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Currency fluctuations had a significant impact on investor returns in 2017. After several years of strong gains, the US dollar was the big loser last year. What lies in store for currencies in 2018?
This article is from our latest edition of MarketWatch, an in-depth report focusing on the Global Economic Outlook for 2018
In recent years portfolio performance has been heavily influenced by currency fluctuations. Since 2014 when the dollar appreciated significantly, investors on this side of the Atlantic benefited when they converted US assets back into their domestic currency. Last year this reversed as the dollar weakened against most major currencies.
Over the course of the year the euro and sterling clawed back as much as 14% and 10% respectively. Although this seems like a large move in a short space of time, through a wider lens it is only a modest reversal - in 2014 the euro was worth as much as 1.40 against the dollar, and one pound bought 1.70 dollars.
As we start a new year, the big question is whether the euro will continue to gain against the dollar? The good news is that the strength of the euro is based on better than expected European economic data and that looks set to continue in 2018. Unemployment is falling, consumer and business confidence is rising, and the European economy looks the most robust it has been since before the Euro debt crisis in 2011.
The US Federal Reserve is expected to continue raising interest rates in 2018 but this appears to be reflected in the current price of the dollar. We think the euro could pause for breath in the short term as the US implements tax cuts and the market begins to factor in the possibility of an Italian election. But we should bear in mind that the euro still looks undervalued against the dollar and in time we would expect it to move higher. The Organisation for Economic Co-operation and Development (OECD) measures fair value based on purchasing power parity (PPP) as being closer to $1.33 (see Figure 1).
The near-term outlook for sterling is extremely difficult to predict. As the clock ticks towards the March 2019 Brexit deadline, we expect significant sterling volatility. The direction is entirely dependent on the outcome of the Brexit process, which is binary. In a good scenario we expect to see sterling gain against the euro and the dollar whereas if there is a bad Brexit, it is possible that sterling would move towards parity with the euro.
The recent weakness in the dollar might tempt investors to dump their dollar assets. This would be a rash move in our opinion. We only have to recall the concerns about the future of the euro during the debt crisis or the impact that Brexit had on sterling to be reminded why currency diversification is important in a portfolio The question is not whether one should hold any dollar assets; it’s how much should be held? In our portfolio construction process we guide investors to hold no more than 20-25% of non-domestic currency assets.