Foreign exchange: a major contributor to portfolio returns

In recent years, subdued global inflation and weak growth have allowed the world’s major central banks to keep monetary policy at extremely accommodative levels. However, this may be changing, as global growth and inflation forecasts have risen amid a shift towards fiscal stimulus in a number of developed economies. With the Federal Reserve (Fed) simultaneously tightening US monetary policy, we see potential for significant foreign exchange market volatility to continue in 2017.

Sterling

Concerns over the economic effects of ‘Brexit’ have weighed heavily on sterling since the UK voted to leave the European Union in June last year. The result spurred a number of pessimistic economic growth outlooks and drew a reaction from the Bank of England (BoE), which reduced UK interest rates and expanded its asset purchase programme. Furthermore, the UK Government announced plans to increase its fiscal spending to support the economy when it begins the formal secession process. These developments weighed further on sterling, but this helped the UK economy achieve better-than-expected performance as UK-based businesses have benefitted from a boost to their international competitiveness. Although Article 50 is yet to be triggered, the economy’s resilience has led the BoE to move to a more neutral short-term stance, although it still retains caution over the secession’s medium term effects.

Somewhat counterintuitively given the likely economic effects of such an event, sterling rallied after Prime Minister Theresa May announced that the UK Government intended to push forward with a ‘hard Brexit’. However, the market’s reaction can be explained as a result of profit taking by investors who had previously sold the UK currency. Despite the currency already being undervalued on a purchasing power parity basis relative to the US dollar, we expect Brexit-related uncertainty to continue to weigh on sterling in the medium term, particularly if the economy begins to deteriorate and if the BoE again shifts towards an easing bias.

US dollar

us_dollars_chart

Figure 1: The dollar has strengthened in recent years, reaching levels against sterling not seen since the 1980s. However, we expect the dollar to remain supported as the Fed raises US interest rates.
Source: Thomson Reuters Datastream

The US economy continues to strengthen, with its labour market tightening and exhibiting growing wage pressures. Meanwhile, headline inflation has accelerated in the US amid diminishing global deflationary headwinds. This led the Fed to increase US interest rates at its December meeting, with the members of the Federal Open Market Committee (FOMC) forecasting three further hikes in 2017. The market has finally begun to buy into the Fed’s forecasts, having perpetually viewed them as overly hawkish in recent years. This has supported the US dollar, which reached highs not seen since 2002 at the start of January.

Away from economic strength and monetary policy expectations, Donald Trump’s rhetoric continues to be a significant driver of sentiment within asset markets and the US currency. Indeed, the dollar’s decline from its January peak can largely be attributed to the new president’s suggestions that the euro, yen and renminbi are undervalued, as well as fears that his protectionist trade and immigration policies could have negative domestic and international growth implications. The Fed has recently stated that it will wait for further clarity to be provided on the size, composition and timing of any fiscal stimulus the Trump administration implements before deciding how this will influence its monetary policy decisions. As such, it is possible that the dollar could experience some short-term downward pressure if no positive newsflow surrounding fiscal policy materialises, as positive government spending expectations have already been priced into foreign exchange markets. Although we note that the dollar is overvalued on a purchasing power parity basis, the Fed looks set to tighten monetary policy and US treasuries already offer more attractive real yields than their international rivals. As a result, we expect the dollar to remain strong relative to sterling over the next twelve months.

The euro

Euro chart

Figure 2: The euro strengthened against sterling considerably in 2016 amid Brexit newsflow. However, with the European political calendar busy in the coming months, we expect sterling to recover in 2017.
Source: Thomson Reuters Datastream

Eurozone inflation has been boosted by the dissipation of global deflationary forces in recent months, prompting the European Central Bank to announce plans to reduce the value of its monthly asset purchases from April 2017. However, we expect Europe’s central bank to remain highly accommodative in 2017, as core eurozone inflation remains low and the labour markets of many European countries retain significant spare capacity. Importantly, unemployment remains elevated in Italy and France, where structural issues are proving headwinds to job creation, and Spain, which is still recovering from the severe labour-market recession it suffered during the global financial crisis. Indeed, the ECB used this as justification to extend its asset purchase programme until the end of 2017 at its December meeting, which caused the euro to reach lows against the dollar not seen since 2002.

The 2017 European political calendar is very busy, with French, Dutch, German and potentially Italian elections occurring over the course of the year. The success of populist political parties in any of these countries could spur European Union referenda similar to that which the UK undertook in June last year and we therefore expect volatility to rise in foreign exchange markets around these events (we note that the pound was the main conduit of ‘Brexit’-related newsflow around the UK’s vote). European politics presents one of the largest tail risks for investors, as questions over the dissolution of the European Union and potentially the demise of the euro could dramatically affect investor and economic sentiment.

Given the economic problems and political event risk, we have retained our negative outlook on the currency.

The yen

Yen chart
Figure 3: The yen sold off towards the end of 2016, but we still expect it to weaken against sterling over the next 12 months.
Source: Thomson Reuters Datastream

We expect upward pressure to remain on sovereign bond yields outside of Japan amid accelerating growth and inflation, rising government borrowing and as the Fed tightens US monetary policy. However, we also expect the BoJ to maintain its recently-established monetary framework, targeting a 0% yield on 10-year Japanese government bonds, as growth is likely to remain subdued in the face of long-term structural headwinds. As such, we see scope for the yen to weaken further over the course of 2017 as the yield differential between Japanese government bonds and their foreign counterparts increases. If China’s economy resumes its slowdown this could also have negative implications for the yen, as such a development would have an adverse effect on Japanese demand.

 


This article was first published by Brookes MacDonald in February 2017.