Tuesday, July 28th, 2015

Get the Currency Right

This is the last strategy note before our summer break, so we thought it would useful to review our recommendations on each of the main equity regions. Recent notes have highlighted our concerns about Chinese equities, falling commodity prices and weak currencies and we have spent some time exploring the implications for asset allocation and sector strategy (like Healthcare and Financials; dislike Energy and Materials). But we haven’t really gone through global equities on a country by country basis. Full details can be found in our All World Country Report, of which this is just a summary.

As ever, we try to identify countries which have a high probability of outperforming the World ex US index on a risk-adjusted basis. To do this we plot our universe on two axes: high to low probability and falling to rising probability. Obviously the best combination is high and rising (the top right-hand quadrant) and the worst is low and falling (bottom left). The good news is that the US is slap-bang in the middle of the top right-hand quadrant and looks as though it is likely to remain there for most of August. It would have to suffer a significant relative sell-off to move out of this quadrant.

The bad news is that there are very few other countries – only Switzerland and Belgium – in the same area of the chart. Switzerland benefits from its exposure to the Financials and Healthcare sectors and also the strength of its currency. The other attractive part of the chart is the extreme right hand edge – high probability of outperformance but with not much potential for improvement because the score is already so high. Countries in this area include Ireland (high exposure to Financials) Denmark (high exposure to Healthcare), Israel (Healthcare and strong currency).

The bottom left quadrant includes China and Russia. Russia is triply exposed to falling energy and commodity prices via its equity market, its currency and its economy. China was in top right quadrant four weeks ago, but the dramatic surge in volatility means that it is unlikely to return there any time soon. The greatest concentration of countries can be found at the extreme left-hand side of the chart. These have a low probability of outperforming the index and scores which have been fluctuating around zero for many weeks. The group includes Australia, Canada, New Zealand, Malaysia, Indonesia, Thailand, Korea, Poland, Colombia and Brazil. The common theme is the weakness of their currencies relative to the US dollar. Most of them have fallen by 5-10% over the last six months, while in the case of Colombia and Brazil it is 15% and 20% respectively.

The top left quadrant (low and rising) has three interesting situations which are close to the boundary with the top right quadrant and on our positive watch list. The UK enjoys of the few currencies which has appreciated against dollar and is traditionally a low-risk market. Singapore is an oasis in South East Asia, with little exposure to commodities and a relatively stable currency, while India is a net importer of commodities with little direct export exposure to China.

This analysis highlights the vital importance of currency movements versus the US dollar. Equity markets are difficult to call on an absolute or relative basis. But whatever else changes in August, we would be surprised if the currency markets staged a big reversal. So if investors don’t like the currency, it’s hard to see why they should buy the country.

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