Currency (Re) Allocations for Pension Investors

How not to get caught out

Originally published in the April 2009 issue

In November 2006 we published an article in Pensions Management magazine arguing the merits of currency diversification for UK investors within their pension. At the time, the article caused quite a stir, as many readers questioned the soundness of the strategy. We argued that most UK investors failed to recognise that GBP and the UK property market were highly correlated. If at the time you believed that the UK property market (both residential and commercial) was over-valued (like we did) and if you believed that the correlation between sterling and UK property would remain intact, then by default you would need to take the view that partial currency diversification out of GBP made sense if your investment objective was to protect your global purchasing power. Those UK investors that did reduce GBP exposure were subsequently rewarded significantly.

At the beginning of 2008 we advised our clients to overweight USD, EUR and SGD and underweight GBP due to our negative views on risk-taking, leverage and property prices. All three currencies performed well relative to GBP. However, we now believe that the currency markets are at the inflection point and that going forward the picture will change dramatically.

Most rational market participants acknowledge that the market is pricing in deflation. Although we agree that in the short term deflationary pressure will persist, we still think it is a “blip on the screen” as we are fundamentally inflationists. In our view money supply expansion will help to stoke the future flames of inflation (with some degree of lag). Inflation will benefit certain currencies and harm the value of others. If you believe in the global economic recovery, in growth and inflation, then you need to be relatively bullish on the commodity story in the medium term.

In an inflationary environment, hard assets and commodity currencies should perform well (in theory so should TIPS but we are avoiding them as we have little confidence in the way inflation is currently calculated). This is the basis for our negative view on the US treasury market. On 12 January 2009 we published a report documenting our bearish view on US Government debt and as a result many of our clients have been short long-dated US Treasuries even in the face of global central bank buy-backs.

The crux of the argument is that we are becoming increasingly negative on safe haven assets, as we do not believe in the Depression story. We expect to see money flow away from safe havens (assisted by the fact that deposit accounts are paying so little) and for investors to start putting risk back on books (attracted by cheap asset prices) with the goal of capital growth. We also believe that if US Treasuries continue to weaken (as they have since the beginning of the year) we may witness money flowing away from USD into other assets and currencies (obviously the big wild card is the Chinese position).

In the same vein we are also negative on the Japanese Yen, so much so that we believe very aggressive investors might consider denominating some of their liabilities in the Japanese currency and hopefully watch their liabilities shrink in the future.

So now what? We are currently recommending to our suitable UK investors that they reduce exposure to USD and EUR and increase exposure to GBP and AUD. We are doing this by switching (at month end dealing) our clients between share classes of their existing single manager hedge funds and FoHF holdings. In other words, we are recommending to our investing clients that they continue to hold units in the exact same alternative investment managers that we have recommended in the past, but to switch between the different currency share classes with the goal of hopefully benefiting from an appreciating currency relative to the legacy currency denomination.

In terms of our bullish views on AUD and GBP, the Australian Dollar (AUD) and global stock markets have both depreciated in value during the credit crisis due to their ‘pro-growth’ bias. Initiating a long position in a commodity currency such as AUD is like expressing the view that the world will recover and demand for natural resources will return, which we think is a good bet. We now think that investors’ risk aversion is diminishing and market participants are actually willing to incorporate more risk in their portfolios. Furthermore, the current low interest rates in many of the “safe haven” currencies like USD and JPY are forcing investors to look elsewhere for yield. Therefore, we foresee a redirection of investment flows towards “commodity currencies” (= AUD) and currencies that were overly punished due to their perception of being “over-leveraged” and property linked (= GBP).

With the Australian economy being primarily driven by commodity exports, the value of AUD is highly correlated with movements in commodity prices. Prices of commodities began to tank during the summer of 2008. Global economic concerns led to a sharp depreciation of AUD against USD and JPY (see figures 1 and 2) as the carry-trade unwound. As depression fears start to recede and coordinated global government spending begins to kick-in, inflation should begin to up-tick and hard assets such as commodities (and real estate) should begin to benefit which should translate into bullish momentum for AUD.

The story is similar in the UK which has also suffered similarly from the credit crisis. The property market, the FTSE100 and the British Pound have all been punished due to their perceived highly-geared status. Whilst there are many valid reasons to be bearish on GBP such as UK interest rates trending downwards, a surge in gilt issuance, and capital adequacy concerns over the British banking sector, a valid questions is, whether it has all been priced in? We think the answer is yes.

The UK economy is flexible and elastic, much more so than an economy such as France (just compare employment laws between the two countries). We believe that this characteristic will help the UK bounce back faster. Historically, the GDP growth cycle in the UK has preceded the GDP growth cycle in the Eurozone (see figure 3).

Projections for the following years and the comparably swift response to financial crisis pressures, lead us to expect to see a sharp UK economy recovery resulting in appreciation of GBP well before the upturn in the Eurozone. We think that GBP may have already started its upward movement as it has been stable against USD and EUR and has appreciated against JPY recently (see figure 4).

Driven by the points detailed above, we have sufficient grounds to believe that the upturn in the so called “risky and pro-growth economies” of UK and Australia may have started. Consequently, we have already advised our investors to ‘currency switch’ their fund holdings out of USD and EUR and into AUD and GBP, locking-in their currency profits from 2008 in sterling terms. THFJ

Gregory Perdon is Head of Alternative Investments at ARjENT Limited in London