Wednesday, September 13th, 2017

Untangling the Currency Effect

Few would dispute the idea that the US sets the tone for what happens in global financial markets, but occasionally it is worth surveying how the choice between fixed income and equities looks to investors in other parts of the world. This is particularly true when FX markets are volatile or trending strongly.

This year, US investors have enjoyed significant windfall returns from international equities thanks to the weak dollar. However, when viewed from Europe, the outlook is not nearly as sunny. Our euro-denominated model is down to 40% equity exposure, having started the year at over 90%. The strong euro means that returns from US equities are negative YTD, while returns from Japan and the UK are only just above zero, and certainly well below their cost of risk. We don’t expect this to change while the weak dollar regime lasts.

The question is what happens next. We could move into a dollar recovery phase, but it is also possible that we move into a more stable FX regime, in which case investors all-round the world will have to stop fretting about currencies and start to prioritise a domestic view. We can’t isolate local equity and fixed income markets from the currency markets, but we can look at models which restrict the choice of assets to domestic equities and domestic government bonds all based on local currency returns.

We track these local for local portfolios on a weekly basis for over 40 countries and we have a 40-page chart book which shows the make-up and performance of our recommended portfolios, as well as our forward-looking indicators as to how we think the portfolio will evolve. The charts on the next page are the two summary charts, which look at the major developed and emerging markets (with the Eurozone regarded as one “country”).

The first is backward-looking and plots the current equity / bond split on the x-axis against the change in the split over the last four weeks. The second plots the current split against our forward-looking indicator. In both charts the top-right quadrant is the most desirable, representing a high and rising allocation to equities (which in turn is based on an improvement in their risk-adjusted returns over the period). In each chart, we plot the last four data points for each country so that we can see the speed and direction of the trend and whether it is accelerating or not.

The key messages are as follows.

China has the highest allocation to equities at the expense of government bonds. The four-week change is zero, because we have been at or close to 100% equity since late June. The forward-looking indicator is also zero, implying that there is no risk of the model reducing its equity exposure in the short term. From a real-world perspective, this is a conclusion that we would be happy to endorse until at least the 19th Party Congress which happens in mid-October.

At the other end of the table, Russia has 2% exposure to equity and a forward-looking indicator of only 4%, suggesting that the highest exposure we could hope over the next month would be 6%. However just because the indicator is positive, it doesn’t mean that the equity exposure will actually rise. Russia had a higher indicator in late July, but failed to make any progress. A view on Russia, is of course heavily dependent on a view on oil and we don’t see any signs of a big recovery in any of our commodity or equity sector models.

The recent strength of China allows Brazil, Australia and Canada to make good progress. The commodity link is obvious and the fact that all three have responded in the same way is comforting. Because of domestic political events, Brazil is much the strongest of these three, with an accelerating trend and an improving forward indicator. It is the only country which is in the top right quadrant in both charts.

By contrast, the Eurozone is one of two countries which is in the bottom left quadrant of both charts; the other is Mexico. The Eurozone has moved from a 65% equity exposure to 35% in a period of just four weeks and the rate of decline has accelerated slightly. The forward-looking indicator has suffered an equivalent decline, but the rate of change is decelerating as it starts to approach the zero-limit. This is the same pattern that we observe in the euro-denominated portfolio which is allowed to invest in international equities, but it makes the point that domestic equities are also much less attractive to euro investors than they were in late July. It is also no surprise to see that that Switzerland is following exactly the same trajectory as the Eurozone, but with a three-week time lag.

So, what about the other big developed markets, Japan, UK and USA? Four weeks ago, all three were on the boundary between top-right and bottom-right in the current situation vs past trend chart. i.e. they all had equity exposure ranging from 80-90% and had been stable at that level for the previous four weeks. Now they are firmly in the bottom right quadrant: high but falling equity exposure and all of them show an accelerating rate of decline. The forward-looking indicators for Japan and the US are still mildly positive, but the UK has turned mildly negative..

This suggests that we are now at the point where declining risk-appetite in Europe has started to have an impact on the USA. The trouble with this formulation is that it requires Europe to be causing a problem for the US, which immediately requires investors to specify a view on exchange rates. We prefer to frame this as a statement about negative feed-back loops affecting investors across a broad range of developed markets in the wake of a significant cumulative FX shock.

Perhaps the best way to sum this up is to use a cap-weighted proxy for the World. This shows that the average recommended equity allocation has fallen from just under 90% at the end of July to its current reading of 65%. The forward-looking indicator is mildly positive at the moment, but at a level which could easily be reversed by one bad week.

None of this changes our view that a dollar-based investor ought to have a high exposure to international equities, while the weak dollar regime persists, and that a euro-based investor ought to favour fixed income. From this it follows they should do the opposite if we move into a dollar recovery phase. However, even if the dollar and the other major currencies were all to stabilize at their current levels, the level of risk-appetite across the world and in the US would likely be significantly lower than it was in the summer. The only real exception to this China, where the government manages the exchange rate and most of the other financial markets.

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