21, but rapidly declined to $1.12 within three weeks before finding its legs and staging a mild recovery back towards $1.15. February resulted in a relatively static trading environment for the currency, but in March, with the initiation of quantitative easing, the EUR spiked lower once again, reaching $1.05 on March 13, a trading level last seen at the beginning of 2003.
Since hitting that low, the trading relationship of USD/EUR has been volatile within a range between $1.05 and $1.10. The two-way action has been precipitated by some wobbles in the U.S. economy of late. The first sign of caution was raised in the U.S. Federal Reserve Bank’s FOMC meeting statement for its March meeting in which the Fed dropped the word “patient” to characterize its posture with respect to potential rate increases, but maintained a decidedly dovish tone to the statement overall. Estimates for a Fed rate increase, including that of the Wells Fargo Economics Group, shifted from June to September.
Other cautionary signs about U.S. economic strength appeared. Industrial production activity remained modest in February after posting a decline in January. February housing data showed a sharp decline in new construction activity, influenced by harsh weather during the first quarter. Durable goods orders pulled back sharply in February, and data from the manufacturing sector was weaker in March. Finally, job growth slowed in March, with a disappointing release for non-farm payrolls of just 126,000, versus expectations in excess of 200,000. The Wells Fargo Economics Group now predicts that first quarter GDP will register growth of just one percent.
Broader implications of a strong dollar
While the EUR is frequently in the headlines, dollar strength is manifest across the board. In a measure of the value of the dollar as an index against the euro, the Japanese yen, the British pound, the Canadian dollar, the Swiss franc, and the Swedish krona, its value of 96.74 is also at a 12-year high. The effect of a strong dollar is showing up in other areas of market performance. Notably, concern has surfaced about the sustainability of the bull market in U.S. equities. The S&P 500 Index has spent the entire first quarter gyrating between roughly 2,000 and 2,100, reflecting this concern. The strong dollar has been a drag on corporate earnings as the value of profits earned in other currencies translates to reduced amounts in U.S. dollars. In contrast, the Euro Stoxx 50 Index, the leading blue-chip index for the Eurozone, has surged 25% during the first quarter. Buoyed by the ECB’s quantitative easing program, incoming data continue to reinforce the notion that a cyclical upswing may be taking hold in the Eurozone. The economic sentiment index rose to a three-year high, French consumer spending rose, and the unemployment rate in Germany fell to another post-reunification low.
Debt and the emerging world
The strength of the greenback has been broad-based and carries important implications for the emerging economies of the world. Against a dollar trade-weighted index that incorporates a broader array of currencies, the dollar is up 11% in the last three months, and 22% over the past year. Currencies across the board are weaker, but some stand out more than others. For example, the Brazilian real has weakened 42% against the dollar in the last year; the Polish zloty by 25%; and the Mexican peso by 14%.
In classic economic terms, the depreciation of these currencies should help their terms of trade by making exports cheaper. However, the other side of the coin has a foreboding element. Many emerging market companies have taken advantage of low dollar interest rates as compared to their domestic economies and have loaded up with dollar debt. As the dollar has appreciated, repaying those debts from local currency revenue sources has become increasingly daunting. While many companies have some revenues in dollars, much of their trade is with other countries whose currencies have also been depreciating against the dollar. With the Fed on the threshold of raising rates, debt service on floating rate liabilities and the refinancing costs of rolling U.S. dollar debt at higher coupon rates will become increasingly onerous.
Without sounding an unwarranted note of alarm, excessive foreign debt is often the genesis of a full-blown currency crisis. Fortunately, these are relatively rare events, but they do happen. The Thai baht crisis of 1997 was precipitated by an overheated domestic economy that had engaged in massive real estate development financed by foreign debt. The Thai situation was compounded by maintaining a fixed exchange rate against the U.S. dollar that had to be abandoned when the government ran out of foreign reserves to maintain the currency’s pegged value. A floating exchange rate serves as safety valve that sounds an early alarm when economic imbalances begin to emerge. To some extent, we are seeing the release of tension already via depreciating currencies against the dollar. But it will prove interesting to see how this situation develops as the world progresses through this post- financial crisis economic cycle.
