Currency movements have always played a large part in determining portfolio performance but this has moved up a gear in recent times, with big swings in the world’s major currencies. Making the wrong call on currencies can cost investors dear, while getting it right can produce great returns.
It is the pound, dollar and euro that most shape the fortunes of UK investors, and an accurate reading of these currencies should leave a portfolio manager in a good position to deliver returns. This is much easier said than done, but there are some clues to look out for.
Roger Hallam, currency chief investment officer at JP Morgan Asset Management, sees more short-term pressure on the pound vs the dollar and euro, but a good chance of medium-term recovery.
“The Bank of England holding [rates steady] in July was a surprise but has just rolled the easing over to August. The market has been disappointed that Mark Carney’s guidance on rates was, at best, unprofitable in the short term and made the actual moves difficult to predict,” he says.
“We expect the UK economy to slow and the BoE to ease in response. A combination of the UK’s current account deficit and general uncertainty will continue to pressure the pound in the short term.
“In the medium term, sterling is undervalued from a long-term Purchasing Power Parity (PPP) perspective. When it is in the high 120s, as recently, we are approaching extreme valuations. At those levels it is as low as it can go because the adjustment is significant enough in terms of long-term valuation to compensate investors for the necessary risk.”
On the other side of the coin, Hallam says the strong dollar story has further to run. “The Federal Reserve has taken a dovish tone but there is evidence the US economy has re-accelerated over recent months. The Fed is cognisant of the pressures its rate-hiking cycle can generate around the world through the appreciation of the dollar, and is therefore very cautious on raising rates.
“If – and it is a big if – the domestic economy is strong enough and employment continues to be robust, the dollar could see some further appreciation in the short term.”
Longer term, Hallam says the dollar could come back to the pack: “Some of the structural headwinds facing the dollar could start to blow a bit harder in the medium term. From a long-term PPP perspective, the dollar is overvalued and we expect the US balance of payments to trend weaker from here.”
New world order
UBS Wealth Management economist Dean Turner says the biggest driver of the currency picture at the moment is the pound. “The Bank of England defied market expectations by holding firm on interest rates at its July meeting, and this measured approach provided some support for sterling,” he says.
“We expect it to settle at its current level versus the dollar over the next three to six months, and potentially strengthen to $1.35 on a 12-month horizon.
“From a 31-year nadir as post-Brexit uncertainty peaked, sterling responded well to efforts by policymakers to create some stability. But this rally presents downside risks for sterling in the short term.”
Eoin Murray, head of investments at Hermes Investment Management, says: “The initial reaction to Brexit is now behind us, and adjustments to a new world of negative front-end rates and low long-term rates will come to dominate market thinking.
“If the Bank of England reduces rates or engages in further QE, there might be a short-term positive impact on sterling, but the medium-term outlook will remain tied to deteriorating economic conditions.
“The dollar has benefited from its safe-haven status recently, and mid-term expectations will be driven by ongoing economic conditions in the US and the outcome of the presidential elections this autumn.”
Turning to the euro’s prospects, Hallam says: “The euro could depend on what Brexit means for the rest of Europe. Initial indications suggest Brexit has increased the popularity of the EU among the other countries rather than diminished it.
“The euro is also supported by strong balance of payments dynamics, running something like a 3% current account surplus. The policy mix will play a role. The ECB has focused on credit easing rather than currency relevant easing, and seems less keen to take the deposit rate lower,” he says.
“Further credit easing is possible but this will not necessarily be currency negative if it is seen to be acting to support growth. If growth is supported by central bank action, it should be currency supportive if interest rates are not cut alongside that.”
Turner believes the dollar’s relationship with the euro will remain stable in the medium term, while he expects the euro to cancel out some of its current strength over sterling, ending the year at £0.83.
Playing the field
Given this outlook, there are a number of things to keep in mind when formulating investment strategy.
Gary Reynolds, chief investment officer at Courtiers, has been taking advantage of dollar strength for some time already but now thinks we are approaching the high point. “At $1.72 in July 2014, the pound looked overpriced against the dollar. At $1.32, it looks more reasonable. Accordingly, we do not expect the pound to fall much further. Another collapse in sterling would require a major destabilising domestic event,” he says.
“The dollar was an easy win for UK investors over the past four years but the next four years will be much more difficult to predict, so wealth managers should hedge their risks and think carefully before betting against their domestic currency.
“We sold all our dollar exposure immediately after the referendum result. We missed a few percentage points but we are mindful of a possible sterling rally, especially if the new government convinces the British public, and the markets, of a brighter future.
“An announcement such as Britain to join Nafta [the North American Free Trade Agreement] would probably send the pound northwards, and we would not like to be unhedged in these circumstances.”