In this part II, I will provide an overview of the potential for generating a positive real return with investment in currencies (including crypto-currencies) and general asset classes such as bonds and equity.
Strength of the greenback
Even though the longevity of the US dollar as the global reserve currency is being questioned by many economists, for now it has become clear once again that the currency is still the go-to currency in times of financial distress. During this year, relative to most of the major currencies, the US dollar has been appreciating sharply. For example, relative to the Euro, the US Dollar appreciated, at the time of this writing, by almost 11 percent this year. This means that those Euro-based investors who held USD-denominated assets in their portfolio, were shielded to a large extent from inflation in the Euro-zone just from changes in the exchange rate.
The appreciation has been driven in part by the sharply rising interest rates in the United States, due to a tightening of monetary policy by the Federal Reserve, thus making it more attractive to hold USD-denominated debt. Also, the economic prospects of the energy self-sufficient United States are by many considered to be more positive than for example for energy importing economies such as those of the European Union and Japan. There are some smaller countries’ currencies, such as the Swiss Franc, that have held up better against the USD this year. For certain, Switzerland is not fully energy-independent, however, inflation has been low relative to the countries in the European Union and Switzerland also has a reputation as a safe haven country with a well-functioning and autonomous central bank, which recently indicated that it would allow the Swish Franc to appreciate rather than to intervene.
Nevertheless, a strong currency can provide headwinds to an economy’s exporting sector and a strong USD can wreak havoc in developing economies. Therefore, even though the timing can be different, typically the major central banks move in tandem to provide some stability to the value of its currency relative to others. The European Central Bank recently also sharply raised interest rates and in response the Euro clawed back some its losses relative to the USD. To what extent this will continue will depend on many factors, one of which is related to how the economies respond to higher interest rates. If economic activity in the Eurozone declines and/ or yields increase too rapidly in some member states, the ECB may be forced to suspend its rate rises, which in turn may lead to a further weakening of the Euro. Rising yields are not only caused by monetary tightening, also fiscal policies and the extent to which governments are borrowing in the capital markets are an important factor.
Shattered dream of the crypto-enthusiasts
If the dream was that cryptocurrencies can become a stable store of value in times of the declining real value of the major fiat currencies, then so far this year has proven that that dream did not come true. Correlation between the major cryptocurrencies and stock markets has strengthened this year, meaning that similar to stock markets, they are down as well. Bitcoin lost almost 52 percent so far this year in USD-terms and Ethereum lost almost 54 percent. Both have regained some value recently, especially Ethereum ahead of the merge, in which the blockchain of the cryptocurrency will move from “proof-of-work” to “proof-of-stake”. This would reduce its energy use, and hence reduce its environmental impact, amongst a number of other supposed benefits. Overall, the value in cryptocurrencies has been too volatile to really allow it to be anything but a speculative asset class.
Nevertheless, a lot will continue to happen in the digital currency space over the next years. The central bank of China has developed a digital yuan, the use of which it intends to stimulate in order to become a rival currency to the USD in global trade. In response, the ECB and Federal Reserve are also conducting studies into launching a digital version of the Euro and USD, respectively. How and if these central bank-run digital currencies will impact the existing cryptocurrencies and their values is difficult to predict at this time.
Bonds and Equities
Also the bonds and equities markets have shown positive correlation this year, which is actually not been positive for investors long both asset classes. Some argue that inflation is the main driver behind both asset classes losing value simultaneously. Inflation pushes up yields as investors need to be compensated for inflation in order to generate a real return on lending money, thereby lowering bond prices. Central bank response to inflation has similarly been one of tightening the money supply, which cools down the economy and may affect company’s bottom lines, thereby lowering equity prices. It is significant, as modern portfolio theory holds that the risk of a portfolio can be reduced by holding a combination of bonds and equities. Therefore, it may have occurred that defensive multi-asset portfolios have actually underperformed equity-only portfolios.
Nevertheless, within each asset class, one can find rays of light. In part I, the increase of value of energy-related equity has been discussed. Companies that are capable of increasing prices equal to inflation, while maintaining margins, have done better. In general, value-oriented stocks have fared better than growth-oriented stocks. If there will be, as some economists forecast, a recession in the major economies, then there are companies that tend to do well in recessionary times.
If anything, the value of an experienced fund manager has only become more apparent. Multi-asset funds that have the mandate to change the weights of asset classes within the overall portfolio, may do very well relative to their peers if the fund managers are able to read the markets correctly. Similarly, equity-only portfolio managers may do very well if they are capable of investing in the companies that do well in these dynamic market circumstances. At Blacktower, we can help you selecting the fund managers that can navigate the current challenging environment in order to provide a real return on your investment portfolio. Please do not hesitate to reach out to us in the Lisbon office.
Add disclaimer: This communication is for informational purposes only and is not intended to constitute, and should not be construed as, investment advice, investment recommendations or investment research. You should seek advice form a professional adviser before embarking on any financial planning activity.