The Sterling...
Talking about the greenback, there’s always another currency at the other side of the trade. The sterling is one of those currencies that has suffered as trade barriers have been raised (a “Brexit” is akin to increasing trade barriers); the Brits also have a current account deficit. And we think those trade barriers will become ever more apparent as the odds of the UK and the EU coming to a prudent trade agreement appear rather dim. We come to that assessment because of the EU’s institutional setup requiring unanimity for new trade deals on the one hand, but a hard deadline on the other hand to leave the EU once Article 50 (the ‘exit’ article) is triggered.
What gets us really negative about the sterling, though, is their fiscal situation. Sure, there may well be a short squeeze at some point because others don’t like the currency but medium to long-term, we believe the Brits may well go down what we call the “Italian road.” That is, we believe they’ll finance substantial deficits with monetary policy that’s too loose, leading to a currency that will cascade lower over time. That’s because we don’t see how the Brits can finance their budgets. When the Brits had their austerity budgets, their finances had moved from what we would call horrible to bad. Now they may well drift back to horrible as government spending increases to cushion the blow from Brexit.
The Euro...
What about the currency investors love to hate? Let me remind readers that everything is relative to what is being priced in. The euro has done well year to date because, we believe investors are increasingly realizing that the lows in rates may have been reached. The dollar started to surge at the first talk of tapering, even as the first actual rate hike was far, far, off. Similarly, the euro may well start appreciating well before rates will actually go up again in the Eurozone.
Recently, European Central Bank (ECB) head Draghi gave an upbeat presentation at a press conference, suggesting (and I’m putting words into his mouth here) we shouldn’t be overly worried about the various upcoming risk events (Dutch election at the time; the French election, etc.), as there isn’t much as we can do about them anyway; and if something bad were to happen, well, he’ll do whatever it takes. Then the Dutch rejected populism. Then the rumor came up that the ECB may hike rates before ending the purchases of securities; this rumor was given credence as the Austrian ECB member of the governing counsel suggested that there are many different rates and, yes, some could be raised before the bond purchases are done.
Separately, we believe the euro has increasingly become a so-called funding currency. Amongst others because rates are so low, speculators are borrowing in euros to buy higher yielding assets. If we have a risk off event, e.g. a sharper decline in stocks, those speculators might have to reduce their bets and, as part of that, buy back the euro. Short covering may not lead to sustainable rallies in the euro, but it’s a piece of the puzzle worth watching.
EM currencies...
Emerging market (EM) currencies tend to be proxies for risk assets, i.e. they tend to do just fine when times are good, but in the case of severe selloffs, our analysis shows they also tend to suffer. We don't think they are as vulnerable as they have been at other times when investors have been chasing yield (remember, in EM markets, higher yielding bonds tend to be available), but any investors exposed to them should keep those risks in mind in the context of an overall portfolio allocation.
Make your portfolio great again...
Before you contemplate how to rebalance your portfolio, think about how institutional investors might be rebalancing their portfolio. U.S. markets have been outperforming, the dollar has been rising. As such, we would think institutional investors might shift assets overseas to rebalance their portfolios, thereby favoring international equities and putting downward pressure on the dollar.
As you might have gathered, I believe most investors are over-exposed to US equities. Equities have performed so well that it’s difficult to get anyone to listen to this concern. And that’s exactly the type of environment that is a fertile ground for bubbles.
Next time, we will be giving specific portfolio construction ideas for this environment. To be alerted, please make sure you subscribe to our free Merk Insights, if you haven’t already done so, and follow me at twitter.com/AxelMerk. If you believe this analysis might be of value to your friends, please share it with them.
Axel Merk is president and chief investment officer of Merk Investments.