The considerable effects of long-term inflation differentials

Fabian Scheler

January 31, 2022

For many years, the strong CHF has taken a bite out of the performance of Swiss investors' global portfolios. However, in real terms, they have not been worse off than their envied American peers.

2 Minute Read

We sometimes get the impression, that CHF based market participants tend to be a bit jealous of investors whose reference currency is the USD. The consistent long-term appreciation of the Swiss Franc may have given the country's residents cheap holidays abroad, but it has also clipped quite a chunk off the returns generated by CHF denominated global portfolios. Systematic foreign exchange hedging may be able to mitigate the problem to some degree but comes with a hefty cost-of-carry due to the country's stubbornly low interest rates.

The chart below illustrates this dilemma by comparing local currency returns of a traditional global multi-asset portfolio (55% equities, 35% bonds and 10% gold). We assume that the portfolio manager hedges the foreign currency exposure obtained through its fixed-income investments but leaves its allocation towards international stocks unhedged. Due to foreign exchange rate changes, the resulting local currency returns vary substantially. Over the past 20 years, EUR, USD and GBP based investors cheered over returns around 300%, twice as much as comparable Swiss investors.

Weak currency translates into strong nominal returns.

Adding insult to injury, CHF and JPY based investors typically experience higher volatility and drawdowns as their reference currencies tend to appreciate when markets tumble.

Being domiciled in safe-haven country results in higher volatility and increases the attractiveness of foreign currency hedging.

However, nominal returns tell only one part of the story. Indeed, most investors are familiar with the fact that inflation rates have been stubbornly low in Switzerland and Japan for decades and significantly higher in the U.S., the U.K. and the Eurozone.

Now, the topic is making headlines again with surging energy prices, labour scarcity, and supply chain disruptions across the world. Nevertheless, the magnitude of structural inflation differentials and their cumulative long-term effect on a currency's purchasing power is often underestimated. Over the past two decades, the U.S. Consumer Price Index (CPI) rose by almost 70%, while prices in Japan have been more or less stable and while U.S. consumers are now experiencing average inflation rates in the high single-digit range, the Swiss CPI has barely moved.

Since 2000, consumer prices in the U.S. increased by 70% while they were more or less unchanged in Japan.

Based on these indices, we have derived the inflation-adjusted, real local currency returns of the previously introduced global multi-asset portfolio. To be fair, the chart below may still not trigger cheers among CHF based investors. However, it suddenly becomes clear that the much higher nominal returns enjoyed by American investors only compensated for the higher inflation rates they have been facing. The highest real returns have been realized by JPY based market participants as their currency moved sidewards despite years of deflation.

Once inflation is taken into consideration the picture changes considerably.

Nominal returns can be strongly misleading, and humans have a tendency to underestimate the magnitude of compounding effects. In the long run, a global 60/40 or 55/35/10 portfolio has served CHF and USD based investors equally well in preserving their purchasing power at home.

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