You Shouldn't Be Surprised By The 'Surprise' Currency Devaluations - Here's Why

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Includes: UUP
by: Eric Basmajian
Summary

The US Dollar tends to rise during decelerations in global economic growth.

Declines in global trade and global dollar shortages occur during global growth down cycles.

This down cycle is set to continue and more currency devaluations should be expected.

The recent depreciation in the Chinese Yuan caught nearly all investors offsides, causing the S&P 500 to decline over 3%. Those positioned for downside risks in assets such as Treasury bonds massively benefited from the short-term dislocation.

Was this a one-time shock or should this be expected to occur again? This is the question many investors are wondering. What if the next devaluation is larger and a 3% decline in the stock market is just the beginning? While the broad stock market declined roughly 3%, some sectors or stocks with exposure to China declined by over 5% in one day.

What if the next currency to depreciate is not the Chinese Yuan? If you have exposure to international currencies through stocks or direct investments, another "surprise" devaluation by China or another country could crash the stock market or your savings once again.

From a cyclical perspective, these devaluations or depreciation in international currencies should not come as a surprise; in fact, they should be expected. You could be taking advantage of these shocks that surprise most investors by simply following the economic cycle and positioning accordingly. The best position to have during an economic down cycle is Treasury bonds, which benefited greatly from the recent turmoil in the currency market.

The best way to protect yourself and your savings from the next currency shock, which is more likely to come during a down cycle (which we are currently in) is to position with the economic cycle and get ahead of the major inflection points.

The US Dollar historically rises when global growth is slowing and falls when global growth is rising.

Back in April of 2018, I was watching the US Dollar bottom and wrote a note to members of EPB Macro Research highlighting the move in the dollar as a confirming data point of the growth rate cycle slowdown that started in January of that year.

Interestingly, the dollar has seemingly bottomed after a multi-month decline. The dollar is one of few currencies up over the past one month and the past one week.

A strong outperformance in the US dollar is a leading indicator of global weakness. A bottom and subsequent sharp rise in the US dollar is something to watch out for as a confirmation of a global economic slowdown.

-April 2018 | EPB Macro Research

Don't let the next currency shock come as a surprise. Once you understand the economic cycle dynamics, and how currencies respond, you'll be more confident in your portfolio allocations.

In a recent note on why cycles matter, which you can read by clicking here, I highlighted seven "up cycles" and seven "down cycles," the seventh which we are currently still in as outlined by the data below.

The cycles, defined using the IHS Markit Global PMI and several factors such as the length of the decline, the magnitude of the decline and the breadth of the decline are outlined in the chart below. Down cycles are from points A to B and up cycles are from points B to A.

Global Cycles:

Source: Bloomberg, EPB Macro Research

We can test the performance of various assets as we did in the previous research note during each up cycle and each down cycle. The results are overwhelmingly clear.

During up cycles, or when growth is accelerating, the US dollar declines as capital seeks higher returns outside the United States. When global growth is decelerating, as it is today, trade growth declines, US dollars become scarce, and capital flows back into the US.

If we look at the broad trade-weighted dollar index, we can see that the US dollar, on average, declines during global up cycles and rises during global down cycles.

Cycle Returns: Trade Weighted US Dollar: Broad

Source: Bloomberg, EPB Macro Research

Let's take the inverse and look at some currencies around the world. During up cycles, the South Korean Won rises a sharp 9% on average while declining an average of 7% during down cycles.

Cycle Returns: South Korean Won

Source: Bloomberg, EPB Macro Research

The most common objections to the US Dollar are the rapidly rising fiscal deficits, the enormous debt overhang and the recent dovish pivot by the Federal Reserve. The facts remain, however, that these factors historically have not been the determining factor regarding the direction of the US Dollar.

Secular conditions and forward interest rate differentials, which are dependent on the economic cycle, drive global currencies. In short, the economic cycle is the most reliable tool you can have when judging the expected return of any asset class.

If we look at the Brazilian Real, we see an average increase of 5.6% during up cycles and a decline in value of nearly 15% on average during down cycles.

Cycle Returns: Brazilian Real

Source: Bloomberg, EPB Macro Research

The results are overwhelmingly consistent. During down cycles, the US Dollar rises against most international currencies.

The Australian dollar is just one more example.

The Australian dollar rises an average of 11.65% during up cycles and declines an average of 7% during down cycles.

Cycle Returns: Australian Dollar

Source: Bloomberg, EPB Macro Research

If we look at the JPMorgan Emerging Market Currency Index, starting around January 2018, the latest economic inflection point, we can see rapid and continued weakness, highlighting the importance of economic cycles.

JPMorgan Emerging Market Currency Index:

Source: Bloomberg, EPB Macro Research

Should you expect more devaluations or depreciation in international currencies? As long as the global economic cycle remains in a downtrend, or in a phase of deceleration, the historical analysis favors continued strength for the US Dollar.

Depreciations or devaluations of foreign currencies are just one of the many risks that can occur and destabilize your portfolio during economic down cycles.

There are much better ways to manage the risks associated with down cycles, which last nearly two years on average, including holding assets that historically perform well during down cycles.

At EPB Macro Research, we use a process of long-leading and short-leading indicators to identify when the economic cycle is shifting. This process identifies when a down cycle is underway before the consensus, allowing you to position accordingly and reduce risk. Also, and equally as important, when up cycles emerge, and growth starts to accelerate, the time to take increased risk and shoot for higher returns is also easily outlined.

The key is finding the assets that historically perform well in all phases of the economic cycle, as we did with Treasury bonds before the nearly 40% rise over the past nine months.

The depreciation in foreign currencies is a common risk associated with decelerations in global growth. It is crucial to understand this as one of the risks associated with down cycles. Should you choose to hold an overweight position in risk assets or hold assets with international currency exposure, that is fine, as long as the risks are well noted.

When you position correctly based on the trending direction of the economic cycle, these "shocks" turn into opportunities.

As long as the global economy and the US economy remains in a down cycle, depreciation and devaluations are an active risk.

At EPB Macro Research, using an objective process of long leading and short leading indicators, you are alerted to the economic cycle risks and the potential inflection points on a regular basis.

Don't let the economic cycle blindside you again.

Knowing the direction of the economic cycle is the best way to maximize your upside and minimize your downside risk. The biggest risk to your portfolio always happens when you are on the wrong side of the cycle.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.