Download Currency Volatility: Economic Drivers and Asset Allocation

Market Perspectives
March 2015
Business Cycle Update:
Currency Volatility: Economic Drivers
and Asset Allocation Perspectives
Global divergences drive currency volatility
In the latter half of 2014, the strengthening US economy pushed the Federal Reserve
(Fed) closer to a tightening stance, while many other large economies weakened and
moved to even greater monetary easing. The first-order effect of these global economic
and policy divergences was a sharp rise in currency volatility, with the US dollar (USD)
surging against most other currencies. In turn, some countries – such as Russia and
Brazil – hiked interest rates to arrest the decline in their currencies.
The beginning of 2015 suggests that most monetary authorities are becoming even
more responsive to the weak growth outlook and to any upward pressure on their
currencies, with competitive devaluations at least a partial motivation. More than
20 countries have eased monetary policy so far in 2015, and countries such as
Denmark and Sweden have even implemented negative interest rates in a bid to keep
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their currencies from appreciating.
While extraordinary monetary policies may be suppressing the ups and downs in the
sovereign bond markets; that volatility continues to be pushed into global currency
markets (see Exhibit 1, below). In January, the Swiss franc appreciated against both
the euro and USD by more than 20% in one trading day when its central bank was
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forced to abandon its currency peg. As a result, we expect foreign exchange (FX)
markets to remain ground zero for greater overall market volatility in 2015.
Exhibit 1: Currency volatility has risen sharply during the past several months
IMPLIED VOLATILITY: MAJOR CURRENCIES VERSUS USD
KEY TAKEAWAYS
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We expect global economic and
monetary policy divergences to continue
and the Fed to begin to raise rates this
year. This will keep the US dollar strong
and currency volatility elevated, though
dollar gains should be smaller and less
uniform than during the past few months
The stronger dollar boosts US consumer
purchasing power and reinforces the
low-inflation mid-cycle economic phase,
providing a favourable outlook for US
equities and, in particular, more
domestic-centric sectors
Our outlook remains constructive for
European equities, as the eurozone
economy’s emergence from a mid-cycle
slowdown is benefiting from the lagged
effect of the euro’s decline, which in turn
should stabilise the currency
A modestly improving global business
cycle supports riskier assets globally,
though weakness in some emergingmarket economies and the prospects of
higher market volatility remain key risks
Authors
Dirk Hofschire, CFA
SVP, Asset Allocation Research
Lisa Emsbo-Mattingly
Director of Asset Allocation Research
Jordan Alexiev, CFA
Senior Analyst, Asset Allocation Research
Caitlin Dourney
Research Analyst, Asset Allocation
Research
Index = Equal-weighted implied volatility versus USD. Implied volatility measures the marketexpected future volatility of a currency exchange rate from now until the maturity date of the currency
options. 3MMA: Three-month moving average. **Major currencies noted on page 6. Source:
Bloomberg Finance LP, Fidelity Investments (AART), as of 20 February 2015.
This document has been provided by
Pyramis Global Advisors. Pyramis is a
subadvisor of institutional investment
products to Fidelity Worldwide
Investment.
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2015 outlook: Strong dollar, but not another 2014
We do not anticipate a reversal of the key factors driving the
USD’s strength, but neither do we anticipate that the dollar will
climb as sharply or as uniformly as it did against other
currencies during the past several months. In 2014, the USD
rose against 40 of the world’s major currencies, with the tradeweighted dollar up 9% and gains against the euro and yen
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exceeding 12%. Currency markets have therefore already
priced in a general expectation of Fed tightening and further
non-US easing, implying it will take additional surprises to
generate more outsized dollar strengthening. For the rest of
2015, we expect the USD to remain strong, but anticipate
overall gains to be more muted and some currencies to stay
relatively steady or to appreciate.
Mixed economic implications of a strong dollar
The effects of a strong dollar on the US economy vary. On the
positive side, USD strength boosts the US consumer’s
purchasing power by making imports relatively cheaper (see
Exhibit 2 left, below) and reinforces both the low-inflation
environment and the positive outlook for the US consumer,
supporting the mid-cycle US expansion (see Business Cycle:
Macro Update, page 3). On the other hand, a strong dollar acts
as a drag on US exports and the earnings of US multinational
companies. The initial impact of translating profits earned
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abroad back to USDs began in the fourth quarter of 2014, and
the reduction in competitiveness will likely be a headwind for
exports in coming quarters.
Outside the US, a strong USD boosts profits of multinational
firms and is positive for countries that export to the US.
