Currency Quarterly Q4 2023 | Insight Investment

Summary

After another resilient performance in 2023, the global economy faces a series of challenges in 2024. Growth is likely to slow, with greater divergence between economies, and political risks appear more elevated than ever, with half of the world’s population voting in some form of election. Fiscal sustainability has become a key question for many economies, and there is little chance of an election-related fiscal tailwind for growth, but more positively, there are some signs that the manufacturing cycle may be bottoming.

For currency markets this creates a complex backdrop – but fading US exceptionalism and the prospect of Fed cuts could help to limit support for the US dollar (USD), in which case the currency’s clear overvaluation may, at last, start to unwind. Later in 2024, the US election could introduce a period of greater uncertainty, especially if seen as the precursor to a new era of trade protectionism under a second Trump Presidency.

In our educational topic this quarter, we examine why certain currencies exhibit cyclicality – becoming highly correlated with risk assets during periods of market volatility – and how this can have a significant impact on traditional hedging programmes.

The Alpha view

In our view, a combination of alternative risk premia and macro fundamentals is the key driver of currencies over short-to-medium-term time horizons. Our sense is that 2024 will be a negative year for the USD, but that it will take time for this theme to emerge. As such, our sense is that the USD is likely to appreciate somewhat in the next few weeks as the market re-prices to expect fewer rate cuts by the Fed. Our supportive short term USD view stems from our Alt Risk Premia model and is supported by both the Carry and Quality factors which are only partially offset by the moderately negative Momentum, Value, and Macro factors. We are also moderately constructive on the euro (EUR), British pound (GBP) and to a lesser extent the New Zealand dollar (NZD). Against that, we are negative on low-yielding currencies such as the Swiss franc (CHF) and the Japanese yen (JPY).

Figure 1: Insight Currency Absolute Return Exposure

Source: Insight. Data as at 4 January 2024. Note: Black dot shows aggregate position.

Longer-term valuation overview

As the investment horizon extends to a multi-year window, valuations are likely to dominate the price action in currency markets. We outline the highlights from our long-term valuation model below in Figure 2:

• The USD remains overvalued, but not against all crosses;
• JPY and Swedish krona (SEK) look very cheap by historical standards;
• The EUR, GBP, AUD and Norwegian krone (NOK) look moderately cheap;
• The Canadian dollar (CAD) and NZD are close to fair value;
• CHF looks moderately expensive.

Figure 2: Local currency overvaluation (+) and undervaluation (-) versus USD

Source: Insight. Data as at 4 January 2024.