The global expansion – a positive world

For most of the last fifteen years, the US consumer has been the driver of global expansion. Most of the rest of the world was in a state of malaise without overly optimistic confidence in the future. This confidence difference has turned around significantly in the last year with the other major global economies showing growing confidence while the US has fallen into swings of confidence and depression.

The chart from the OECD Economic Outlook provides a good review of consumer and business confidence for the major global economies. This strong global confidence is a key reason for the continued world growth which outstripping what is happening in the US. Consumer and business confidence are above the US for the first time since the recession of 2001.

Confidence numbers can be fickle especially in the US where the swing are much greater than in other major economies. Confidence sometimes just describes sentiment to current conditions, but longer-term trends provide a good indication of what consumers and business will do with their wealth. It never makes sense to fight the trend in confidence.

Housing markets around the world at extremes

There has been a tremendous focus on the US housing market, but it is not the only housing market which has moved to or is at highs. A cross sectional analysis by the OECD in their latest economic outlook provides evidence that housing markets are at peaks around the globe. In fact, the US market may seem tame by some measures. As a percentage of GDP, housing investment is not at the highest level relative to other countries and the US market is not at its peak. A number of the high growth European countries have housing investment that outstrips the US.

There may not be any hiding through diversification in global housing markets. For some foreign investors, the US may still seem like a good deal especially with the decline in the dollar. While we are not arguing that real estate is a bargain in the United States, a global perspective makes this issue less of a problem at this point. Nevertheless, the unwinding of excess in asset classes that are not as liquid as stock or bonds will take time and a rising interest rate market is not at all helpful.

ECB sells 37 tons of gold in the last two months

It is unusual to have central banks comment on their gold sales. Their gold reserve policies have always been somewhat of a mystery to the market even with a Central Bank Gold Agreement in place since 2004. The ECB announced that they were engaged in active selling over the last two months but have now decided to stop for the rest of the gold agreement year which ends in four months. This caused a $10 rise in price. The reaction was more to the information that no more sales would be held for the rest of the Agreement year than to the past sales.

While European central banks have signed an agreement which has bound their behavior since September 2004 to limit the extent of sales, this activity always causes markets to take notice especially with more gold above the ground in vaults than in the ground. The ECB has sold about 60 tons of gold this Agreement year. Gold now represents about 16% of the total ECB reserves. Banks have usually been active in the lease market for gold where they have driven down yields to levels below short rates; nevertheless, the total central bank gold sales for this year have totaled 242 tons.

With the high price of gold, there is no reason why more sales from central banks will not occur especially if there is continued controlled world inflation. Central bank gold sales place a higher level of uncertainty in this market than would be expected from just the diversification behavior of investors.

What is going on with foreign exchange styles?

There has been a surge in interest with trying to classify foreign exchange trading. This style classification movement is an extension of what has been done in the equity markets and with hedge funds over the last few years. For equity markets, there has been significant interest in trying to analyze value versus growth style effects. For alternative investments, there have been a number of classification schemes to find those factors that best represent returns for hedge funds. Foreign exchange style identification has moved beyond comparisons to simple benchmarks like a basket of exchange rates and has focused on measuring trading strategies. Banks, starting with ABN-Amro, have classified foreign exchange trading into four distinct styles: trend-following, carry, volatility, and valuation. This certainly does not capture the value-added from many managers but it does increase the level of transparency associated with FX traders.

The trend-following style attempts to generate return through using simple moving average principles. Long exposure is held in those markets which have an uptrend and short exposure is held for those which are trending down. Positions are a weighted average of cross-over signals with different time lengths or look-back periods. There is no risk management or stop loses with this style, only a trend identification procedure. The style only looks at the value of trending without any other indicators such as relative strength. Signals could be easily replicated with a simple spreadsheet.

The carry style holds long exposure in a set of those currencies which have the highest short-term yield. Short positions are held in those currencies that have the lowest yield. The carry strategy is based on the belief that money will flow to those countries that have high nominal interest rates causing the currency to appreciate. Again there is no risk management and positions are equally weighted without any input on the relative size of the yield positions. Banks will often separate carry models into developed and emerging market portfolios.

The valuation strategy could focus on a number of models but often uses a simple purchasing power parity equation. It buys those currencies that seem cheap relative to PPP and shorts those which are overvalued against relative inflation rates. The long and short positions are based on the assumption that exchange rates will mean revert to their fair value. Positions are only taken in those currencies that deviate by a specific percentage.

The volatility strategy will buy straddle for those currencies that have low volatility and sell those currencies which have high volatility.

The correlation of these strategies or styles is low. A simple correlation table since the end of 2000 shows that each strategy is somewhat unique. There is gain from forming a diversified portfolio of these strategies. Volatility from a combination is lower than would be found from just forming a weighted average of these strategies.

Nevertheless, the performance of these strategies has changed markedly over the last five years. Trend-following which has been one of the best strategies for currencies has shown negative performance over the last five years. Volatility trading has flat-lined over the last few years as volatility in the currency markets has declined and stabilized. Given the decline with inflation around the globe, there has been a limit in the deviations away from fair value for developed currencies. The greater stability in fundamentals, trends, and volatility has made the carry strategy a winner over these same periods. In fact, employing only the carry strategy would have provided the best overall return over the last five years. A mixed strategy would have created a lower volatility portfolio but would have cost investor’s return. Running a simple optimization of these strategies would create a portfolio which is almost completely skewed to carry strategies. There is no need to use anything else, except this is looking back in time. This is the classic corner solution when employing an optimizer.

So what does style analysis tell us about forming a foreign exchange portfolio? A stable market environment means that a high exposure to carry strategies is most effective. The stable economic environment across the globe creates limited appeal for the valuation strategy. Trend-following will only work if there are large dislocations expected in the markets. Volatility strategies will have limited value if there is stable and low volatility.

Nevertheless, it is not clear what will be the market environment in the future. A strategy of holding high exposure to carry over the next five years may not be appropriate. Hence, forming a balanced strategy may still make sense especially if you have clear expectations on the global environment which suggest greater uncertainty.

Preparing for the future may require careful analysis of FX styles and views on the future global environment. It is easy to argue the extremes that carry should continue to dominate or that we will find a less favorable carry environment as strategy performance reverts back to a mean. Markets have a tendency to do the unexpected, so a balance of strategies may be the most prudent.