For example, the weakening euro has served to reinforce the
upswing in eurozone exports to the US, providing support to the
region’s re-emergence from a mid-cycle slowdown (see
Exhibit 2 right, below, and the Europe section of the Macro
Update, page 4). On the downside, a strengthening USD tends
to raise the debt-service burden of many global borrowers,
most notably emerging-market (EM) countries and companies
that borrowed heavily in USDs and now must repay with
weaker currencies. For the moment, financial instability is
present exclusively in countries such as Russia and Venezuela
that have experienced plunging currency values and a negative
terms-of-trade shock from lower oil prices. However, capital
outflows in China – which has about $900 billion in short-term
external liabilities – present a potential risk to the global
economy if China is forced into a large devaluation of its
currency. Overall, given the rise in EM private external debt
levels in recent years, additional dollar strength would provide
another cyclical headwind for EM countries.
Impact of currency on asset allocation outlook
The various economic and market crosscurrents lead us to a handful
of conclusions about how currency markets and the stronger USD
may affect asset allocation considerations during 2015.
First, the impact on the US equity market may be mixed. US
consumer spending and more domestic-focused industries will
likely benefit from the reinforcement of higher purchasing power
and lower inflation, offsetting restrained export activity and
multinational corporate profits. Taken together, the stronger
USD may prolong the healthy, moderate-growth, low-inflation
mid-cycle economic phase, which historically has been
supportive of US equities. However, the potential relative
Exhibit 2: The strengthening US dollar makes imported goods relatively cheap for US consumers (left),
and has helped boost eurozone exports to the US (right)
US IMPORT PRICES
EUROZONE EXPORTS TO THE UNITED STATES
3MMA: Three-month moving average. Exports denominated in euros. Source (left): Bureau of Labor Statistics, Haver Analytics, Fidelity Investments
(AART), as of 31 January 2015. Source (right): Statistical Office of the European Communities, Haver Analytics, Bloomberg Finance LP, Fidelity
Investments (AART). Export data as of 31 December 2014; FX data as of 31 January 2015.
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benefits may accrue to more domestic-centric sectors such as
consumer discretionary and financials, which are represented
in greater proportion in small-cap equities than in large caps
(see Exhibit 3, right).
Second, the impact on non-US equities also may be mixed.
To the upside, cheaper currencies can provide a boost to
export industries and the profits of multinational companies.
On the other hand, additional currency weakening detracts
from the returns to US investors (in USD terms) and presents
financial challenges to some EM borrowers. We expect the
eurozone economy to benefit from the lagged effect of the
euro’s decline, which, in turn, should stabilise the currency.
As a result, our outlook remains constructive for European
equities. As a group, EM countries may face larger currency
depreciation that would present a greater headwind for their
equity returns. Third, the trend of continued higher volatility
in FX markets reinforces the potentially varied effects across
different countries, industries, and companies. These
divergences should create a broader range of opportunities for
active security selection, particularly among global companies.
Last, we expect continued fluctuations in FX markets to set the
tone for higher volatility in global financial markets over the
course of 2015.
The Asset Allocation Research team employs a multi-timehorizon asset allocation approach that analyses trends
among three temporal segments: tactical (short-term),
business cycle (medium-term), and secular (long-term). This
monthly report focuses primarily on the intermediate-term
fluctuations in the business cycle, and the influence those
changes could have on the outlook for various asset classes.
Business Cycle: Macro Update
Recent US data releases have been mildly disappointing, with
the stronger dollar and weaker external environment slowing
the pace of manufacturing, exports, and other globally focused
sectors. However, these trends serve to reinforce the positive
consumer outlook and the low-inflation, mid-cycle expansion.
US Economic Sectors
Employment and consumption
The labour market remains on a trend of steady improvement. The
US has added over one million jobs during the past three months,
the strongest three-month gain since 1997.5 Leading indicators
suggest an incrementally improving wage outlook, with the National
Federation of Independent Business (NFIB) survey showing the
percentage of small business owners planning to raise
compensation is at a post-recession high. Retail sales growth data
have continued to disappoint, possibly due to declining nominal
prices for many goods, but solid inflation-adjusted income gains
should support a pickup in consumption. Labour market
improvements, lower gas prices, muted inflation, and a strong
Exhibit 3: Domestic-centric US equity sectors may benefit more
from a stronger US dollar
INTERNATIONAL REVENUE EXPOSURE BY SECTOR
Source: FactSet, Fidelity Investments (AART); revenue (sales) data as of
31 December 2013. *See endnotes for large and small cap indexes used.
dollar continue to support the purchasing power and real
income outlook of the US consumer.
Inflation
Inflationary pressures remain muted as a result of global
disinflation, the drop in oil prices, and tepid domestic wage gains.
