What can currency markets tell us about stock market performance?
On 21 May 2019, CFA Society Switzerland welcomed David Ranson of HCWE & Co. back to the Confederation to hold a lunchtime presentation at Hôtel Alpha-Palmiers in Lausanne. Mr. Ranson is an independent market research analyst and spoke on the topic of the connections between relative currency valuations and subsequent equity market performance. The title of his talk was “International Country Bets Based on Currency Instability”.
Choosing where to invest
Relative currency valuations are leading indicators of stock market performance. By analyzing them carefully, we can make educated bets on which equity market to choose for an upcoming investment cycle.
This idea comes from a detailed analysis presented by Mr. Ranson. Looking at the currency and stock markets for both developed and emerging economies, he discovered a pattern that held over many economic cycles: as currencies lose value (with respect to some reference like the CHF or gold) the local stock market, priced in the reference currency, gains value. After all, if the assets of a firm have real value (property, plants, equipment, trademarks) then they should maintain that value despite losses to the value of their reporting currency.
Although the idea makes good sense, Mr. Ranson stated that it goes against standard economic theory. He pointed out that because currency markets move very fast they make good leading indicators. Changes in both inflation and interest rates move slower, as these take time to catch up with currency repricings.
An “expected currency surprise”
According to Mr. Ranson, equity markets price in expected currency behavior. That is, if a currency has been appreciating for some time against some benchmark, that information is already contained in stock market valuations.
However, an unexpected move in a currency – a surprise – causes stock markets to react: if a currency for example appreciates unexpectedly in value, the local equity market reacts by moving in the opposite direction. To take an example, we can think here of the Swiss flash boom-slash-crash of January 2015. The Swiss National Bank (SNB) had for several years been printing nearly unlimited quantities of Swiss francs to try to depress the valuation of the currency and keep exporters competitive. With newly created Swissies the bank bought mainly Euro assets onto their growing balance sheet and thereby kept the local currency at a level of around 1.20 per Euro.
On 15 January of that year, however, the SNB unexpectedly dropped this peg, and the ever-in-global-demand Swissie instantaneously shot up in value by 40%, taking it well past parity with the Frankfurt-based currency. (It settled back down to around a 20% gain by the end of the trading day, still a huge one-day move in any currency.) The SMI (main Swiss market index) reacted by dropping 12% in a single trading session. As the SNB subsequently backpedaled on their rash announcement, the Swiss franc dropped back in value and the equity market made back its losses over the next months. (Please refer to the graph below. In grey is the sudden appreciation of the CHF versus the Euro, accompanied by a sudden drop in the SMI.)So, to predict equity performance it is these types of currency surprises that we seek. But how is it then that we can “expect” a currency surprise? Well, we can’t really. But by looking at the relative valuations of all major currencies together, we can see where likely currency surprises might manifest. And deploy our capital accordingly.
A rolling investment strategy
So, the strategy here is to ask the question: which markets have the greatest scope for a positive currency surprise? Since currency valuations tend to mean-revert over time, we could look to currencies that have lost the most value over a given previous period (say the trailing year) and choose to buy equities in the markets of those countries.
Even better, we could implement this strategy on a rolling basis. For example, we divide our equity allocation into 12 pieces. At the end of each calendar month, we look at which currency has lost the most relative value over the trailing year, and allocate to the corresponding equity market.
However, note that this idea contains within it an embedded assumption: that an investor wants to be in any equity investment at all on a given period. In some periods, most or all of the major world equity markets contract and investors in any of them end up with less capital than they began with. In these cases, this model will merely help an investor to choose the least-lossy equity parking places for his cash. The model should therefore be deployed as part of a broader asset-allocation strategy.
Outlook for 2019
The four weakest currency performers in this model in 2018 were Australia, Canada, Sweden, and the UK. On that basis, the model expects these countries’ equity markets to outperform their counterparts in the US, the Eurozone, Switzerland, Japan, and China in 2019.
There are around another 50 countries that could be added to this model, to add to the richness of choice for allocations.