In this Part II, I will outline the potential for generating a positive real return with investment in currencies (including cryptocurrencies) and general asset classes such as bonds and stocks.
Even though the longevity of the US dollar as the world’s reserve currency is questioned by many economists, for now it has become clear again that the currency is still the go-to currency in times of financial distress. During this year, against most major currencies, the US dollar has appreciated strongly. For example, against the euro, the US dollar has appreciated, at the time of this writing, by almost 11% this year. This means that Euro-based investors who held US dollar-denominated assets in their portfolio were largely insulated from inflation in the Eurozone solely because of changes in the exchange rate.
The appreciation was fueled in part by the sharp rise in 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. Furthermore, the economic outlook for the energy self-sufficient United States is seen by many as more positive than, for example, for energy-importing economies such as those of the European Union and Japan. Some currencies from smaller countries, such as the Swiss franc, have held up better against the USD this year. Certainly, Switzerland is not completely energy independent, but inflation has been low compared to countries in the European Union, and Switzerland also has a reputation as a safe haven country with autonomous and well-functioning central bank, which recently indicated that this would allow the Swiss franc to appreciate rather than intervene.
Nevertheless, a strong currency can provide headwinds to an economy’s export sector and a strong dollar can wreak havoc in developing economies. Therefore, although the timing may be different, the major central banks usually act in tandem to provide some stability to the value of its currency relative to others. The European Central Bank has also raised interest rates sharply recently, and in response the Euro has recouped some of its losses against the USD. How well this continues will depend on many factors, one of which has to do with how economies react to higher interest rates. If economic activity in the Eurozone declines and/or if yields rise too quickly in some member states, the ECB could be forced to suspend its rate hikes, which could lead to a further weakening of the Euro. The rise in yields is not only caused by monetary tightening, fiscal policies and the extent to which governments borrow in capital markets are also an important factor.
Shattered dream of crypto-enthusiasts
If the dream was that cryptocurrencies could become a stable store of value in times of decline in the real value of major fiat currencies, then so far this year has proven that dream has not come true. The correlation between major cryptocurrencies and stock markets has strengthened this year, which means that, like stock markets, they are also falling. Bitcoin has lost almost 52% so far this year in US dollars and Ethereum has lost almost 54%. Both have regained some value recently, especially Ethereum before the merger, in which the cryptocurrency blockchain will change from “proof of work” to “proof of stake”. This would reduce its energy consumption, and therefore its impact on the environment, among a number of other supposed benefits. Overall, the value of cryptocurrencies has been too volatile to really allow it to be anything more than a speculative asset class.
Nonetheless, a lot will continue to happen in the digital currency space over the next few years. The central bank of China has developed a digital yuan whose use it intends to stimulate in order to become a competing currency of the USD in world trade. In response, the ECB and the Federal Reserve are also conducting studies on the launch of a digital version of the euro and the USD, respectively. How and if these central bank-run digital currencies will impact existing cryptocurrencies and their values is difficult to predict at this time.
Bonds and Stocks
Additionally, the bond and equity markets have shown a positive correlation this year, which is actually not positive for long-term investors of either asset class. Some argue that inflation is the main driver of the simultaneous loss of value of both asset classes. Inflation drives up yields because investors must be compensated for inflation in order to generate a real return on lending money, which drives down bond prices. The central bank’s response to inflation has also been to tighten the money supply, which cools the economy and can affect corporate bottom lines, thereby lowering stock prices. This is important because modern portfolio theory holds that portfolio risk can be reduced by holding a combination of bonds and stocks. Therefore, defensive multi-asset portfolios may actually have underperformed stock-only portfolios.
Nevertheless, within each asset class, one can find rays of light. In Part I, the increase in the value of energy-related stocks was discussed. Companies able to raise prices in line with inflation, while maintaining their margins, have done better. In general, value-oriented stocks performed better than growth-oriented stocks. If there will be, as some economists predict, a recession in major economies, then there are companies that tend to do well in recessions.
On the contrary, the value of an experienced fund manager is all the more evident. Multi-asset funds that have a mandate to shift asset class weightings within the overall portfolio can perform very well relative to their peers if fund managers are able to read the markets correctly. Similarly, portfolio managers who only use equities can do very well if they are able to invest in the companies that do well in these dynamic market conditions. At Blacktower, we can help you select fund managers who can navigate today’s challenging environment to deliver real return on your investment portfolio. Do not hesitate to contact us at 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 from a professional advisor before embarking on any financial planning activity.