Macro Monthly The power of currency

• Amid the rebound in equity valuations and a still very uncertain path for trade negotiations, we move our outlook for equities to neutral from overweight.
• Active currency management may provide hedging properties for portfolios against particular risks, like trade policy.
• We like short AUDUSD and short USDJPY over the medium term for economic and valuation reasons, but also see these trades as useful hedges against US-China trade escalation.

We write this Macro Monthly just before the June G20 meeting, when Presidents Trump and Xi are scheduled to meet and discuss the prospects for renewing trade talks. While our base case is that the two leaders ultimately strike a deal at some point over the coming twelve months, there is plenty of uncertainty on (1) whether we will get that final outcome and (2) the path to get there. Given ongoing cooling in economic data and high levels of uncertainty on potential trade outcomes, we have downgraded our outlook for equities to neutral from overweight. Indeed, economic and market pressures may need to rise on both countries before their respective leaders are prepared to make a deal which sticks. At the same time, both presidents could move towards active de-escalation, removing prior tariffs and catalyzing a further re-rating of risk assets. The unpredictability of the (geo)-political process is what makes a neutral, rather than aggressively overweight or underweight position sensible at this juncture.

Sovereign fixed income, such as US Treasuries, will likely provide some protection from adverse trade scenarios but there are a few reasons why they may be suboptimal for hedging these specific types of shocks. For one, tariffs are inflationary by nature, given that they drive up the costs on businesses and consumers. Second, market pricing for the Fed and other central banks is already substantial, with the rates market pricing about 75 basis points of easing from the Federal Reserve (Fed) by year end. Relatedly, there may be some hesitance by the Fed to deliver the full easing priced into markets given uncertainty about the outlook for trade policy and its true economic effects.

Enter foreign exchange

Taking active positions in currencies is one way to express particular macro views or hedge against specific risks, such as an escalation in trade tensions. In Investment Solutions we run a pure FX portfolio named the Currency Absolute Return Strategy (CARS), which focuses on idiosyncratic economic and valuation signals for the world's liquid currencies. As a whole this strategy offers diversification to largely long-only portfolios that are driven substantially by market beta. But we also leverage our research for CARS to run currency overlays for other allocation strategies. Specifically, we can identify currency trades that we expect to work over time due to economic and valuation reasons, but also offer particularly attractive hedging properties around specific risks. Ideally, they provide an asymmetric risk profile—moving a great deal if a risk outcome we are hedging happens, while only moving somewhat if the event does not. We believe that short AUDUSD and short USDJPY are two trades that fit the bill.

Short AUDUSD

Australia is a small open economy with significant commodity exports, many of which go to China, an engine for global trade. This makes the Australian dollar highly sensitive to global growth and China's economic prospects. As such, AUDUSD is likely to depreciate meaningfully if US-China trade tensions escalate, raising downside risks to China (and global) economic prospects. The Korean won and Taiwanese dollar are also tied into China's supply chain (via tech as opposed to commodities), and would likely also weaken in an adverse trade scenario.

What makes AUDUSD particularly interesting as a short though, besides being a highly liquid currency, are Australia's idiosyncratic domestic economic pressures. Core to this is Australia's cooling housing market, which had previously been a meaningful support to household wealth and consumption. With activity and prices cooling, the Australian economy faces significant downside risks. This is especially true given how large household wealth is compared to disposable income—a fall in house prices may lead to negative 'wealth effects' for the consumer and weigh on consumer spending (Exhibit 1). And income growth itself is fading: Wage growth is softening because underemployment is still high, and trending higher (Exhibit 2). The Reserve Bank of Australia (RBA) is cutting rates to offset some of these pressures (which should also help to weaken the currency), but when large imbalances that have grown over a long time start to unwind, it is difficult to achieve a soft landing. Thus even if there is a trade deal which helps lead to a temporary bounce in AUD, the domestic economic pressures will remain a headwind.