Why Currency Matters
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Before I begin this week’s article I wanted to provide you with a short update on a few things. Firstly, going forward I will be publishing articles fortnightly but will continue to update the portfolio every week, published on the ‘Portfolio’ page of The Spark’s website. For those of you who are signed up for our email list, I will email the updated portfolio each week to you. Therefore any changes I make will be explained the following week.
Secondly, I have made two recent errors. I had made a mistake when adding Anglo American (LSE: AAL) to the portfolio, booking a cost of £214 rather than £286. I am not sure how I did this (I must have been sleeping when I inputted it into my Excel spreadsheet!). This meant that roughly 0.8% of performance was incorrect and the cash balance was £75 too high, however, this has now been corrected. Also, I had forgotten to add dividends to the portfolio’s cash balance at the end of Q1 2022, which amounted to 0.3% of the total portfolio value and should be added to the cash balance. However, I have decided that, rather than add this amount to the cash balance, I would leave it to account for the theoretical ‘transaction costs’ for the five trades I placed during the quarter. This will give a fairer reflection of the total return for the portfolio. Transparency is highly valued here at The Spark!
With that aside, on to this week’s article
What is Forex?
The currency market is the biggest and deepest (most liquid) financial market in the world (well above the stock and bond markets) with around $6 trillion of active trading volume daily, making it one of the most important financial markets.
Although the bond and stock markets are huge, segments of these markets can still be cornered (controlled/manipulated). In the bond market, central banks can buy large amounts of bonds to suppress yields (called yield curve control – YCC) such as in the case of Japan. A bond’s yield moves in the opposite direction to its price, so if there is a large inflow of money to buy such bonds, the price rises and the yield falls - this is the essence of YCC. In the stock market, shares can be squeezed, such as GameStop in the Reddit meme stock saga of January 2021. However, the sheer size of the foreign exchange or ‘forex’ market makes it virtually impossible to manipulate.
You’ll often see currencies quoted in post offices or on the market as ‘USD/GBP’, for example. The first currency is the ‘base’ currency (USD) and the second is the counter/quote currency (GBP). The base currency is always 1. In this example it is 1USD. Therefore, if the USD/GBP exchange rate is 0.78, then every $1USD you convert to British Pounds turns into 78 pence.
From an investor’s standpoint, currencies can be broken into two groups, the majors and the exotics. Majors are the main currency pairs, such as USD/EUR (US Dollar to Euro), the most traded currency pair in the world. Exotics would be any uncommon currency pair. One example would be the GBP/TRY (British Pound to Turkish Lira). These pairs are traded less and are therefore less liquid (less capital flowing in and out of them, making it harder to buy and sell).
So, what function do the currency markets have and why is it important from an investment standpoint?
Why Currencies Move
Like many of the instruments that move in financial markets, the movements of the forex markets come from supply and demand. A lot of the explanation behind currency movements could be thought of as a comparison between two countries. If the US economy is stronger than the British economy, it is likely that the US Dollar will rise in value against the British Pound. I will use the US Dollar as an example to convey the many other ways a currency can be affected by the wants and needs of the world.
One large contributor to the movement of a currency is imports and exports. Overseas companies need US Dollars (USD) to pay for exports of US goods to their country, raising demand for US Dollars. On the other hand, US companies (importers) purchase overseas currencies to pay for imported goods arriving in the US, so they sell USD for other currencies.
Another major contributor to the movements of the US Dollar is speculation from investors and traders. This comes in several forms. One way, much like above, is where overseas investors seek to invest in US assets, and therefore buy USD to do so, increasing demand for the currency and raising the USD exchange rate against the foreign investor’s home currency (see chart 1). The opposite effect is realised when they sell US assets. On the other hand, US investors seeking to invest in foreign assets will sell USD to buy foreign currencies, increasing the supply of USD and causing a weakening in the USD exchange rate compared with the currency they are converting to. The US Dollar can also move due to pure speculation over shorter periods by traders, betting on short-term weakness or strength due to recent news or black swan events like the outbreak of a pandemic.
Chart 1
This can be applied today, as we have seen a significant rise in the USD recently (see below). The US Dollar Currency Index chart below compares the US Dollar against a basket of other currencies, including the British Pound (GBP), Japanese Yen (JPY), and Swiss Franc (CHF). As you can see, USD has risen exponentially of late. This has happened for several reasons. Firstly, USD is seen as a safe haven for cash when times get tough, or uncertainty rises in financial markets. Recently, recession worries, the Russia-Ukraine war, and the continuing property crisis in China have caused investors to flock to USD for this reason.
