Currency is an asset class no investor can afford to ignore. Even if you don't trade forex, you're likely to have overseas equity or bond holdings – either directly or in funds – whose value fluctuates with the exchange rate. And if you avoid that risk by sticking to UK stocks, the international nature of the FTSE means that you're still faced with the choice between exporters, who will benefit from a weakening pound, and importers, who will win if sterling strengthens.
So it's annoying that currency movements are infamously tough to forecast. They depend on a cocktail of macroeconomic and geopolitical factors that are much harder to unravel or research conclusively than the micro-economic fundamentals of an individual company. Many professional money managers hedge their currency exposure as a matter of course, explaining that they don't want to call a market on which they can get no exclusive angle beyond their own 'view'.
The other problem is that trading foreign exchange is a zero-sum game. Holding currencies is not profitable in itself – as holding stock in a dividend-paying company or bonds from a coupon-paying government is. So returns are only available if you play gains in relative value, which are necessarily mirrored by losses on the other side of the trade. The pound's gain against the dollar is the dollar's loss against the pound.
What this means in practise is that underperforming currency traders don't just undershoot a rising index, like underperforming fund managers; they actually lose money. And beyond the world of investment, currency's relativity is the problem at the centre of international bickering about 'currency wars' and 'competitive devaluations'. Countries want weak currencies to boost exports in the recovery. But because exchange rates are relative, if one country weakens its own currency it strengthens those of its trading partners. Bilateral weakness is a logical impossibility.
Currency wars
So far, only two countries have risked diplomatic tensions with direct attempts to deflate their currencies. Switzerland's central bank sold reserves of the Swiss franc last year, and Japan did the same this September. But because neither of these are major consumer economies, they escaped the ire unleashed on the US when the Federal Reserve renewed its quantitative easing (QE) strategy last month. China likes to blame its ever-widening trade surplus with America – the greatest global imbalance – on the Fed's loose monetary policy, which has kept the dollar weak ever since the dot-com crash.
Naturally, Washington doesn't see it that way. It maintains the People's Bank of China has kept the yuan artificially weak for years by using the trade surplus to buy US Treasury bills, thereby keeping the yuan off global exchanges.
But China also has a serious, pressing point: dollars printed in the west, where interest rates are still at record lows, inevitably find their way into emerging markets, pushing up local currencies and stoking inflation. The major emerging economies fear a return of the so-called 'carry trade' – borrowing in dollars or yen to buy higher-yielding growth currencies – that dominated forex markets in the mid 2000s.
Hot Brazilians
Brazil has been the most obvious victim of this trend so far. So much foreign capital has poured in that the Brazilian real has almost risen back to peak 2008 levels and the government has resorted to raising taxes on foreign purchases of its debt. Indeed, Brazil's finance minister Guido Mantega was the first official to speak openly of "currency wars" in late September. Yet other emerging-market currencies, such as the Indian rupee and Thai baht, have also performed strongly, and so have commodity currencies such as the Australian dollar. The bind for these economies is that if they raise interest rates to dampen creeping inflation – as Australia did as early as October 2009 – they will make their currencies even more attractive to foreigners.
This general thawing of risk-aversion has been the overarching trend in currency markets since March 2009 – just as in equity markets. But it has been periodically halted by a series of macro-political problems that have provoked sharp moves back into traditional safe havens such as the dollar and yen. First, investors woke up to the euro's woes in Greece; then the US issued disappointing second-quarter economic growth numbers; most recently Ireland has bagged the headlines.
The result has been a so-called 'risk-on, risk-off' environment in which all asset classes have been swept together by recovery hopes and recession fears in alternation. One key question for 2011 is how long this environment will last. Colin Harte at Baring Asset Management thinks it is already breaking down, so that currencies will follow more idiosyncratic paths next year, depending on national macro-economic issues rather than global sentiment. But Thanos Papasavvas, who heads the currency team at Investec Asset Management, isn't so sure. "The test will be if emerging markets sell off in the next mini-crisis," he says.
First to tighten
Another central question is whether any of the big four central banks – the Fed, the European Central Bank, the Bank of England and the Bank of Japan – will raise interest rates. It looks unlikely in the short-term: the US's latest QE package is due to last until June; the euro crisis seems bound to continue; UK fiscal retrenchment starts in earnest come January; and Japan hasn't tightened interest rates for years. Mr Papasavvas doesn't expect any tightening before the fourth quarter of 2011.
Still, the performance of the big-four currencies in 2011 will depend on the perceived recovery trajectories of the economies they represent. On this there is also little consensus. Mr Harte thinks QE will be scaled back as the US recovery firms up, making the greenback the most attractive major currency. But Mr Papasavvas is much keener on the euro on the basis that the market, spooked by Europe’s weaker periphery, has overlooked the strength of its Germanic core. Duncan Higgins, an analyst at forex broker Caxton FX, is most bullish on the pound, believing the UK government's austerity drive will have a lesser impact on the economy than generally feared.
Sterling is the most important rate to get right for UK-based investors, whose liabilities are priced in sterling. Fortunately, this is a rare point of agreement in our spot poll of experts. They all believe the pound remains undervalued after its rocky run before the May general election, when investors – quite wrongly as it turns out – assumed a hung parliament would lead to budgetary incontinence. If sterling strengthens against the other major currencies next year, as this implies, foreign stocks would face an uphill struggle for UK-based investors. That would reverse a two-year trend that has been a major tailwind for British devotees of the Dow.
Best stick to Blighty
Another reason why sticking to sterling may be wise is that the carry trade isn't the automatic money-earner it used to be. Investors used to be almost guaranteed a return by borrowing in yen and buying Australian dollars, for example, just on the basis of a 5 per cent interest-rate differential. But Mr Papasavvas points out that since currency volatility has moved back to more historically normal levels, sudden exchange rate movements can wipe out those gains. Carry-traders now have to look beyond yield to the much more complicated business of spotting valuation anomalies.
This isn't impossible – Mr Harte at Barings thinks the Australian dollar and most Latin American currencies have become overvalued, but likes the Mexican peseta and the emerging Asian currencies. But taking a view on such exotic economies requires a lot of leg-work, so investors who want global currency exposure may be better off enlisting the help of a professional by buying a fund – we look at some options below.
Meanwhile, those who do decide to stick with UK stocks should bear in mind that a strengthening pound will boost margins for importers and squeeze them for exporters. But this has to be weighed against the gloomier growth outlook for importers, which will have to battle against higher VAT to sell their wares on the high street. The great advantage of investing in sterling-denominated stocks is that the unpredictable world of currencies will only affect your portfolio at the margins. That's particularly attractive if the pound is poised for a comeback.
Currency trends