Dave Napalo is the head of Foreign Exchange Risk Management for Wells Fargo. He is based in Chicago and can be reached at email@example.com.
Ask the expert U.S. multinationals struggle to cope with a strong dollar Matt Daniel, derivatives sales representative for Wells Fargo Foreign Exchange, explains hedging strategies to companies that want to understand how FX risk affects their financial performance from an earnings and cash flow perspective. Read article
The U.S. dollar has experienced a steep rise in value against most major foreign currencies since May 2014. For many U.S. multinationals, these events have created significant challenges. Corporate earnings reports and the analysis offered by equity analysts about foreign exchange (FX) often mention "headwinds" as a major factor influencing corporate financial performance. These developments have pressured many corporate FX risk managers to better understand their exposures and to reassess their efforts to manage the potential risks.
Surprise . . . hits to FX gain and loss line
As rates change, existing monetary FX-denominated assets and liabilities (i.e. FX-denominated trade account receivables and payables, or assets and liabilities related to FX-denominated lending and borrowing activities) are re-measured into an entity's functional currency based on changes in spot rates, with gains and losses recorded in the income statement each period. Many companies that had never experienced significant FX gains and losses before this past year and had remained unhedged have been surprised at the size of losses incurred recently on FX asset balances against the U.S. dollar.
As a result, many companies' first priority has been to improve oversight and management of these exposures. In theory, it is easy to understand where the risks come from; they are on-balance sheet, represent a risk to a future cash flow, and produce gains and losses that affect the entity's consolidated earnings. In practice however, some companies face significant challenges tracking and capturing changes to their asset and liability balances. This situation usually results from systems and information technology shortcomings that need to be addressed by improved integrated financial reporting.
Looking beyond hedging current FX assets and liabilities, companies are further challenged to understand how FX risk affects their financial performance from an earnings and cash flow perspective. This is particularly true for companies with foreign subsidiaries that use the local currency as their functional currency, which is most often the case. In contrast to booked FX assets and liabilities, these exposures are more subtle and even more difficult to grasp.
FX effect on margins and consolidated earnings
While it is common for foreign subsidiaries to have revenues and expenses that are denominated largely in their functional currency, other companies may have subsidiaries that have significant cross-border flows. The flows may be third-party or intercompany transactions, or a combination of both. Changes in FX rates will affect the economic performance of the subsidiaries as expressed in their functional currency on a stand-alone basis, and will affect the parent company's consolidated financial performance. Because these FX effects are hidden in a company's margins, or result in revenues or expenses that are simply higher or lower depending on the exchange rate used to translate the transaction, it is more difficult for companies to identify and quantify the exposures.
To meet these challenges and provide insight, it is essential that companies understand the:
- Potential FX risk to their cash flows
- Potential risk to their consolidated earnings
- The impact of hedging forecasted transactional cash flows on the company's earnings risk
Earnings and cash flow risks defined
The definition of risk to earnings and the risk to cash flows is based on the principles of FX translation as defined by ASC 830 (FAS 52), namely:
- Cash flow risk is defined as transactions that are denominated in a currency other than an entity's functional currency
- This includes intercompany and third-party transactions
- Earnings risk is defined as all non-U.S. dollar-denominated, third-party transactions
- Earnings exposures exclude intercompany transactions because these exposures net in the consolidated results
- For U.S. dollar reporting companies, changes in FX rates do not affect earnings on the consolidated value of forecasted U.S. dollar-denominated revenues and expenses, no matter where they are incurred across the organization
As an example, assume a U.S. parent company has a Great Britain pound (GBP)-functional subsidiary in the United Kingdom. Assuming revenues and expenses shown in Table 1, the notional amount of the company's earnings and cash flow risks are as follows:
Table 1: Earnings and cash flow risks - Unhedged portfolio
|Revenues||Expenses||Earnings risk - net||Cash flow risk - net|
|+GBP 1,000||-GBP 500||+GBP 500|
|+Danish krone (DKK) 300||+DKK 300||+DKK 300|
|+Euro (EUR) 200||+EUR 200||+EUR 200|
|+U.S. dollar (USD) 600||-USD 500||+USD 100|
|Total earnings risk by currency:||+GBP 500
All amounts shown in GBP equivalents
Notice that some of the transactions meet the definition of both earnings and cash flow risks, while other transactions only meet one of the definitions. Depending on the size of the company and the nature of the transactional cash flows, the portfolio of earnings and cash flow risks could be significantly different in size and in composition. If companies expect to understand FX risk, it is essential that they understand their exposures in these terms and quantify the potential risks on a portfolio basis consistent with a best practice approach.