Although core inflation measures remain weak, we expect wage
gains in the service sector to cause core measures to tick back up
during 2015. Late-cycle inflationary pressures are still absent
amid global disinflation and incremental wage gains.
Corporate and credit
US corporate and credit conditions remain conducive for economic
expansion. While fourth-quarter 2014 earnings declined due to
poor results in the energy and telecom sectors, full-year earnings
for 2014 are still on track to rise 5% YOY,6 and we expect midsingle-digit profit growth in 2015. The dollar’s strength and muted
global demand may continue to present headwinds for
manufacturing activity and multinational profits, but profit margins
should remain high due to muted inflationary pressures. Solid
corporate profitability and credit access remain tailwinds for
the mid-cycle expansion.
Housing
The housing market expansion remains subdued but supported by
incremental improvements. Permitting activity for new construction
continues to grow at a mid-single-digit pace, and mortgage
applications for purchase – a leading indicator of demand – are
now rising slightly.7 The housing market continues on a slow
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but positive trend, underpinned by lower mortgage rates,
easing lending conditions, and falling unemployment.
GLOBAL
Europe
The eurozone is emerging from a mid-cycle slowdown, as
monetary and credit conditions are shifting from headwinds to
tailwinds. The European Central Bank’s (ECB’s) quantitative
easing announcement surpassed market expectations, and the
ECB’s balance sheet is poised for greater expansion after two
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years of decline (see Exhibit A, below right). Economic sentiment
has moved broadly higher in recent months, as the manufacturing
sector remains in expansion, banks continue to ease lending
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standards, and a cheaper currency and oil prices provide positive
reinforcement. Though still slow, Europe is showing clear
signs of an improving mid-cycle expansion.
China
After a multiyear property and credit boom, China is struggling to
absorb excess capacity and avert financial instability in the midst of
a cyclical downturn. Most indicators point to generally weak but
relatively stable economic activity, with the continued drop in
property prices particularly troublesome. Policymakers further
broadened their easing efforts by cutting banks’ reserve
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requirement ratios for the first time since 2012, but these
measures are only offsetting the rise in foreign capital outflows and
are not sufficient to drive a sustainable acceleration of the overall
economy. China continues on a decelerating trend with an
elevated risk of a growth recession.
Global summary
Stark divergences punctuate the global landscape, with the
strengthening US economy moving toward policy tightening, while
weakness and disinflationary trends in other major economies
have led to increased stimulus measures abroad. Leading
economic indicators for the 40 largest economies around the world
have remained stable, as just over half have improved during the
past six months, with energy exporters experiencing some of the
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greatest weakness. On a positive note, the majority of large
industrialised countries benefit from lower commodity prices and
bond yields, which should help stabilise global demand. Global
growth is positive but likely to remain slow, with improving
conditions in major developed economies, while many larger
emerging economies still face recessionary pressures.
Exhibit A: Economic expectations for the eurozone
have begun to rise alongside the ECB’s accommodative
monetary policy
ECB BALANCE SHEET VS ECONOMIC SENTIMENT
Japan
Negative real (inflation-adjusted) wages and the April 2014
consumption-tax hike caused a downturn in domestic demand that
pushed Japan into a mild recession. Although Japan’s economy
remains sluggish, tentative green shoots have emerged – some
corporate sentiment indicators have improved in the last two
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months. Japan remains in a mild recession, but may be
bottoming alongside lower oil prices and a weaker yen.
Outlook/asset allocation implications
The lagged effects of the sharply lower moves in commodity
prices, bond yields, and non-US currencies are starting to
provide some stabilisation to the global business cycle. Europe
is best poised to benefit from these trends, as favourable
cyclical conditions should overcome continued political risks in
Greece and Ukraine. China’s tepid outlook remains the biggest
impediment to a broad-based global economic reacceleration,
and the possibility of a capital-outflows-induced currency
devaluation represents the biggest risk to the global economic
outlook. Policy divergences and an eventual move to monetary
tightening in the US will likely squeeze global liquidity and
generate FX volatility that could reverberate more broadly
across asset markets.
Source: ZEW, European Central Bank, Haver Analytics, Fidelity Investments
(AART). ZEW data as of 17 February 2015; ECB data as of 31 January 2015.
As a result, we expect that a modestly improving global
backdrop will take place within an environment of higher
financial-market volatility. From an asset allocation standpoint,
the stronger dollar and relatively weak external conditions may
constrain the near-term upside in the US economy, but they
also serve to reinforce the low-inflation, mid-cycle dynamic that
continues to support economically sensitive assets such as
equities and high-yield corporate bonds. We expect the Fed is
still on track for a rate hike in 2015, but any tightening is likely
to be gradual, implying high-quality bonds remain an important
offset to equity risk even at this point in the cycle. Outside the
US, European equities stand to benefit further from the
economy’s mid-cycle acceleration.
