The Swiss National Bank’s most recent intervention brought blessed relief to Switzerland’s pension funds. Emma Cusworth assesses the trade-off between capitulation to haven hunters and rising inflation
Swiss investors have suffered a turbulent year as the franc’s safe-haven status pushed it to painful highs, threatening to undermine the domestic economy. By early August, EUR/CHF hit an all-time low of 1.03 and USD/CHF sank to 0.72, a 52-week low.
The Swiss National bank (SNB) responded aggressively, introducing a floor for the euro exchange rate, providing much-needed relief for beleaguered pension funds.
However, currency is a relative game. With the political environment and economic fundamentals still very strong, the Swiss franc’s safe-haven status remains intact and markets could test the SNB’s resolve. If the SNB is forced to expand its balance sheet, as it has promised to do, inflation might spiral out of control. Much depends on the future of the euro and US dollar in determining the outlook for Swiss investors - the necessity for them to hedge their currency exposure and protect themselves from inflation.
“The Swiss economy has suffered dramatically from the unprecedented flows into the franc,” says Markus Hübscher, head of the Swiss Railways pension fund, PK SBB. “It happened very fast but took a while for people to digest the magnitude and damage of the move and to realise it would remain overvalued until the euro situation was resolved.”
The strong franc exacerbated portfolio losses. According to UBS’s Pensionskassen Barometer, the average Swiss pension fund lost 17% on foreign equities for the year to 31 August. The S&P500 had fallen 3% and MSCI world 5% in US dollar terms over the same period and MSCI Europe was down 14% in euro terms. Figures from Complementa show that the average funding ratio among public and private pension funds was 95% at the end of August, but 92.9% among those without currency hedging. PK SBB, which has hedged one third of its currency exposure, predominantly in fixed income and alternatives, was down 1.3% for the year. “Without this, we would have lost 2.3%,” Hübscher says.
The prospect of deflation and a serious decrease in economic competitiveness created the political cohesion that allowed the SNB to set a EUR/CHF floor of 1.20 on 6 September. The result was an immediate 8% depreciation of the franc against the euro. Caisse de Prévoyance de l’Etat de Fribourg said that the floor alone had allowed its portfolio to bounce back 15%.
The floor also spread the pressure more evenly across Europe. “Since late 2009, financial market tensions had been vented in one exchange rate - EUR/CHF - until the SNB set the floor,” says Sophia Drossos, currency fund manager at Morgan Stanley Investment Management. Since early September, the euro has depreciated across the board. “The pressures have not gone away, but they are manifesting elsewhere.”
The critical question now is whether the SNB can maintain this floor long term. It has promised it will “enforce this minimum rate with the utmost determination and is prepared to buy foreign currency in unlimited quantities”. But Switzerland’s relative strengths present a significant challenge. Its political stability, healthy public finances and current-account surplus will support demand in times of crisis. “The safe haven status of the franc is unquestionable,” says Ursina Kubli, economist at Bank Sarasin. “However, in the short term, the upside will be capped at 1.20. The SNB’s euro/CHF floor has high credibility in financial markets: the SNB is fully committed to avert deflation risks.”
The market has been surprised by how successful the SNB has been, agrees Morgan McDonnell, head of FX markets at RBC Dexia. But he adds: “The issue driving the franc is not a Swiss issue - it is a foreign sovereign debt issue. If everything else were to get worse, investors will go back into the franc. In that case, the SNB may be throwing a lot of good money after bad.”
The early signs are promising; despite a sharp downward move in global markets in September, EUR/CHF remained stable, easing slightly to 1.22 by 28 September.
But the SNB’s foreign-exchange reserves, currently around 6% and already 55% euro-denominated, are significantly depleted after making losses on unsuccessful interventions over the past two years.
“A small loss on currency could wipe out the reserves on the balance sheet,” says Fabrizio Quirighetti, chief economist at SYZ Asset Management. “Even where investors believe EUR/CHF will remain stable, the franc is still preferable, so the SNB will have to defend itself against some pressure.”
Because the Swiss economy is highly integrated with that of Germany, it represents a play on Germany’s strength - without exposure to Europe’s weaker periphery. According to Peter Bänziger, CIO at Swisscanto, “the SNB has solved the specific problem in Switzerland, but without a sustainable solution to the European debt problems, the floor cannot hold and the SNB will be tested. If the SNB moves in parallel with the ECB it will have to increase the money aggregate massively and expand its balance sheet. That will certainly generate inflationary pressure.”
For an economy currently fighting deflationary pressures, inflation of 2-3% would be positive. Faced with maintaining an implied interest rate of 3.5%, Hübscher “would highly welcome more inflation”. Philippe Waechter, chief economist at Natixis asset management adds that “near-0% inflation is too low. Once it reaches 2%, the SNB’s strategy will likely revert to controlling inflation”.
But the SNB might not act quickly enough, for which there is precedence: after imposing a minimum Deutschmark/CHF rate in 1978, inflation jumped to over 7% by 1981. “It needed three years to come back down again,” Bänziger says. “It is likely the SNB won’t pick the right moment to remove the floor this time. While there is currently no inflation pressure, it will definitely be a problem in the medium term.”
Bänziger therefore recommends an allocation to inflation-linked bonds. Given the restricted availability of local inflation-linked paper, investors will have to buy European and US bonds, which are subject to FX risk.
“For those who have not already hedged their currency exposure,” Bänziger says, “doing so would be logical. The SNB has given investors a second chance to put hedging in place. Investors must take that chance. There is a tail risk the floor will not hold, but tail risks have a habit of becoming normality. This will be a critical issue for pension funds in the next weeks and months.”
The decision to hedge or not depends on investors’ belief in the SNB’s ability to maintain the floor. “This hinges on the euro-zone calming down,” argues Joe Corbach, head of commodities and currencies at Swiss & Global Asset Management. “The conditions of arbitrage suggest the current EUR/CHF rate of 1.22 shows markets are questioning the SNB’s ability, willingness or persistence to hold the floor for one year.”
According to Quirighetti, because the floor is credible short-term, Swiss investors should wait for more clarity before hedging dollar or euro exposure. “Hedging euro exposure may become necessary if there is a big problem in the euro-zone, but it is too soon to do that,” he says.
Furthermore, recent dollar appreciation has been very positive for investors. “Swiss investors holding US equity on an un-hedged basis would have seen a big benefit from this move,” says Pierre Lequeux, Aviva Investors’ head of currency management. “The critical question is whether you believe the SNB can weaken the Franc further or not.”
For those that believe the SNB is credible, hedging FX risk has become less attractive, as Hübscher says: “There are good reasons to start a discussion on whether to reduce or even give up currency hedging against the euro.”
In the short term, the EUR/CHF floor provided a much-needed reprieve and markets seem reluctant to bet against the central bank. However, if the SNB is forced to print money, inflation would soon follow and the SNB will need to take timely action to prevent a repeat of the massive inflation hike of the early 1980s.