The effect of hedging on earnings and cash flow risk
Corporate hedge programs are usually focused on hedging non-functional currency-denominated revenues and expenses to the functional currency of the entity. These types of transactions also enjoy the advantage that they generally qualify for cash flow hedge accounting under ASC 815 (FAS 133). Using our example above, companies might enter into hedges designated as cash flow hedges of the forecasted DKK- and EUR-denominated revenues, as well as the forecasted net U.S. dollar-denominated revenues. These cash flow hedges are aptly named because they effectively hedge all non-GBP-denominated transactions to GBP, reducing cash flow risk to zero.
But what is the effect of hedging on the company's earnings risk? Looking at the new risk profile in Table 2, we now have the following:
Table 2: Earnings and cash flow risks - Cash flows hedged 100%
|Revenues||Expenses||Hedge effect||Earnings risk - net||Cash flow risk - net|
|+GBP 1,000||-GBP 500||+GBP 500|
|+DKK 300||-DKK/+GBP 300||+GBP 300|
|+EUR 200||-EUR/+GBP 200||+GBP 200|
|+USD 600||-USD 500||-USD/+GBP 100||+GBP 100|
|Total earnings risk by currency:||+GBP 1,100|
All amounts shown in GBP equivalents
The portfolio of earnings exposure now consists of only GBP compared to a portfolio of GBP, DKK, and EUR earnings risks. Additionally, the notional size of the earnings exposures is larger, not smaller. Less diversification and larger notional sized exposures usually result in more risk, not less. It is very likely that by hedging 100% of cash flow risks, earnings risk will be higher, not lower.
For companies whose objective is to reduce risk to their transactional cash flows, this may be the right hedge solution. From a best practices perspective, these companies should also understand the effect on their earnings risks.
If a company's objective is to reduce earnings risk, the hedge solution may be different. Without the benefit of portfolio analysis, the optimal hedge solution to reduce earnings risk might be to hedge 100% of the forecasted U.S. dollar expenses, as shown in Table 3:
Table 3: Earnings and cash flow risks - Hedges to optimally reduce earnings risks
|Revenues||Expenses||Hedge effect||Earnings risk - net||Cash flow risk - net|
|+GBP 1,000||-GBP 500||+GBP 500|
|+DKK 300||+DKK 300||+DKK 300|
|+EUR 200||+EUR 200||+EUR 200|
|+USD 600||-USD 500||+USD/-GBP 500||-GBP 500||+USD 600|
|Total earnings risk by currency:||+DKK 300
All amounts shown in GBP equivalents
The effect of hedging the forecasted U.S. dollar-denominated expenses results in a significantly lower notional amount of earnings exposures, but notice that cash flow exposures are higher than they were on an unhedged basis.
This simplified example illustrates the potential trade-offs between hedging forecasted cash flows and the effect on earnings and cash flow risk. In real situations, the analysis required to reach a valid conclusion is more complicated. A model is usually required to search for the portfolio of hedges designated against forecasted cash flows that first reduces cash flow risk to a minimum, and second, to identify the optimal combination of hedges that reduces earnings risk.
Not all companies have the types of exposures that create a tradeoff between hedging to reduce earnings risk and cash flow risk. In many cases, hedging transactional cash flows reduces earnings risk to the same amount and in the same direction. It is important that companies understand these risks and the effect of their hedging programs on both risk metrics. For companies looking to design a hedge program and define their policy objectives for the first time, this framework is a good place to start.
Matthew N. Daniel is a derivatives sales representative for Wells Fargo Bank, N.A. He is based in New York and can be reached at firstname.lastname@example.org.