US Dollar index tends to rise in crises, Source: TradingView
Another reason is due to interest rates. If one country is raising interest rates faster (or adheres to more sound money principles) than another country, its currency will rise against the other. Using an example, if interest rates are lower in Japan than they are in England, a Japanese investor could borrow money in Japan and invest this capital in British bonds, collecting a relatively risk-free profit (see chart 2 below). The effects of such interest rate differentials can be witnessed today with the EUR/USD exchange rate, which is down over 12% since January 2021 partly because the Federal Reserve (US central bank) is more hawkish than the European Central Bank (ECB).
Chart 2
Japan has been a poor inflation hedge
I initially bought iShares MSCI Japan Index (LSE: SJPA) as I hoped investors would flock to this region to shelter from rising inflation in other developed nations since Japan’s inflation rate is still very low. The Japanese Yen has also traditionally been a safe haven currency that investors race to in times of strife, however, this is not the case today. The Japanese Yen is down over 10% compared to the US Dollar this year, making it the worst-performing currency out of all the major forex pairs (see below).
Pressure on the Yen has mounted as interest rate rises from other major central banks have diverged from the policy at the Bank of Japan (BoJ) – Japan’s central bank. The BoJ has been operating YCC (explained above) since 2016 to prevent the Japanese 10-year bond yield from rising above 0.25%. This continued stimulus at a time when other banks are pursuing more hawkish agendas has prompted global investors to sell Japanese securities… and the currency (for the reasons explained above). Japan is also a net importer of energy and commodities, meaning it has been hurt by recent price spikes as a result of the Russia-Ukraine war.
JPY/USD down over 10% in 2022, Source: TradingView
On a side note, Japan is the largest buyer of US Bonds. If the Japanese Yen is weakening against the US Dollar, it will take more Yen to buy these bonds. This is negative for US bonds, as its largest buyer may no longer have the capacity to purchase more from them at a time they are attempting to sell them back into the market (quantitative tightening). Are shorting bonds the only hedge today?
To substitute for the sale of the iShares Japan ETF, I will add a position in Ruffer Investment Co. (LSE: RICA). Although the trust has £900m of assets (below my £1bn minimum requirement), this is a fund (purchases a portfolio of assets), and its primary aim is to protect capital. Therefore I believe the risks of holding this fund are significantly reduced. The reason I included the £1bn market cap rule was to stay away from small-cap stocks, which are notoriously illiquid (hard to buy and sell). I do not see this issue arising with RICA. Other great trusts are Capital Gearing Trust (CGT) and Personal Assets Trust (PCT), both of which have a strong history of protecting investors’ money in times of turmoil. I have analysed all three and decided that I like RICA best, in terms of both asset mix and management. The fund’s full 2022 outlook can be found here, a lot of which I agree with, hence the reason for adding it to the portfolio.
Growth will continue to hurt
On a final note, continued rising inflation and hawkish shifts from the Federal Reserve are proving to be headwinds for long-duration assets like bonds - but more specifically for The Spark’s portfolio, technology, and growth stocks. There is still lots of negativity toward these sectors, even though some now seem to be priced attractively. However, I see no need to add further, as cheap can always get cheaper! I believe I have purchased the growth stocks in The Spark’s portfolio at a good valuation and over a reasonable time frame, I should therefore be rewarded. Thankfully my position sizing has allowed me to hold these stocks without it making a major impact on the overall portfolio return, as they have not performed since I originally purchased them.
This is not the environment to take additional risk (see below), so I will continue to be patient and sit on a larger cash position, awaiting improvement in the macroeconomic environment before adding to such positions. A consolidation or fall in oil prices could be the trigger for lower inflation numbers and higher risk-taking. On the other hand, a continued high inflation number, sell-off in bonds or harsher rate raises from the Federal reserve could leave us even worse off than we are now… not to mention an invasion in Taiwan by China.
HIgh-Yield (Risky) bonds continue to sell-off, Source: TradingView
Action:
Selling 100% of iShares MSCI Japan Index (LSE: SJPA) at £34.10, booking a £53.76 loss (10%)
Buying 4.2% in Ruffer Investment Co . (LSE: RICA) at £3.14
Portfolio Return Year-To-Date: 1.5% vs S&P500: -11%
Total Return since inception (20/09/21): 7.5% vs S&P500: -2%
Summary
My exposure to US investments has helped my performance because of the currency exposure to the US Dollar vs GBP, as investors flock to this safe haven in times of uncertainty. I hoped the Japanese Yen would have the same effect but unfortunately that has not occurred. The Swiss Franc and US Dollar seem to be the major safe havens today.
Until next time,
Peter
Disclaimer
This communication is for informational and educational purposes only and should not be taken nor used as investment advice, as a personal recommendation, or solicitation to buy or sell any financial instrument. This material has been prepared without considering any particular recipient’s investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past or future performance of a financial instrument, index or structured product are not, and should not be taken as, a reliable indicator of future performance. I assume no liability as to the accuracy or completeness of the content of this publication.