Stock investors could be forgiven for feeling bruised and battered by recent turbulence in the markets. But they should spare a thought for their peers in the foreign-exchange (FX) markets. September was a real roller-coaster ride, and things only look set to get worse.
The real game-changer came in early September, before the euro’s topple. On 6 September the Swiss took drastic action to tackle what they see as their currency’s damaging strength. The Swiss National Bank – Switzerland’s central bank – said it would “no longer tolerate” a rate below CHF1.20 to the euro. The CHF promptly slid around 8% against the euro.
It’s easy to sympathise with the Swiss. The country’s ‘safe haven’ reputation and proximity to Europe’s most troubled countries means that money has been flooding in from those who are worried about devaluation or disruption in their own countries. The resulting strength in the Swiss franc has been bad news for the country’s vital manufacturing sector. The Swiss don’t see why they should see their own economy suffer because the rest of Europe can’t get its act together.
But there are two problems with the Swiss move. Firstly, from a Swiss point of view, there’s no guarantee it will work. Yes, they can in theory print unlimited amounts of Swiss francs to defend the CHF1.20 level. But as Stuart Thomson of Ignis Asset Management points out, when they last did this in 1978, inflation leaped from 1% to 5% in a year. With few other ‘safe’ assets out there, the Swiss franc will remain attractive to anyone just looking for the return of their capital, rather than a return on their capital.
Secondly, and more importantly, even if it doesn’t work, the Swiss move means that the gloves have come off. US Treasury officials have tried to argue that “Switzerland is a special case given its safe-haven status, which distorts the impact of monetary policy on its currency”, writes Nicholas Hastings in the Wall Street Journal. But “with Switzerland already having taken matters in its own hands, without any apparent consultation with its trading partners”, other countries could follow suit. In short, this is a major escalation in the so-called ‘currency wars’.
The problem is this: no country in the world right now wants a strong currency. With the global economy already frail and showing signs of heading into another slowdown or even recession, countries are desperate for ways to stimulate their economies. With most of the developed world sporting zero per cent interest rates, the most obvious way to try to boost business is by having a weak currency (which makes your economy more competitive by lowering relative labour and export costs). So it’s a race to the bottom – and now that even the ECB has apparently given up defending the euro, the race is becoming ever more frantic.
So which currencies will be left standing? And what can investors do to protect their wealth? Here we take a look at prospects for some of the major currencies, and below, we suggest ways to take advantage and diversify your currency risk.
No more ‘safe havens’
The reaction of analysts after the Swiss move was to argue that the likes of the Norwegian and Swedish currencies (the ‘Scandis’, as FX traders call them) would strengthen as investors used them as alternative ‘safe’ havens to the Swissie. The trouble is, the Scandinavian countries now have every reason to pursue policies, such as cutting interest rates, that weaken their currencies – why should they stand by and be swamped by damaging currency inflows?
As for Japan, as Thomson points out, that country has been advised since 1994 to find policies to weaken the yen. Indeed, last month Japan spent $58bn selling yen, the most for any month since 2004. The Swiss move has made it much easier for the Japanese to continue doing so. After last weekend’s G7 meeting in Marseille, the Japanese finance minister noted that the other members didn’t warn against Japan intervening in its currency: “I believe we gained understanding toward our view on currencies.” That hasn’t stopped the dollar from falling against the yen amid the recent panic. But it would suggest that it might be foolhardy to bet on the yen strengthening much further from here. Thomson notes: “We believe that the yen will be weaker on a six- and 12-month basis as the central bank is forced to stimulate its economy to deter safe haven flows.”
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What about the so-called commodity currencies? The Australian and Canadian dollars have been highlighted as potential new ‘safe-haven’ candidates, backed as they are by huge reserves of ‘hard’ assets. Australia has its miners, and Canada has its oil, lumber and water resources. However, just as is the case with the Scandis and the yen, there’s no reason for the Australian or Canadian governments to sit back and accept these safe-haven flows without reacting. Central banks in both countries seem to have shelved plans to raise interest rates any further. Both are uncomfortably exposed to the global economy. Australia looks very vulnerable to any slowdown in appetite for commodities, from China in particular, as we highlight below.
Runners-up in the ‘least ugly’ contest
Britain’s economy is in no way healthy. The question on the minds of the Bank of England’s finest is whether or not to print more money, not when to raise interest rates. Inflation remains well above target, punishing savers and keeping the property market (outside London) in a state of paralysis.
Yet, when you compare it to Europe, Britain at least looks relatively stable. So the good news for British investors is that, while sterling is not the strongest currency in the world, nor is it the basket-case it threatened to become a few short years ago. Writing in our Money Morning email, Dominic Frisby said that, while he believes the pound could slip to $1.50 by Christmas time as the dollar strengthens, it could also rise against the euro, to between €1.20 and €1.25.
What about Asian currencies? Most Asian countries, and emerging markets in general, certainly look to be in better fundamental shape than most Western economies. They aren’t weighed down with debt, their populations are often younger, and they have managed to keep their economies growing through the downturn. We look at ways to play the long-term rise of Asian currencies below.
That leaves us with the US dollar. Almost by default, it looks likely to do well. It has already been picking up – the trade-weighted dollar index (which measures the dollar’s performance against that of its biggest trade partners) is up by around 4% in the past fortnight. This makes sense. Federal Reserve chief Ben Bernanke may not like the idea of a stronger dollar, but while he can print money all he wants, the one thing he can’t do is peg the dollar to another currency. As the global reserve currency, and denied all other alternatives, money looking for a safe home still comes running to the US.