In the spotlight International outlook softens for U.S. companies in 2015 U.S. companies are less enthusiastic about the global business outlook this year, according to results from the Wells Fargo International Business Indicator survey, which reflected a dampened short-term outlook for 2015. Read article
U.S. companies are less enthusiastic about the global business outlook this year, according to the results from the 2015 Wells Fargo International Business Indicator survey (PDF)*. Although firmly in positive territory for the second consecutive year, the overall 2015 Wells Fargo International Business Indicator score fell five points from 68 in 2014 to 63 in 2015, reflecting a dampened short-term outlook. In addition, only 37% of U.S. companies participating in the Indicator survey said that they see the global business climate improving this year.1
As a result, significantly fewer U.S. companies expect their exports or international business profits to increase:
- 39% see international business profits increasing in 2015 (down from 51% in 2014)
- 30% anticipate exports increasing in 2015 (compared to 50% in 2014)
"The latest Indicator results reflect what we're seeing in the marketplace and hearing from our customers," said Sanjiv Sanghvi, head of Wells Fargo Global Banking. "Continued concern about global economic conditions, slowing growth in China and other major economies, the value of the U.S. dollar and its effect on exports, are all impacting short-term international business activity. However, while the near-term outlook has softened, U.S. companies value international markets for business development and we expect to continue to see them investing in the global marketplace as they plan for long-term growth."
U.S. companies see long-term value in international expansion
Despite being less positive about their international business activities in the near-term, the majority of executives surveyed are more bullish about future global prospects.
In terms of where U.S. companies see opportunities down the road, China and Mexico top the list of the future growth "hot spots", with Brazil, India and Canada also ranking high in interest.
The Indicator survey revealed a difference in the hot spots identified by larger companies ($500 million+ annual revenue) versus smaller companies ($50-$100 million annual revenue). Larger companies are focused — and perhaps better positioned — to capitalize on more distant markets for long-term expansion. Smaller companies tend to see expansion opportunities closer to home.
Projected "hot spots" for future growth
|Larger U.S. companies||Smaller U.S. companies|
|China (31%)||China (17%)|
|India (24%)||Canada (17%)|
|Brazil (24%)||Mexico (17%)|
These are just some of the key findings from the 2015 International Business Indicator survey. To view the complete results, including a copy of the full report, visit wellsfargo.com/indicator.
About the Indicator survey
The Wells Fargo International Business Indicator tracks the strength and direction of the international outlook of U.S. companies. More than 250 U.S. companies were surveyed; companies that conduct at least some international business and with annual revenue of $50 million or more.
1. The International Business Indicator score represents the average of responses for two questions regarding the level of importance and activity that U.S. companies expect from their international business in the next 12 months. The Indicator score ranges from zero to 100, where 100 indicates an absolute positive outlook, 50 indicates a neutral outlook, and zero indicates an absolute negative outlook.
People power Introducing Dean Cooper A London native, Dean is responsible for large multinational corporate companies. He is passionate about finance and sports, an avid traveler, and enjoys playing golf, cycling, and cheering on the Arsenal Football Club. Read article
Born and raised in London, Dean is a senior relationship manager for Wells Fargo Global Banking, responsible for large, multinational corporate companies. He has more than 30 years of banking experience and previously worked as a director of Global Banking & Markets for HSBC before joining Wells Fargo about two years ago.
Dean is passionate about finance. "I like to win," he says, explaining, "Winning to me means establishing and growing relationships — and helping clients succeed on an international scale."
He exhibits his dedication to the business through his many long-term relationships with chief financial officers and treasurers. "Customer relationships thrive on strong communication. I strive to be viewed as a trusted advisor, the first person they call when they need guidance or advice," he says.
In his spare time, Dean is equally as fervent about sports as he is finance. He is a season ticket holder for the Arsenal Football Club and often spends his weekends watching football. He also enjoys playing golf, cycling, and spending time with his wife and two sons.
Dean also enjoys traveling. "I've had many memorable holidays in the U.S...my banking career has managed to bring me to all corners of the globe," he says. "While I've spent most of my time in the U.K., I've been fortunate to have short-term assignments in Hong Kong, India, and the Middle East." However, he says, "There is still so much more to see and explore."