In recent weeks we have seen a reversal in some year-long currency trends. Since the middle of April the US dollar has been strong, sterling has been weak, and many emerging market currencies have been falling too. In this week’s note we consider what it means for some key global asset prices if these new trends persist.
We generally try and interpret any currency moves with caution, as history has shown that they are extremely difficult to value. However, the US dollar is correlated to multiple asset classes, including emerging markets and commodities, so in many ways sits at the heart of asset allocation decisions and it is therefore important for us to consider the wider implications should the US dollar continue to strengthen.
Generally speaking, a strong US dollar leads to tighter financial conditions in many parts of the world and is therefore considered a headwind to global economic growth. Emerging markets, for example, have a material amount of their debt denominated in US dollars, so as the dollar rises the cost of their debt also rises. This inverse relationship between emerging markets and the dollar can be seen in the chart below, which shows recent dollar strength favouring developed markets over emerging markets.
The correlation between the US dollar and the relative performance of DM and EM equities
Source: Bloomberg, 08/05/2017 – 09/05/2018.
That said, we are of the view that emerging markets are not a homogenous group, and that some countries have become less sensitive to global factors with foreign debt generally lower and more flexible exchange rates able to act as a shock absorber. We are directly invested and have no benchmark so can be very precise in our emerging markets exposure, avoiding regions most at risk, like Argentina.
Taking a closer look at what we own, the Hong Kong equities have their currency pegged to the US dollar, while India’s domestically driven growth story means it is fairly uncorrelated to the dollar. Our Latin American equities and emerging market bonds are most vulnerable here, particularly with their currencies selling off too, but these are only small positions that we have scaled this way to limit currency risk. Importantly, our exposure here is liquid. We have been trimming these positions and if this trend continues we will take a pragmatic approach and potentially have zero exposure here again.
Historically, oil, gold and other commodities have also had a negative correlation to the US dollar. As the US dollar rises, commodities become more expensive in other currencies, and demand falls. It’s interesting that despite the recent rally in the US dollar, capital continues to flow into oil. This suggests that the primary driver of oil has shifted, to geopolitics, or perhaps that market participants don’t expect the US dollar rally to persist. Either way, with a broadly positive macro backdrop we are comfortable with our energy exposure at present.
Sterling has also traded in huge range over the past few weeks, dropping quite sharply as it approached the pre-Brexit level. If this trend continues it could trigger a dramatic asset allocation shift towards the UK. Despite ongoing political and economic uncertainty, the UK market is biased towards overseas earners and is therefore a big beneficiary of a weaker currency. The opportunity becomes even more attractive when you consider how much the UK has lagged global equity markets since June 2016. We have been fairly light in the UK for some time now, but have been building this position up again more recently.
Our regular readers will be aware that we take a risk management approach to currencies, not return-seeking. This doesn’t just involve hedging first order effects, but it’s important to consider the wider implications of the primary trends, especially for instrumental currencies like the US dollar.
The value of investments will fall as well as rise and investors may not get back the original amount invested.
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Source for information: Miton as at 09/05/2018 unless otherwise stated.
The views expressed are those of the fund manager at the time of writing and are subject to change without notice. They are not necessarily the views of Miton and do not constitute investment advice.
Miton has used all reasonable efforts to ensure the accuracy of the information contained in the communication, however some information and statistical data has been obtained from external sources. Whilst Miton believes these sources to be reliable, Miton cannot guarantee the reliability, completeness or accuracy of the content or provide a warrantee.
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