Keep an eye on foreign markets

Apr 23 2008 by Iain Laing, The Journal

SO far, 2008 has been a difficult year for most markets – equities have been battered by fears related to the economic slowdown in the US, while the ongoing credit crunch has resulted in dislocation in debt markets.

Meanwhile, commodity prices have been strong but volatile, with US crude oil prices surging above $117 a barrel. In recent weeks, however, one market has been conspicuous by its relative absence from the headlines: foreign exchange.

As many sterling investors only ever invest in traditional asset classes such as UK equities or UK bonds, or some blend of the two, it’s easy to forget about foreign exchange (FX). This is surprising, as the FX markets are some of the largest and most liquid in the world. Moreover, from a UK consumer’s perspective, changes in FX rates can affect the price of a huge number of items – everything from the price of foreign holidays to the rate of return earned on non-sterling investments. For example, investment returns that may look spectacular when expressed in local currency terms may look much less impressive when translated into sterling.

For this reason, products which allow investors to more actively manage their foreign exchange exposure have surged in popularity over the past decade. Other products which are specifically designed to enable investors to profit from movements in FX markets have also become more widely available. Indeed, given the lower nominal gains from traditional asset classes like equities and bonds in recent years, it’s not surprising that investors have looked to other markets to try to boost their overall levels of total return.

Looking at specific trends within FX markets, it’s clear that sterling has fallen against many currencies this year. But is it set to fall further? The question is of some interest, even if you don’t have to buy your holiday money just yet.

There are various ways of estimating what a fair value for sterling is. On some of them, sterling already looks too cheap. But there are good reasons to think that it could fall further. Many economists prefer to consider what they call a fundamental equilibrium exchange rate, or FEER. (The FEER is the rate that should bring an economy’s external position – external revenues versus external payments – into balance.) This FEER calculation suggests that sterling is still overvalued.

What of other currencies? We believe that the US dollar will appreciate over time, if not in the very short term. That said, we do not expect big movements in the dollar against the euro, although the dollar should lose ground against the single currency later this year and through 2009.

The non-dollar dollars – Australian, Canadian and New Zealand currencies – also look set to weaken.

So, whether you are looking to augment your portfolio returns or just trying to understand why that foreign holiday now looks more expensive than it did last year, it is well worth keeping an eye on the FX markets.

From a UK consumer’s perspective, changes in foreign exchange rates can affect the price of a huge number of items