David Jane, manager of Miton’s multi-asset fund range, says he is increasing his exposure to euros and the yen at the margin.
We don’t often cover the topic of currencies, given that as a rule we endeavour to keep the level of currency risk in our portfolios contained. This is on the basis that currency moves are relatively unpredictable and there’s 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 its strength focus on the growth of the US economy versus international peers and 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’s 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. 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 narrow 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 and therefore this issue may again fade as time goes by.
Trade tensions have also led to a strong US dollar. 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) 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 the consensus. The data in most cases suggests that the factors driving this strength may reverse over time. We have recently been increasing our exposure to euros and the yen at the margin.
David Jane is manager of Miton’s multi-asset fund range.