OGM quarterly letter 2Q 2022:


The US dollar has slumped in recent months, taking it to its highest valuation against other major developed currencies in more than 35 years. While higher U.S. interest rates make shorting the U.S. dollar in currency futures markets a potentially tricky proposition, this interest rate differential is not a problem for holders. of shares. An overvalued currency has a negative influence on the performance of stocks in that country. In contrast, a cheap currency is a tailwind for equities in the developed world, leaving developed markets like the Eurozone and Japan poised to benefit from their undervalued currencies. To date, the effects of the expensive dollar have not been so noticeable in the United States, but the impact has quickly been felt in other countries. The strong dollar and high commodity prices have thrown some less developed countries into distress. While a cheap currency seems like an unmixed good in the developed world, things are a bit more nuanced in the emerging world where the benefits of an undervalued currency can be undermined by poor policy choices. Yet currency valuations in the emerging world today are attractive enough that even allowing for some bad decisions, they should still be a source of equity market support over the next few years. The current mix of cheaper equities and cheaper currencies outside of the US appears to be a promising backdrop for a reversal from the dominance of US equities of the past decade.

One of the most famous phrases ever uttered by a US Treasury Secretary was John Connally’s quote at the November 1971 G-10 meeting that “The dollar is our currency, but your problem.” It’s a wonderful line, and the sentiment certainly resonated with European governments who were seriously annoyed that the Nixon administration had just ended the convertibility of the US dollar (USD) into gold, thereby unilaterally introducing the world in the era of purely fiat currencies. But despite his quip’s enduring fame, what Connally said was wrong, or at least his implied message was wrong. In November 1971, the USD was definitely a problem for the United States, as a half-decade of rising inflation and a fixed gold conversion rate had left the dollar massively overvalued against its peers. It was a simpler world then, however, and the act of abandoning the gold standard triggered a major devaluation of the dollar, relieving pressure on the US economy. Today, the USD again looks surprisingly overvalued in many ways, and the impact is reverberating around the world. The questions equity investors need to ask themselves today are whose problem is the overvalued dollar and how, if at all, should they adjust their equity portfolios in light of the monetary environment. current ?

Measure currency valuation

Most versions of currency valuation models are riffs on “The Law of One Price”, which says that goods and services should cost the same regardless of the currency in which they are valued. As the famous model from The Economist suggests, a Big Mac in Tokyo should cost the same as one in New York or New Delhi. 1 As a quick glance at the Big Mac Index would show, this “law” fails virtually everywhere at some point, and it does so particularly strikingly for countries with significantly different levels of development. But despite this problem, currency valuation models are reasonably predictive and – given the lack of many better alternatives – widely used in finance. According to the real effective exchange rate model of the Bank for International Settlements, 2 the dollar looks more expensive than in all but two events over the past 51 years – the 1971 levels that marked the end of the Bretton Woods agreement and the mid-1980s dollar bubble that led to the agreement of the Plaza. 3 We can clearly see the three periods in Exhibit 1.

It’s not entirely clear why the USD has gotten so strong lately, but there are a few different factors that can be cited. The USD tends to be a safe-haven currency – it goes up in tough times for risky assets and down in boom times. This may help explain the latest surge, but not quite the move from 2012 to 2020 that took us from some of the lowest levels in history to quite highs. Another recent pilot appears to be a carrier. The Federal Reserve has been more aggressive in raising rates than other developed central banks and currency speculators like to bet on carry, as my colleagues from GMO’s Systematic Global Macro team discuss – and warn against – in their recent article “Let’s not get carried away”. ”

The previous two peaks in the USD resulted in active policy action by the US and other governments to pull it back. Today’s levels are not that high. It would take another 5% more to get us to where the dollar peaked in 1985, and we don’t hear of a repeat of the Plaza Accord. Certainly, the impact of the strength of the dollar is no longer as significant as it was then. Europe is not invaded by American tourists who buy everything they see, 4 and although a number of American companies have complained with regret about the impact of the rising dollar on their profits, they are not shouting like Caterpillar and Boeing did at the time. Maybe that means currency valuation doesn’t matter as much as it did in the 1980s. Or maybe the impact of a strong dollar these days is less about the impact than he has about the United States and more about what he’s doing in other parts of the world. Since the answers to these questions may well be different in developed and emerging countries, I will examine them separately.

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