Why UK Investors Should Care About the Euro

Currency Risk: Understanding What You Own

Currency values can move quickly, especially relative to more conservative investments like bonds, so currency risk is of higher importance for more cautious portfolios. This was particularly evident in the 2001 to 2007 period, although is a healthy reminder today. 

To uncover how we value a currency, let’s start with a thought experiment. Take the green line below, which shows the history of the euro relative to the US dollar since 1999. Can you determine what the “fair value” today should be? Is the euro currently cheap or expensive? And, can you pick the points in history where the currencies were at an extreme?

Most people can pick the extremes reasonably well in hindsight but have a lot more difficulty understanding where we are at today. This is largely due to a framing effect and issues dealing with perspective. Furthermore, they have a lot of trouble attaching a confidence level or probability to their assessment.

At Morningstar Investment Management, we use what we think is a common-sense approach to determine the fair value of a currency, which is centered around the principle of purchasing-power parity. As a model, this works on the basis that the same amount of money should buy the same comparable goods regardless of the country in question. A common example is The Economist’s Big Mac Index, where we can compare the price of a McDonald’s burger in various countries and can understand the impact of currency and inflation over time.

Of course, we need to widen the analysis beyond hamburgers, so we use three ways to measure prices of goods and services and how they change over time: the consumer price index (CPI), the producer price index (PPI), and purchasing-power parity (PPP). We also try to apply longer-term thinking, which is achieved by looking back beyond the advent of the euro.

We can create much-needed perspective in this regard by using the European Currency Unit, a unit of account in the European Union prior to the introduction of the euro, as an excellent proxy to pre-date the euro. This gives us a history back to 1982, instead of 1999, incorporating differing environments for us to analyse.

Looking beyond fundamentals, we look to ground our analysis by factoring in some of the intricacies of the euro, including any potential hedging costs, with the primary objective to understand any key risks to our thesis.

Structural Imbalances & Political Issues

Many euro critics cite that it is impossible to maintain economic unity using a single monetary policy among a collection of states that set their own fiscal policies.

Politically, growing nationalist election results in some euro member states suggest less willingness to integrate further. However, recent surveys also show that as much as 74% of the people in the euro area believe in the union. Importantly, this approval rating in the euro area is higher than at any point since 2004, although Italy is a known outlier.

We take some comfort from such survey results, although acknowledge that adverse economic and political developments can change this picture quickly, especially at an individual country level. For instance, the Eurozone crisis showed that it doesn’t take large member states to create structural economic issues that can undermine the integrity of the union.

Whilst hard to quantify, is it clear that no clear political consensus exists for creating a fiscal union today – it would require a unanimous decision of all members, making this unlikely for the foreseeable future. However, as a whole, we take some comfort from the fact that the European Union–and Eurozone for that matter–have had well-balanced external accounts. Instead, the troubles tend to originate among individual member countries, which have presented significantly divergent economic and fiscal characteristics.

The Extreme Central Bank Stance

The European Central Bank has kept interest rates at record lows, which affects borrowing costs for a currency investment strategy called the carry trade, which in turn impacts the correlation and performance profile of the euro during periods of market stress.

Carry traders borrow in a low-yielding currency, like the euro, and invest in higher-rate assets in another currency, reaping the difference between the two rates. This is a very straightforward way to make money until the currencies move against the trader’s position.

Underlying this, research suggests that in times of market turbulence, carry traders often have to liquidate their positions procyclically – that is, they add to the selling pressure on a downward currency and to the buying pressure on an upward currency. The impact of such developments must not be disregarded and remains a risk today.

On Balance, Where Do We Stand?

Our analysis shows that the euro currency is likely to be slightly below fair value relative to the US dollar and around fair value relative to sterling. So, without any extreme signals at present, it supports a balanced stance with careful application to reflect the risks stated above.

The extended challenge is to understand how best to reflect this view at an individual holding level. For instance, holding European assets for the sake of the currency might not be a smart approach, especially given the low yields on offer among government debt markets. Therefore, our positioning is likely to balance an aversion to currency risk with an opportunistic view of the investment universe.

The last point relates to humility. Currency markets rarely follow a guided path, so we must appreciate the scope for error and our willingness to be patient. In reality, currency moves can happen in a matter of days, while at other times, a move towards fair value can take decades. We never know with certainty when these shifts may occur, so positioning and sizing must reflect this difficulty.