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The mid-cycle expansion persists in Germany and the US, while China and Japan face late-cycle and recessionary pressures
TYPICAL BUSINESS CYCLE
Note: This is a hypothetical illustration of a typical business cycle. There is not always a chronological progression in this order, and there have been
cycles when the economy has skipped a phase or retraced an earlier one. Economically sensitive assets include stocks and high-yield corporate
bonds, while less economically sensitive assets include Treasury bonds and cash. *A growth recession is a significant decline in activity relative to a
country’s long-term economic potential. We have adopted the “growth cycle” definition for most developing economies such as China because they
tend to exhibit strong trend performance driven by rapid factor accumulation and increases in productivity, and the deviation from the trend tends to
matter the most for asset returns. We use the classic definition of recession, involving an outright contraction in economic activity, for developed
economies. Please see endnotes for a complete discussion. Source: Fidelity Investments (AART).
Authors
Dirk Hofschire, CFA
SVP, Asset Allocation Research
Jordan Alexiev
Senior Analyst, Asset Allocation Research
Lisa Emsbo-Mattingly
Director of Asset Allocation Research
Caitlin Dourney
Analyst, Asset Allocation Research
The Asset Allocation Research Team (AART) conducts economic, fundamental, and quantitative research to develop asset allocation
recommendations for our portfolio managers and investment teams. AART is responsible for analysing and synthesising investment perspectives
across the asset management unit to generate insights on macroeconomic and financial market trends and their implications for asset allocation.
Asset Allocation Research Analysts Austin Litvak, Jacob Weinstein, Ilan Kolet, and Joshua Lund-Wilde also contributed to this article.
Thought Leadership Vice President Kevin Lavelle and Thought Leadership Director Christie Myers provided editorial direction.
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Views expressed are as of the date indicated, based on the information
available at that time, and may change based on market and other conditions.
Unless otherwise noted, the opinions provided are those of the authors and not
necessarily those of Fidelity Investments or its affiliates. Fidelity Investments
does not assume any duty to update any of the information.
7
Source: Mortgage Bankers Association, Haver Analytics, Fidelity Investments
(AART), as of 13 February 2015.
8
European Central Bank, Haver Analytics, Fidelity Investments (AART), as of
31 January 2015.
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Generally, among asset classes, stocks are more volatile than bonds or
short-term instruments and can decline significantly in response to
adverse issuer, political, regulatory, market, or economic developments.
Although the bond market is also volatile, lower-quality debt securities
including leveraged loans generally offer higher yields compared to
investment grade securities, but also involve greater risk of default or
price changes. Foreign markets can be more volatile than US markets due
to increased risks of adverse issuer, political, market, or economic
developments, all of which are magnified in emerging markets.
Investment decisions should be based on an individual’s own goals, time
horizon, and tolerance for risk.
In general the bond market is volatile, and fixed-income securities carry interest
rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This
effect is usually more pronounced for longer-term securities.)
Fixed-income securities carry inflation, credit, and default risks for both issuers
and counterparties.
European Central Bank, Haver Analytics, Fidelity Investments (AART), as of
20 January 2015.
10
Bloomberg Finance LP, Fidelity Investments (AART), as of 24 February 2015.
11
Economy Watchers Survey, Cabinet Office of Japan, Haver Analytics, Fidelity
Investments (AART), as of 31 January 2015.
12
The 20 developed-market economies include Australia, Austria, Belgium,
Canada, Denmark, Finland, France, Germany, Ireland, Italy, Japan, the
Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, Switzerland, the
United Kingdom, and the United States. The 20 emerging-market economies
include: Brazil, Chile, China, the Czech Republic, Estonia, Greece, Hungary,
India, Indonesia, Malaysia, Mexico, Poland, Russia, Slovakia, Slovenia, South
Africa, South Korea, Taiwan, Thailand, and Turkey. Source: Organisation for
Economic Co-operation and Development (OECD), Foundation for International
Business and Economic Research (FIBER), Haver Analytics, Fidelity Investments
(AART), as of 31 December 2014.
* Exhibit 3 indexes: Large Cap – S&P 500 Index. Small Cap – Russell 200 Index.
Past performance is no guarantee of future results.
** The 10 foreign currencies mentioned in Exhibit 1 include: euro, British pound
sterling, Swiss franc, Japanese yen, Canadian dollar, Australian dollar, New
Zealand dollar, Norwegian krone, Swedish krona, Chinese renminbi.
