Risk is complex, but few events are truly unpredictable. Thomas Anderson, managing director at Moneycorp Americas, shares how you can assess risk and prepare despite the seemingly unpredictable nature of FX
Black swan events are unpredictable, unexpected, and have heavy impacts but they are rare and incredibly uncommon. After closer examination, events that seem like black swans at first are actually grey or even white swans.
The pandemic is a good example of this. While it was unexpected for many, it would be amiss to say that it was unpredictable. The past 20 years have seen many near-pandemic illnesses and the World Health Organisation had even warned about the world’s lack of preparedness in 2019.
The strength of the USD is another unexpected event for many. At the outset of 2022, it looked like the USD was going to weaken, but the exact opposite happened with the USD reaching multi-year peaks.
While many analysts saw this as a black swan, those with keen eyes saw the greenback’s rise to power as a white swan event. The euro’s supply chain vulnerabilities combined with the US’ active monetary policy meant that some forecaster’s predictions of the EUR/USD reaching $1.1 by the end of 2022 should not have been that surprising. However, most forecasters underestimated the rate of the USD’s strength, as the EUR/USD pair slid down to parity by July 2022.
When even analysts can not come to an agreement, it is clear that currency swings are not something that is easily predictable. Consensus forecasts, which are shown to be accurate in most cases, fail to be a good predictor for currency moves. However, this does not mean that companies should ignore changes in currency. Currency swings should always be accounted for in corporate forecasts as even slight shifts in foreign exchange have heavy impacts on businesses. Companies that already have forecasts should reassess and ensure that severe and unexpected currency swings are taken into account, or at least have a plan to address the discrepancy in some way.
Earlier this year Microsoft had to adjust its forecasts due to the unexpected growth of the USD, and still cited a negative impact of $595m. However, large global companies like Microsoft, expect this impact in their forecasts and are prepared to absorb it without taking a hit to the bottom line. The percentage that each company can absorb is different due to different liquidity requirements, asset mixes, and FX exposure, but companies should prepare all the same or risk raising prices and losing a competitive edge.
To mitigate the effects of currency swings and FX exposure, companies need to consider using hedging tools such as forward contracts, currency options, and currency swaps. These are all viable tools to lower FX risk and can allow for a company to come out of an unstable market relatively unscathed.
As much as they try, forecasts can not be as comprehensive as they need to be, and treasurers should have contingency plans in place when things go awry. Outsized currency moves are not an uncommon sight for those that keep a close eye on the markets and can be considered grey swans at worst. Many outsized currency moves have even happened recently as seen with the Japanese Yen’s quick drop into a 24-year low against the USD and the Euro/USD parity among others. However, when left unchecked, these can have heavy negative impacts on a corporation’s capital and borrowing depending on its exposure.
Companies that operate globally or partake in FX borrowing are more heavily exposed to FX risk. For these businesses, especially those that operate in the American market, they need to have policies in place that allow for quick pivoting and flexibility when these currency moves occur. These moves can happen quickly which results in only a brief timeframe to pivot or take advantage and mitigate the risk.
Forecasting and knowing how much volatility can be absorbed are important but maybe even more so is the planning and policies on how to deal with future events. Moving into 2022 Q4 and 2023, there are many white swans that need to be prepared for.
One major ongoing event that should be on nearly every treasurer’s mind is the continual strengthening of the USD. With the Federal Reserve’s announcement of their hawkish plans to combat inflation, it seems likely that the USD will remain volatile and the currency of choice in the uncertain global market. For domestic companies, this could be great news as the cost of imports will continue to fall, but companies that focus on exporting will suffer the drawbacks of a strong dollar. Foreign companies looking for good investments at this time can also look towards US assets for strong returns.
Other white swans that treasurers must consider in their budgets are the continued supply chain disruptions. The semiconductor chip shortage and the oil shortage are likely to continue into 2023 and need to be budgeted for. Manufacturers that rely on semiconductor chips can adjust their forecasts and budgets for 2023 with that in mind and any business that relies on shipping should expect prices to remain high.
Global inflation and recession are also swan events that need to be prepared for, with inflation being a currently active issue and recession being a potential future grey swan event. Treasurers must consider inflation-resistant assets to avoid damage to the bottom line and reassess their current investments, evaluate risk, and then plan a course of action based on that assessment.
To plan against recession, companies need to spend more time carefully planning and researching investments and risk management policies. Treasurers need to identify the mix of long- and short-term assets in their corporation that work for them and ensure that their FX needs are hedged against adverse movements. With proper planning, treasurers can help companies navigate a potential recession and come out stronger through deleveraging, decentralising globally, and retaining the workforce.