16 Nov 2022
We have witnessed some extraordinary things in financial markets in recent months, not least in the UK, where a combination of inflationary pressures, central bank comments and government policy have resulted in sharp sell-offs in seemingly the full suite of UK financial asset classes, from stocks, to bonds, to sterling itself.
While we make no claims about our short-term forecasting abilities, the combination of an oversold asset class priced in an oversold currency can present an attractive opportunity to investors, as a recent research note from GMO highlighted. The authors take the famous sentence uttered in 1971 by then-US Treasury Secretary John Connally to the rest of the G10 that “the dollar is our currency, but your problem”, and flip it to point out that, for US-based investors with a global remit, the US dollar is their currency, their problem.
GMO’s rationale is simple, but well-researched, using equity market, currency and corporate earnings data stretching back over 50 years, covering both developed and emerging markets. It can be summarised as a double-whammy of a cheap stock market plus undervalued currency providing a ‘heads you win, tails you win in a different way’ set of potential outcomes.
As GMO puts it, equity investors in countries with overvalued currencies have two ways to lose, while those with undervalued currencies have two ways to win, since an oversold currency that moves back to fair value will generate a corresponding equity move in an investor’s base currency, while if the currency does not move back toward fair value, earnings growth should be well above average to the extent that the relevant companies generate business overseas.
GMO methodically shows that, with near monotonic relationships, the cheaper a currency is to start with (based on real effective exchange rates), the stronger that currency performs over the subsequent three years, and vice versa, with the same relationship applying (in an investor’s base currency) to the relevant local equity markets, and to the constituent companies’ earnings growth, too. In other words, the starting point of a cheap currency is a strong leading indicator of positive future currency returns, equity market returns and earnings growth, with the opposite being true of overvalued currencies (which lead to poor currency returns, poor equity market returns and lower earnings growth), a relationship which applies to both developed and emerging markets (although it is stronger in the former).
When combined with an assessment of regional equity market valuations, this can provide the double-whammy mentioned above, whereby investors can benefit from an appreciation of both the relevant currency and the region’s equity market valuation (when measured by the cyclically adjusted price-earnings ratio), with Europe and Japan screening particularly cheaply on this combined measure today, while the US appears expensive on both counts.
Another market that screens cheaply is (yes, you’ve guessed it) the UK, with the recent sell-off in both UK capital markets and currency offering the double-whammy and asymmetrical risk/reward scenario that GMO has shown has paid off handsomely for investors in the past. Strategists at Liberum recently commented that the “feedback we get from investors is that they consider the UK uninvestible as long as there is such government chaos”, which we believe is just the kind of extreme aversion that provides attractive opportunities for patient investors with a sufficiently long time horizon. While the short-term volatility can certainly set our pulses racing, we are reminded of a comment from another UK broker that “uninvestible spells ‘BUY’ ”.