Currency - an all weather philosophy

Financial markets are experiencing another bout of turbulence amid rising doubts about the strength of the global economic recovery. In our view, the global growth outlook has deteriorated in recent months, and the issues guiding investment in the months to come will elicit very different reactions across currency markets. While we anticipate the yen, dollar and euro will continue to trade within their recent ranges, more dynamic shifts could be in store for currencies across the G10 and beyond. The increased volatility that may result from gathering macro-economic clouds, is likely to provide interesting for active currency investors.

First and foremost, while we do anticipate slower growth, we see little likelihood of a double dip. In our view, the extent of the slowdown depends on a combination of factors, including the impact of the sovereign debt crisis at the eurozone's peripheries, and pending financial regulatory reform on both sides of the Atlantic. But central to the progress of the global recovery is the continuing skilful management of monetary and fiscal policy. Growth momentum is slowing, due to the fading effect of government-sponsored stimulus in major developed markets, and the gradual onset of policy tightening elsewhere - particularly in China, the epicentre of global demand.
So how are central banks likely to react to these ongoing challenges? In the G3 at least, we believe monetary tightening is still unlikely for the foreseeable future, and this holding pattern for key funding rates is likely to prevent major shifts in rates between the euro, yen and US dollar. We consider the risks to this benign outlook for the euro/dollar exchange are tilted towards further euro weakness, given the potential for contagion from the euro zone's fiscally-challenged peripheries to the larger members of the union. In our view, the pressures on the yen are relatively evenly balanced. Its potential for further weakness against the dollar will probably be capped by the Fed's ‘lower for longer' stance on interest rates. And any sharper yen appreciation is likely to elicit a policy response by Japanese officials.

In contrast, global developments could bring more of a shakeup for currencies beyond the G3. We anticipate China's monetary policy tightening will ease growth back to around 8%-9% in the second half of 2010, presenting a potential setback to global demand. Within the G10, the economies most vulnerable in this scenario would be those with large manufacturing sectors supported by commodities exports, and as a result we look for the Australian dollar and Norwegian krone to underperform sterling, the Swedish krona and the Swiss franc.

Though the policy measures Chinese authorities have undertaken so far have helped curb money supply, we expect some further pickup in consumer price inflation, from the current 3.1% to around 4.5% in the coming months. This combination of higher inflation and slowing growth - mirrored in manufacturing surveys in many emerging market economies in recent months - may present a more challenging environment for risk assets in the second half of this year.

In terms of emerging market currencies, a defensive investment strategy that reflects this macro-economic outlook for the near term would in our view be best focused on those countries with healthy balance of payments profiles and that are least susceptible to potential slowdowns in foreign investment. Currencies to avoid are those disadvantaged by a negative balance, or those central European currencies most exposed to the potential fault lines in the euro zone economy.

That said, capital inflows to emerging markets have been very resilient this year, as investors have favoured assets underpinned by strong momentum in output growth, and allocated away from developed markets struggling with severe debt and fiscal problems. Since the start of the year, investors have ploughed $33.4bn (£22.1bn) into emerging market debt funds, of which around 60% are local currency funds in line with the benchmark GBI-EM family. Even as equities markets suffered over the past month from the first twinges of a global slowdown, we saw little sign of redemptions or retrenchment in capital flows to EM, and we feel this fundamental strength will persist, underpinning the strength of the currencies. The low cost of trading currencies makes them an efficient way to express economic views and, by taking a flexible, analytical approach to the relative merits of a broad universe of currencies, investors can generate returns even in turbulent or unusual economic situations.

To discuss these themes further please call - David Curtis, head of UK institutional business, GSAM.
Tel: 44(20) 7552 0287 Email: [email protected]