Consumer spending, private business investment and government expenditures have kept the economy growing above potential over the past few years.
Yet both business investment and the pace of hiring have recently been decelerating back into line with a more modest pace of growth.
This is the normal state of affairs as business cycle upswings lose their momentum and settle back into long-term trends.
Read more of RSM’s insights into the economy and the middle market.
But when this deceleration is combined with heightened policy uncertainty, businesses and investors need to think hedging their downside risk.
It is clear that volatility in interest rates, bond yields and foreign exchange markets will accelerate and that firms will need to consider ways to hedge that volatility.
We expect real gross domestic product growth in the United States to slow from 2.8% last year to 2.5% this year and next.
Our forecasts are in line with assumptions by the Federal Reserve at its December meeting that real, or inflation-adjusted, GDP will revert to its long-run rate of 1.8%.
The Fed said in December that the “economic outlook is uncertain,” prompting the central bank to cut its policy rate to a range of 4.25% to 4.5%.
But we expect the Fed to delay further cuts to later in the year in light of the uncertainty regarding international trade, and the knock-on effects of that uncertainty on employment and inflation.
Despite complacency across asset markets as exemplified by the low level of investment grade corporate bond spreads, the impact of this uncertainty will be felt in the foreign exchange markets and U.S. financial asset markets.
Already, foreign exchange markets are experiencing greater volatility and, consequently, higher levels of risk.
Corporate financial departments, with an eye on the business cycle or the possibility of an economic shock, will need to explore methods of hedging against future losses.
Financial risk management
One provider of hedging products breaks down financial risk management into three categories:
- Interest rate risk management: This is particularly applicable for floating-rate debt exposure that is more associated with large firms. Small firms are more likely interested in cash-flow hedging.
- Commodity risk management: The general goal in this category is to achieve predictability in future expenses and sales.
- Currency risk management: This requires daily attention and is characterized by three types of programs to protect:
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- Cash flow protection, or changes in revenue and expense streams.
- Balance sheet protection, or changes in the income statements.
- Net investment protection, or changes in the value of foreign direct investment.
For example, while a currency devaluation could lower the cost of meeting a payroll, a devaluation of the currency could affect the profitability of a foreign investment.
This scenario is a simple overview of hedging against future losses. We advise speaking to specialists in risk management and hedging practices.
Measuring domestic investment risk
Monetary policy is transmitted to the real economy through the financial sector.
Whether you are concerned about the safety of business investments or your 401(k), there is the need to understand the effect of policy changes on a portfolio.
The RSM US Financial Conditions Index monitors overall risk in the financial sector. It is a composite score, determined by the prices and volatility of assets in the money, bond and equity markets.
Our index does not directly account for volatility or prices of currencies. An exchange rate measures the demand for one currency compared to another, with the numerator and denominator each subject to the demand for that specific country’s assets.
Our financial conditions index is currently positive, trading just above zero, where zero suggests normal levels of risk in the financial markets.
Whether this is a wait-and-see moment for the markets or reflects a standoff between apprehension and optimism is still to be determined.
After all, there are risks on the horizon, including the prospect of a short-term debt-ceiling standoff, a long-term debt crisis and the potential of a trade war.
Volatility in the foreign exchange market
It has been said that because of the global economy, every firm is exposed to foreign exchange risk, at least to some degree.
Business among the developed nations is transacted in free-floating exchange rates, with the U.S. dollar and its bond market anchoring the process.
Nevertheless, our trading partners in Japan and Europe will point to the dollar’s runup in 2022 and the yearly peaks and valleys ever since as playing a large role in the dollar-denominated cost of oil, the cost of doing business with the U.S., and those countries’ competitiveness.
We would also expect volatility to be greater among the currencies in emerging markets than it is in developed economies.
It is arguably more difficult to find market-makers in emerging-market currencies, and the demand for their products is more prone to changes in the business cycle.
Volatility in both the developed and emerging market currencies has moved higher recently, threatening to break above long-run averages.
Businesses with exposure to offshore suppliers or investments should be paying attention.
Aside from the volatility that occurs with each exogenous shock to the global economy, there has been an overall decline in foreign exchange volatility since 2012.
We attribute this easing to the growth and maturation of the financial and commodity markets and to the increased efficiency of a foreign exchange market able to adapt to changes in the supply and demand for currencies.
But there is also the impact of China and its significant role in global trade.
It could be argued that, because China has manipulated the value of its currency, U.S. businesses have been somewhat immune to the risk of foreign exchange volatility.
This could change, however, with the potential of a currency devaluation increasing as trade tensions between the U.S. and China rise.
This would not be the first time that China has devalued its currency. There was a 50% devaluation in the yuan in 1994, followed by a peg until 2005.
From 2005 to 2014, the renminbi was allowed to appreciate as China seemingly moved toward an open economy.
That move ended when a new era of currency depreciation took hold even as China’s gross domestic product grew in the 6% to 7% range.
In fact, our research suggests that the Chinese will most likely devalue the CNY in excess of 10% this year. (PLEASE LINK TO THAT NOTE)
While consumers in the West would welcome cheaper Chinese goods, a devaluation of the renminbi implies that businesses with investments in China would suffer from the lower value of those investments on their bottom line which is the point of the 10% tariffs slapped by the U.S. on China recently.
Volatility in the equity market
A buy-and-hold strategy in the S&P 500 index would have returned 12.3% each year on average since the end of the financial crisis.
For much of that period, interest rates were extremely low, and one could argue that equities were the only game in town for investors seeking return. Adding to that argument was that volatility in equity markets had moved below its non-financial crisis average by 2012 and then stayed there.
The exceptions were the 2020 pandemic and then the recovery from the 2022 inflation shock.
What is also interesting is that the yearly rates of return in the S&P 500 and the Nasdaq have tracked each other for the most part of the past 20 years, most likely because of the inclusion of tech stocks in the broader index.
As such, a technical trader might be looking for further confirmation of a correction or a full-blown downtrend in each of the indices.
In terms of early-warning signals, the price-to-earnings (CAPE) ratio of U.S. equities is now moving upwards, once more approaching the tech-bubble episode leading into the dot.com bust.
We note that the CAPE ratio is only one measure for investors to follow, and stress that we are not offering investment advice.
Volatility in the bond market
For many reasons, trading in the bond market seems oblivious to the prospect of significant changes in monetary and fiscal policies. Trading on the benchmark 10-year Treasury has been centered on 4.5% and roughly range bound within 4.25% to 4.75% in the year and a half since 2022.
Absent another shock, we would expect this range-bound trading to continue, assuming the Fed can gradually reduce its policy rate to its 3% objective.
The result of the range trading has been a decline in Treasury market volatility as measured by the MOVE index that has now settled at its long-term average.
This relative stability in the Treasury market has been matched by a compression in corporate yields along with a decline in spreads of both investment-grade and high-yield corporate bonds.
The investment grade spread is the lowest since 1997.
The takeaway
While most measures of risk are backward looking, it is important to monitor the trends in financial asset prices and their volatility. There are many forward-looking metrics that can help firms and investors hedge volatility across financial markets.
This should be in conjunction with monitoring global monetary and fiscal policies with an appropriate weight given to geopolitical developments that affect commodities as well as capital flows.