Note Sept. 18, 2020: New Is Old, Again – Currency on Watch

Note Sept. 18, 2020: New Is Old, Again – Currency on Watch – New is old, again – currency markets need to be on watch. Amid massive quantitative ease since 2008, currency translation surprise has seemed a consensus afterthought in major markets. Still, capital markets cycles have invariably in the past involved abrupt changes in currency features. Now, foreign exchange translation and business pressures exit in emerging markets. For myriad reasons in majors, the Yen is now close to 105 to the U.S. dollar, the Euro pushing up to 1.18, the Renminbi close to 6.8 while sterling waxes and weaves again around Brexit risk.

Prolonged compression for administered rates was recently again underscored by the Federal Reserve, ECB, Bank of Japan, Bank of England and others. Substantive economic recovery now appears placed for 2021 by institutions like the IMF,OECD and World Bank but even then incorporates bifurcation. Not so long ago, major preoccupations and sources of surprise lay in foreign currency translation challenges in financial statements as well as contribution therefrom on revenues. They are likely to resurface. Onto political tensions this year, coincidentally but factually so, both Covid-19 pandemic and irredentist territorial claims have been compounding. Currency volatility is likely to expand, despite the central banks.

The $6.8 trillion in daily currency trading dwarfs annual global GDP of $88 trillion in 2019. It is diverse by participant and not easily tamed. We would also expect  a resurgence by participants like hedge funds in activity such as convertible arbitrage, paired trading and currency arbitrage. In a time of slow revenue growth, even minor exchange rate changes could be magnified in impact on financial statement translations. In asset mix as hedge, we would espouse precious metals exposure at overweight. Volatility in equities and fixed income is likely to be elevated, not least due to high valuation and solvency risk. Despite central bank liquidity interventions into capital markets replete with massive fiscal and monetary largesse, the case for strong balance sheets remains apt. Irrespective of geography or sector, currency translation has increased potential to bite on both financial structure and earnings delivery.

In 2019 as a whole, global gross domestic product (GDP) totaled some $ 88 trillion. Expectations such as those released earlier by the IMF, World Bank and others, as well as most recently by the OECD on September 16,2020 suggest global GDP contraction of around 4 ½% for 2020 to be followed by 5% recovery for 2021. If so and over two years, it still would likely leave the total GDP value as being at risk of a plateau when compared to prior years since 2008. Equally important, there appears considerable bifurcation between countries both in the contraction in 2020 and in the recovery expected in such projections for 2021. For a considerable time, revenue pressures can be expected to be intense for countries and companies alike.

According to the triennial trading statistics last compiled as of April 2019 by the Bank for International Settlements, currency trading globally adds up to some $ 6.8 trillion per day with 88% involving U.S. dollars. It is likely to be rising and dwarfs the total global GDP estimated to be $88 trillion for 2019 and declining in 2020. Especially diverse are the types of participants in currency activity in ranging from physical exchange to facilitate trade by countries to small individuals simply transacting to send funds to company treasurers managing financial structure amid short and long term capital commitments to investment portfolio as well as speculative positioning, including the use of derivatives. Currency trading is not easily tamed.  

Not so long ago, major preoccupations and sources of surprise for capital markets lay in foreign currency translation changes in financial statements as well as contribution therefrom on revenues. These experiences took place during periods of political and economic uncertainty, including about inflation In the last decade, currency has appeared to take a secondary position both for governments and in terms of earnings surprise for companies. Still, in capital markets, currency expectations could and have changed abruptly. Past examples include both emerging economies like Malaysia and in the G-7,  most saliently the U.K. More recently at one extreme and despite the prolonged expenditure of considerable sums and negative rates for years now, the Swiss National Bank has had trouble restraining the Swiss Franc. At the other extreme in also expending considerable sums and tighter interest rate policy, several emerging but weak economies have started experiencing currency pressures increasingly so in the last twelve months. Meanwhile and with its export heft, China has had a meaningful upswing in its currency with implications still to be domestically and globally assessed. These developments have been evolving amid minimalist administered rates in G-7 economies including the U.S., the European Union, Japan and the U.K. as well as many significant others.

In the U.S., Japan and in Europe exist both central bank and political tussles amid individual hues of domestic political uncertainty as well as flux in central bank policy. In the United States,  the upcoming several months include an especially bitter runup and post November 3, 2020 election period. Despite not long ago of not having an inflation target,  the Federal Reserve has placed major emphasis on moving away from a specific 2% inflation target but otherwise appears obfuscating, especially ahead of the U.S. election.

In Japan, a new prime minister has emphasized growth but few details appear. For the European Union, social policy like refugee standards and standards of justice as well as fiscal measures like budgets remain sources of stress. Further between it and the U.K., the handling of backtracking on Brexit agreements once more emerge as stresses. Meanwhile, both the European Central Bank (ECB) earlier and the Bank of England more recently appear more focused on short term liquidity in economies. Solvency and deficits appear getting little attention from many authorities. Coincidentally but factually so, both Covid-19 pandemic and irredentist territorial claims have been compounding onto political tensions this year. Currency volatility is likely to expand, despite the central banks focusing on liquidity.

In a period of revenue growth being slow and political turmoil of various stripes being up, even minor exchange rate changes could be magnified in impact on financial statement translations. Due to their unpredictability, currency effects tend to be of surprise to consensus. Currently it is likely to be especially so as there have only been few such bouts within recent memory for capital markets. They also appear obsessed with short term momentum. Volatility in equities and fixed income is likely to be elevated, not least due to high valuation and solvency risk. In fixed income both of the government and private variety, yield compression appears mandated by central banks but solvency is a consideration. For equities globally, valuation is high. As benchmark, the S&P 500 appears in present valuation to be incorporating the much espoused but never achieved consensus expectation of sustained long term annual earnings growth of 12% (compared to an actual achieved historical rate closer to 7%). Individual and not necessarily unseasoned concept equities at over 50x P/E  multiples would appear to have incorporated long term annual earnings growth expectations closer to 20%. Re balance between valuation and momentum appears overdue and is likely to include currency volatility. The next test could lie within the Q3/2020 results due imminently in October.

In asset mix as hedge, we would espouse precious metals exposure at overweight Despite unprecedented central bank interventions into capital markets replete with massive fiscal and monetary largesse, the case for strong balance sheets remains strong. Irrespective of geography or sector, currency translation has increased in potential of biting on both financial structure and earnings delivery. StrategeInvest’s independent consultancy operates as Subodh Kumar & Associates. The views represented are those of the analyst at the date noted. They do not represent investment advice for which the reader should consult their investment and/or tax advisers. Any hyperlinks are for information only and not represented as accurate. E.o.e.