The USD: a structural turn or a corrective phase in a sustained decline?
(This is an excerpt from our April Portfolio Update. In the mean time we have entered a position in EM currencies vs the dollar, as mentioned in our blotter earlier this week.)
The way the consensus has changed towards the USD in the last several months has been extraordinary and frankly, a little disingenuous. Back in January / February, the attitude towards the USD was quite negative. Rate differentials didn’t matter. Trade and fiscal deficits, central bank reallocations and capital flows away from US assets would see the USD continue its downward spiral.
Oh, how different the world has become in the last couple of months.
Suddenly, rate differentials are the only driver, European growth woes and the dysfunction of Italian politics is front and center, and the Japanese current account surplus is an irrelevance. This is a classic example of price action changing the narrative, and the narrative is one where USD strength is here to stay. As with sentiment being excessive in January when the consensus was the dollar was a bottomless pit, I get the sense that bullish sentiment towards the USD or more specifically, negativity towards emerging market currencies is becoming extreme. This is creating an extraordinary opportunity in the emerging world on a multi-year view.
More on EM currencies in a minute but I continue to look for opportunities to sell the USD, predominantly against the Yen. With the Japanese running a current account surplus that is approaching 4% of GDP, I continue to believe that USDJPY will find a ceiling relatively soon. We covered a short position for a small loss during the course of the month and re-established the short as we came into May. We are underwater on the strategy but continue to have faith in the idea and will look to add.
EM Currencies are lagging on an antiquated narrative. EM equities are dirt cheap
If I was to pick one point of frustration in 2018, it has been not only the underperformance of emerging market currencies but also the way I have expressed this theme.
From our March Portfolio Update:
The rationale for being long high yielding EM currencies is compelling and a narrative I have articulated throughout this report and many times since the start of 2018. Of course, every currency pair needs a funding leg, and my dogmatic bearishness towards the UK has led me to choose the wrong one. While Russian woes and US tariffs on global steel and aluminum have been a headwind for EM, the poor performance of this strategy is all about choosing the wrong funding currency and I have to keep a very close eye on this over the next few weeks. It would be a disaster to get the trajectory of EM currencies correct, only to choose the wrong funding vehicle.
In March, being short the GBP against EM amplified the losses in our EM carry strategy. In April, it helped at the margin, but the portfolio still suffered a 75bp loss via this strategy. The underperformance of emerging market currencies is explicable if one accepts that the antiquated paradigms of USD dependency and emerging market contagion still apply. I do not believe this. I have written at length over the past 12-18 months about how the structural framework for emerging markets has improved dramatically.
There are pockets of economic / financial stability concerns within emerging markets. Turkey is a worry, as are the impact of sanctions on the Russian economy. The stalling of Argentina’s reform process and the pressures on the Peso are a worrying development, but this idiosyncratic risk should concern those investors who thought it prudent to lend a serial defaulter capital for 100 years. As for the rest of EM, the longer-term prospect remains extremely compelling. Malaysia proved the vibrancy of its democracy. India is rebounding post their soft patch, based on the Goods and Services Tax and the “De-monetization” drive. Despite increase trade tensions with the Trump administration, Chinese growth remains vibrant and a pillar of support of the emerging world. The medium to long term outlook for emerging market growth and asset returns is incredibly compelling. Emerging market underperformance appears extreme and should come to an end soon.
Regular readers know my EM equity narrative. MSCI emerging at 12.5 times forward is inexpensive and getting cheaper due to this correction in EM currencies over the last several months. In the daily gyrations of financial assets, we often lose sight of the true long-term drivers. Trade is one of those issues that most investors give very little attention to and ironically, the US / China trade dispute is a small negative for Asia versus the long-term benefits of both TPP-11 and eventually RCEP. It is very difficult not to get extremely bullish on the economic outlook for TPP countries when tariffs on 90% of goods and services will go to zero by early 2019. It is clear from a conversation with Expert Series contributor, Deborah Elms, Founder of the Asian Trade Centre, that the United States has screwed up by exiting TPP, as the deal that was signed was a major benefit to US corporates in the aggregate. While the chance of the US being readmitted at some stage in the next few years is high (if they choose to), any “better deal” would be a marginal improvement at best.