Diversification does not ensure a profit or guarantee against loss.
Index definitions
All indices are unmanaged. You cannot invest directly in an index.
The S&P 500® Index is a market capitalization–weighted index of 500 common
stocks chosen for market size, liquidity, and industry group representation to
represent US equity performance. S&P 500 is a registered service mark of
Standard & Poor’s Financial Services LLC.
Investing involves risk, including risk of loss.
The Typical Business Cycle depicts the general pattern of economic cycles
throughout history, though each cycle is different; specific commentary on the
current stage is provided in the main body of the text. In general, the typical
business cycle demonstrates the following:
• During the typical early-cycle phase, the economy bottoms out and picks up
steam until it exits recession, then begins the recovery as activity accelerates.
Inflationary pressures are typically low, monetary policy is accommodative, and
the yield curve is steep. Economically sensitive asset classes such as stocks
tend to experience their best performance of the cycle.
• During the typical mid-cycle phase, the economy exits recovery and enters
into expansion, characterised by broader and more self-sustaining economic
momentum but a more moderate pace of growth. Inflationary pressures
typically begin to rise, monetary policy becomes tighter, and the yield curve
experiences some flattening. Economically sensitive asset classes tend to
continue benefiting from a growing economy, but their relative advantage
narrows.
• During the typical late-cycle phase, the economic expansion matures,
inflationary pressures continue to rise, and the yield curve may eventually
become flat or inverted. Eventually, the economy contracts and enters
recession, with monetary policy shifting from tightening to easing. Less
economically sensitive asset categories tend to hold up better, particularly right
before and upon entering recession.
Russell 2000® Index is a market capitalization-weighted index designed to
measure the performance of the small-cap segment of the US equity market. It
includes approximately 2,000 of the smallest securities in the Russell 3000 Index.
Sectors and industries defined by Global Industry Classification Standards (GICS®).
S&P 500 sectors included in this report are defined as follows: Consumer
Discretionary – companies that tend to be the most sensitive to economic cycles.
Energy – companies whose businesses are dominated by either of the following
activities: the construction or provision of oil rigs, drilling equipment, and other
energy-related services and equipment, including seismic data collection; or the
exploration, production, marketing, refining, and/or transportation of oil and gas
products, coal, and consumable fuels. Financials – companies involved in activities
such as banking, consumer finance, investment banking and brokerage, asset
management, insurance and investments, and real estate, including REITs.
Information Technology – companies in technology software & services and
technology hardware & equipment. Health Care – companies in two main industry
groups: health care equipment suppliers, manufacturers, and providers of health
care services; and companies involved in research, development, production, and
marketing of pharmaceuticals and biotechnology products. Consumer Staples –
companies whose businesses are less sensitive to economic cycles. Industrials –
companies whose businesses manufacture and distribute capital goods, provide
commercial services and supplies, or provide transportation services.
Important Information
Please note that there is no uniformity of time among phases, nor is there
always a chronological progression in this order. For example, business cycles
have varied between one and 10 years in the US, and there have been
examples when the economy has skipped a phase or retraced an earlier one.
Endnotes
1
Haver Analytics, Fidelity Investments (AART), as of 24 February 2015.
2
Bloomberg Finance LP, Fidelity Investments (AART), as of 24 February 2015.
3
Bloomberg Finance LP, Fidelity Investments (AART), as of 24 February 2015.
4
Standard and Poor’s, Fidelity Investments (AART), as of 19 February 2015.
5
Source: Bureau of Labor Statistics, Haver Analytics, Fidelity Investments
(AART), as of 6 February 2015.
6 Source: IBES, Fidelity Investments (AART), as of 30 January 2015.
Information presented herein is for discussion and illustrative purposes only and is
not a recommendation or an offer or solicitation to buy or sell any securities.
Index or benchmark performance presented in this document do not reflect the
deduction of advisory fees, transaction charges, and other expenses, which would
reduce performance.
Certain data and other information in this research paper were supplied by outside
sources and are believed to be reliable as of the date presented. However, Pyramis
has not verified and cannot verify the accuracy of such information. The information
contained herein is subject to change without notice. Pyramis does not provide legal
or tax advice, and you are encouraged to consult your own lawyer, accountant, or
other advisor before making any financial decision.
These materials contain statements that are “forward-looking statements,” which
are based upon certain assumptions of future events. Actual events are difficult to
predict and may differ from those assumed. There can be no assurance that
forward-looking statements will materialise or that actual returns or results will not
be materially different than those presented.
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Important Information
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