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USD 10% undervalued, says State Street

Investors should reconsider their currency hedging strategies as an undervalued US dollar is predicted to strengthen according to Colin Crownover, State Street Global Advisors global head of currency management.

The US dollar is as much as 10 per cent undervalued relative to other major currencies, says Crownover, who also forecasts that the economic-growth gap between the US and emerging markets will narrow in the coming year.

“We are bullish about the US dollar and not because the US economy is without the problems it certainly has,” Crownover says. “But currencies as always are a relative endeavour and of the major economies, the US economy has lesser issues than the others.”

Crownover’s views on the US dollar are within a context of slowing global growth and the eurozone “slightly slipping into recession”.

“Regardless what people say about China, the United Kingdom or Japan, there are really only two games in town and, in terms of large liquid investments, there are US-dollar denominated assets and euro-denominated assets,” he says.

“So, whether you are central bank or an institutional investor, if you have concerns about the euro-project – which it is valid to have – then at the margin that causes an allocation away from eurozone assets into US assets.”

Crownover cautions that the attractive relative valuations of European equity markets compared to potentially expensive US equity prices may mitigate some of these allocations away from euro assets.

The US dollar has shown counter-cyclical characteristics in recent times, with the currency strengthening when investors look to shed risk at times of market uncertainty, according to Crownover.

He notes the US dollar is now “a good diversifier” in the basket of currencies an investor holds, balancing out other pro-cyclical currency exposures.

Crownover recommends US-based investors look to slightly increase their ratio of hedged assets, given the likely appreciation of the US dollar.

“Our analysis would tend to indicate that 50 per cent is not a bad hedge ratio for the US over the long term. But you probably want to do a little bit more today because the US dollar is undervalued.”


Slowing dragon, emerging markets
The softening in world growth is set to hit exporting countries in Asia, and Crownover predicts that China will slow more than many market pundits suggest, while Japan could be a potential bright spot in the region.

“Relative to what is happening in the global economy, you are seeing a bigger impact on emerging markets this time around than you did at the advent of the GFC.”

Crownover notes that the Organisation for Economic Co-operation and Development’s leading economic indicators for the US and Japan show that they are holding up in the face of slowing growth, with China showing signs of its deceleration picking up pace.

“The leading economic indicators look gruesome for China, dropping by about 3 per cent year on year. So, in our opinion China is slowing down by more than what the official statistics would have you believe,” he says.

State Street’s view is that the Chinese economy will grow by 7 per cent and could even slow further if the central government decides not to carry out fiscal stimulus.

The company is not alone in its pessimistic outlook for China, with fixed income giant Pimco also warning at the start of the year that China could slow by more than many were forecasting.

Like State Street, Pimco sees growth as closer to 7 per cent than the 8 to 9 per cent typically predicted.


Buy and hold doesn’t pay
While acknowledging the underlying fundamentals of emerging markets generally, Crownover is quick to dispel what he sees as a myth regarding currency exposure to emerging markets.

It is common to hold broadly unhedged positions in emerging markets, with the view that over time emerging market currencies will appreciate against the US dollar on the back of relatively strong economic growth and healthy sovereign balance sheets.

Crownover says there are times when this buy-and-hold strategy for emerging market currencies has played out, such as the period leading up to and during the financial crisis, but over the long-term this approach has not paid off.

“For a US-dollar investor a market capitalisation basket of emerging market currencies has lost almost 10 per cent over the last year. If an investor simply bought and held that same basket of currencies over 10 years, they made exactly zero,” he says. “So there are periods when it looks quite good, but over the long run this has not added much alpha to a portfolio.”

Crownover says the underlying fundamental strength of emerging markets is already built into the price of most of these countries’ currencies.

Despite the recent sell-off, most of these emerging market currencies are overvalued, according to Crownover.

“Our advice to investors right now is if you hadn’t done emerging-markets-currency hedging previously, this might not be a bad time to do so,” he says.

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