The one thing that might harm the dollar’s recovery is the Fed’s next meeting on 21 September. But markets are already expecting ‘Operation Twist‘ (another version of quantitative easing). If the Fed fails to find anything more drastic than that, and Europe remains in crisis (which seems likely), then it’s going to be hard for Bernanke and his colleagues to force the dollar back down. In the short term at least, the US currency looks like being one of the few contenders left standing if the currency wars worsen. We look at how to profit below.
What to buy to diversify
One way to try to profit from volatility in the currency markets is to spread bet, which is one of the easier ways for retail investors to play the FX market. This is, of course, risky – you can lose more money than you initially stake, and currencies can move very rapidly indeed. However, if you are interested in trading, you can find out more about how to go about it here, where you can also sign up for our free trading email, MoneyWeek Trader.
An alternative is to use currency exchange-traded products (ETCs). The idea is that you can buy an ETC that will replicate the performance of a certain bet (say, shorting the euro against the dollar) without taking the risks involved in using leverage, as you do with spread betting. As to which currencies to go long on, our main view would be to go long the dollar (ie, buy it) versus the euro, as the single currency could still have a long way to fall. Another possible trade could be to short the Aussie against the Japanese yen – if China shows signs of an obvious slowdown, the Aussie would take a serious hit, while Japan still tends to benefit when investors are in ‘risk-off’ mode.
If you’d rather not dabble in the currency markets directly, but are still looking for ways to diversify your exposure, then one good option is to look at Asian income funds. As we note above, most Asian currencies are likely to do well over time – these are the areas where the growth is, after all. Cris Sholto Heaton, who writes the free weekly MoneyWeek Asia email, likes the Aberdeen Global Asian Local Currency Short Duration Bond Fund. It invests in various Asian government bonds, usually maturing in one to three years’ time. As Cris notes, there is some interest-rate risk involved, but it is relatively low, and this is one of the most straightforward options for anyone looking for a way to play rising strength in Asian currencies over the long run.
If you have a greater appetite for risk, emerging-market income funds are another good bet. The Somerset Emerging Dividend Growth Fund (020-7499 1815) from Somerset Capital hunts for income stocks from areas as diverse as Brazil, Taiwan and Turkey, so you are getting exposure to a broad range of markets. If you’d rather stick more closely to Asia, investment trust options include the Aberdeen Asian Income Fund (LSE: AAIF). It currently trades on a premium to net asset value of 5.2% (it rarely trades at a discount) and pays a dividend of 3.6%.
What if the dollar comeback continues? My colleague David Stevenson wrote here about how to profit from the potential resurrection of the dollar a few months ago, via four FTSE 100 stocks that are heavily exposed to the dollar. The four, which we still like, are utility giant National Grid (LSE: NG) – which also distributes electricity in America – and is on a p/e of 12.4 and pays a dividend yield of 6.3%; pharma giant GlaxoSmithKline (LSE: GSK) on a p/e of 11, and a yield of 5.4%; aerospace engineering specialist Cobham (LSE: COB), on a p/e of nine and a yield of 3.7%; and defence group BAE Systems (LSE: BA), which is on a p/e of seven and pays a dividend yield of 6.8%.
And, as ever, hang on to gold. The yellow metal has dropped off a bit from its highs recently, and may struggle if the dollar makes a serious comeback, but it’s still well worth having as insurance against disaster. In the race to the bottom, we can’t know what tricks governments will pull out of their hats. As David Bloom of HSBC notes, “gold is the only safe-haven asset that will not do QE [quantitative easing], put in capital controls, or complain”.
Australia’s nasty case of ‘Dutch Disease’
You’d think an abundance of natural resources would be a good thing for a country, writes Philip Gillett. But it can be as much a curse as a blessing. Why? As foreign nations buy the local currency to pay for its commodities, the currency strengthens. As a result, exports from local manufacturers become less competitive. Eventually, indigenous industry collapses, and the economy is left reliant on a heavily cyclical industry selling products with little value added. This process of hollowing out is known as ‘Dutch Disease’ (after the experience of the Netherlands in the 1960s, following the discovery of a large gas field off its coast in 1959). And now Australia looks like a prime candidate to contract the same illness.
Australia has natural resources to burn. It also has a purchaser of insatiable demand on its doorstep: China. As commodity prices have boomed, so has the Australian dollar. At the start of 2009 you would have got A$1.43 for a US dollar. Now you would get less than A$1.00. Property prices in Australia have rocketed too, with the ratio of income to house prices as high as ten in Sydney: to put that into perspective, London peaked at a ratio of seven. Unemployment is low and steady at 4.9%, with reports that miners can get paid over US$200,000 per annum. But Australia has now become a two-tier economy. While miners and property punters have gained, other businesses, and manufacturing in particular, are wilting. Bluescope Steel, Australia’s largest steelmaker, recently said it was closing one of Australia’s three blast furnaces, citing the strength of the Aussie, with the loss of 1,000 jobs. Tourism is down by 15%, wine exports by 3%. Indeed, it is now estimated that 80% of businesses in Australia are suffering due to the strong Aussie. Worse still, lending to small businesses – which provide 38% of Australia’s jobs – has slowed as banks favour making lucrative property loans instead.
What can Australia do? Unfortunately, it’s probably already too late – cutting interest rates to weaken the currency would only fuel the property bubble. With growth slowing in the US, the Aussie has already slipped from a high of $1.10 to around $1.02. The real carnage will come when China’s party ends: because Australia will have little left to show for the current commodities boom other than a stagnant economy, higher unemployment as small business suffer, a bursting property bubble, and potentially a banking crisis. Sound familiar?
• Philip Gillett has been working in the financial markets for more than ten years. He holds an economics BSc, IMC and CISI diploma and is a member of the PFS.
• This article was originally published in MoneyWeek magazine issue number 555 on 16 September 2011, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.