This note does not often cover the topic of currencies, particularly given that as a rule we endeavour to keep the level of currency risk in our portfolios contained, on the basis that currency moves are relatively unpredictable and there is no long-term expected return from an overseas currency. However, from time to time markets appear to bake in a consensus that seems inconsistent with the facts.
Consensus on currencies is that the US Dollar will strengthen at the expense of other currencies and indeed so far this year it has marginally strengthened on a trade-weighted basis. The arguments for strength usually given are the growth of the US economy versus international peers and a related factor, the gap between US interest rates and those of other major developed economies leading capital to flow into the US. In addition, the Euro is widely expected to weaken because of internal political disagreements, a much weaker domestic economy and ongoing QE.
In financial markets, we consider the direction of travel as important as the starting point. Therefore, while the starting point favours the US Dollar, the direction of travel of each of the features above appear to be somewhat different over the coming months.
The likely upward path of US interest rates seems baked into the market’s expectations with everyone fully aware that the US economy is very strong, particularly with the tax cut impact and continuing benign inflation. However, it is arguable that the tax impact will have worked its way through the system after a year and the longer-term benefits will arise only gradually, while the impact of a rising US fiscal deficit is immediate.
At the same time, the Eurozone is very close to fiscal balance, partly as a result of Germany running a surplus, but also as a consequence of steadily falling deficits elsewhere. On balance, the market should consider that as a reason for a strong Euro and weaker US Dollar.
Later this year the ECB will most likely begin, admittedly slowly, to exit from its QE programme, again making the direction of travel of Eurozone monetary policy favourable towards the Euro, where expectations of the path of interest rates continue to remain extremely subdued despite an improving economy. The gap between US and Euro yields may at least stop widening and could be narrowing as we look forward a year. Again, the direction of travel favours the Euro going forward.
A further point is that the Euro may have indeed been strengthening already were it not for the supposed political turmoil, most recently in Italy, holding it back. Again the prospect of a break-up of the Euro currency block is largely imagined, not a reality, and therefore this factor may again fade as time goes by.
A final factor which has led to a period of a strong US Dollar has been the trade tensions bothering markets. Financial markets have treated this broadly as a reason to take a ‘risk off’ position, leading to a strong US Dollar and falling treasury yields. If the US were to impose more tariffs, this is in fact inflationary for the US, while there would be less natural buyers of US Dollar assets, leading to a weak US Dollar. The market is pricing this as a risk event, not a genuine trade war, and given the US Dollar’s strength, capital has been coming home to the US as a safe haven. Looking beyond the near term, it can escalate into a genuine reduction in global trade, in which case the US Dollar would weaken because of higher US inflation and less buyers of US assets from trade surplus countries. Alternatively, the noise may fade as forthcoming US elections pass and concessions are made by all sides, so they can all claim victory, in which case the market can return to a ‘risk-on’ mode and the US Dollar would weaken.
In conclusion, on balance the period of US Dollar strength may pass as we move forward, particularly given how much it has become consensus, and the data in most cases suggests that the factors driving this strength may reverse over time. We have been increasing our exposure to Euros and the Yen at the margin, recently.
The value of investments will fall as well as rise and investors may not get back the original amount invested.
Forecasts are not reliable indicators of future performance.
For funds investing globally, currency exchange rate fluctuations may have a positive or negative impact on the value of your investment.
For Investment Professionals only. Not for onward distribution. No other persons should rely on any information contained within this document.
Source for information: Miton as at 11/07/2018 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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