By Ugo Lancioni, Senior Portfolio Manager
Over the course of 2016, we saw relatively wide ranges in the prices of the major currencies against the U.S. dollar - on average 14.4%. However, despite the swings, nearly all currencies finished the year almost unchanged. The exception was the British pound, which suffered a significant depreciation following the UK vote to leave the European Union. Market dynamics were often driven by large positioning shifts ahead of key political events rather than gradual adjustments to fundamental changes.
From a currency market perspective, the most important events were the Brexit vote, Donald Trump winning the U.S. election and the numerous OPEC meetings on whether or not to reduce oil supply.
The start of 2017 will see the follow through of many of these events, starting with Donald Trump's inauguration at the end of this week. Since his election victory, inflation expectations have risen significantly in anticipation of many of the economic policies he promised during his election campaign. The market will look closely for indications of the extent to which they will be implemented. In a recent press conference he announced that he will be the "Greatest Job Creator God ever created," but some of the Trump trades that the market had embraced since his election (long U.S. dollar, short rates and long equities) partially reversed as he provided little detail around his policies.
In Europe, March sees the triggering of the official exit process for the UK leaving the EU as well as the Dutch elections. French, German and possibly Italian elections are then spread throughout the remainder of the year. However, despite these political distractions, it is important to remain focused on the fundamentals.
Setting the bar high
The New Year started positively with U.S. equity markets reaching all-time highs and relatively low levels of risk aversion, despite the high degree of political uncertainty. In the U.S., fundamentals are robust and improving. And with the Federal Reserve expected to hike their policy rate two or three times in 2017, the U.S. dollar could take another leg higher. However, although recent U.S. domestic data have been very strong, we believe this has already been reflected in the price of the U.S. dollar. Therefore, should the data fail to satisfy this level of optimism, especially with respect to the implementation of Trump's policies, the dollar may suffer.
In continental Europe, after three years lagging behind the U.S., the gap has started to narrow. Data have been surprising on the upside with many indicators pointing towards stronger growth for 2017. In December, the European Central Bank extended its Quantitative Easing program, albeit at a reduced level of monthly purchases. However, the market is not pricing the possibility of a further reduction in the ECB's easing policy, which, in a reflationary environment, could see European rates move higher and offset the stronger U.S. dollar.
So where should investors be looking from a currency perspective? Our analysis suggests that Scandinavian currencies, which are closely linked to the European trading bloc, remain significantly undervalued: between 15 and 20% relative to other major currencies. Swedish data, for example, have been much stronger lately and the combination of stronger data and higher inflation could lead to an adjustment higher in the Swedish krona. We believe that Scandinavian countries in general could outperform other G10 countries this year.
In terms of overvalued currencies, our analysis suggests the Swiss franc is significantly overvalued relative to the other major currencies. The Swiss National Bank is pursuing a negative interest rate policy and remains active in the currency markets to mitigate any franc appreciation. Moreover, as global yields move higher, the Swiss franc will come under pressure as interest rate differentials widen in favor of a lower franc.
Elsewhere, the Japanese yen sold off dramatically in the fourth quarter of 2016 and reached levels that are beginning to look stretched. We believe the yen is vulnerable to a correction, especially if markets experience some turbulence in high yielding assets.
Commodity-dependent currencies such as the Australian dollar, New Zealand dollar and Canadian dollar may underperform relative to other major currencies. This suggests that following the popularity of the carry trade in the second half of 2016, these currencies are overvalued from a long-term fundamental perspective. Should volatility increase, we may expect these currencies to come under pressure.
Finally, China has changed the currency weightings in the basket used to fix the renminbi, reducing the weight of the U.S. dollar. Moreover, there is evidence of aggressive intervention in order to limit capital outflows from the country. Investors should monitor the situation in China closely because the global implications of developments in China and its currency could be significant.
To conclude, there is scope for further gradual U.S. dollar appreciation in 2017 if the data remain strong. However, a near-term correction is to be expected as the market is keen to assess the likelihood of success of the new administration's policies. More details need to be unveiled. European currencies will offer good value from a longer-term perspective if we enter a reflationary phase. Political uncertainty is likely to stay with us for a while.
In Case You Missed It
U.S. Producer Price Index: +0.3% in December month over month and +1.6% year over year
- U.S. Retail Sales: +0.6% in December
What to Watch For
- U.S. Consumer Price Index
- NAHB Housing Index
- Thursday 1/19:
- U.S. Housing Starts & Permits
- Andrew White, Investment Strategy Group
Statistics on the Current State of the Market - as of January 13, 2017
|S&P 500 Index||-0.1%||1.7%||1.7%|
|Russell 1000 Index||0.0%||1.8%||1.8%|
|Russell 1000 Growth Index||0.3%||2.7%||2.7%|
|Russell 1000 Value Index||-0.4%||0.9%||0.9%|
|Russell 2000 Index||0.4%||1.1%||1.1%|
|MSCI World Index||0.3%||2.2%||2.2%|
|MSCI EAFE Index||0.8%||2.6%||2.6%|
|MSCI Emerging Markets Index||1.7%||3.9%||3.9%|
|STOXX Europe 600||0.6%||2.0%||2.0%|
|FTSE 100 Index||1.8%||2.7%||2.7%|
|CSI 300 Index||-0.8%||0.3%||0.3%|
|Fixed Income & Currency|
|Citigroup 2-Year Treasury Index||0.1%||0.0%||0.0%|
|Citigroup 10-Year Treasury Index||0.4%||0.5%||0.5%|
|Bloomberg Barclays Municipal Bond Index||0.7%||1.2%||1.2%|
|Bloomberg Barclays US Aggregate Bond Index||0.2%||0.4%||0.4%|
|Bloomberg Barclays Global Aggregate Index||0.5%||0.5%||0.5%|
|S&P/LSTA U.S. Leveraged Loan 100 Index||0.0%||0.3%||0.3%|
|BofA Merrill Lynch U.S. High Yield Index||0.1%||1.1%||1.1%|
|BofA Merrill Lynch Global High Yield Index||0.2%||1.1%||1.1%|
|JP Morgan EMBI Global Diversified Index||0.3%||1.7%||1.7%|
|JP Morgan GBI-EM Global Diversified Index||0.2%||0.7%||0.7%|
|U.S. Dollar per British Pounds||-1.1%||-1.4%||-1.4%|
|U.S. Dollar per Euro||0.4%||0.7%||0.7%|
|U.S. Dollar per Japanese Yen||1.3%||1.4%||1.4%|
|Real & Alternative Assets|
|Alerian MLP Index||-1.3%||1.2%||1.2%|
|FTSE EPRA/NAREIT North America Index||-2.2%||-0.1%||-0.1%|
|FTSE EPRA/NAREIT Global Index||-1.1%||0.9%||0.9%|
|Bloomberg Commodity Index||1.4%||1.2%||1.2%|
|Gold (NYM $/ozt) Continuous Future||1.9%||3.9%||3.9%|
|Crude Oil (NYM $/bbl) Continuous Future||-3.0%||-2.5%||-2.5%|
Source: FactSet, Neuberger Berman
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