Legg Mason Perspectives: Currency Markets – The Dollar is King… Or is it?

By Richard Lawrence, Senior Vice President, Portfolio Management – Brandywine GLOBAL

 

Risk aversion is helping support U.S. dollar for now, but the longer-term outlook remains clouded by uncertainty.

The indiscriminate selloff that battered financial markets during March left no stone unturned. For globally focused managers such as ourselves that meant currency markets were a source of significant volatility during the month. While the news from China in early 2020 gave us some concern, there was little foreshadowing of the carnage to come as January and early February were relatively benign periods for currency performance, with the dollar index (DXY) appreciating a modest 3.6%. However, from February 20 until March 9, DXY dropped by 5% and the U.S. equity market sold off as investors anticipated preemptive policy easing by the Federal Reserve (Fed) in response to the rising economic risk presented by the coronavirus outbreak.Around March 9, all hell broke loose in the currency complex as global demand for dollars surged. One way this shows up is via the widening of currency basis. Below is a chart of EUR basis showing a drastic drop during mid-March—this indicates investors paying a premium for dollars amidst diminished liquidity. The dollar index surged from 95 to almost 103 by March 20.

Graph: EUR-USD Basis Swap (3M Euribor vs. 3M Libor) 3M

CHART 1.

Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

The global thirst for dollar liquidity triggered an unprecedented series of responses from the Fed. While the Fed is of course the central bank to the U.S., it serves as the de facto central bank to the world’s financial system given the dollar’s role in global trade and financial activity. Therefore, the Fed needed to move fast to preserve that status. We saw four programs established or enhanced over the course of two weeks:March 15: The cost of weekly dollar swap lines was reduced with foreign central banks that had standing swap line arrangements, such as Canada, England, Switzerland, Europe, and Japan.

March 19: The swap line program was extended to include Mexico, Brazil, Korea, Singapore, Australia, New Zealand, Norway, Sweden, and DenmarkMarch 15: Swap lines with the original five central banks increased in frequency from weekly to daily.

March 31: The Fed announced a new program, the foreign and international monetary authorities (FIMA) facility, allowing foreign central banks with Treasuries on deposit at the Fed to use them as repo collateral to obtain additional dollar liquidity.

As these programs started to take effect, some of the liquidity stress in dollar funding markets started to ease as evidenced by the drop and subsequent stabilization in DXY (see Chart 2 below) as well as the ensuing improvement in cross-currency basis as seen in Chart 1.

Graph: DXY Currency

CHART 2

Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

Maybe the most critical variable in our work right now is the dollar. So, where does the dollar go from here? Perhaps we need to frame that answer across multiple time horizons.

The Near-Term
In our view, short-term currency performance tends to be driven by factors such as momentum, risk appetite, sentiment, and liquidity. Given that uncertainty—what we call “information risk”—remains elevated it is likely that risk aversion keeps the dollar in demand. For now, the Fed seems to have done enough to relieve the worst of the dollar squeeze, although probably not enough to push the dollar into a sustained declining trend. Therefore, our near-term view is that the dollar may stay firm but should not appreciate meaningfully from here. Furthermore, as countries around the world start to re-open their economies, we would expect dollar demand to ease somewhat.

The Medium-Term
Over the medium term, currencies tend to be driven by factors such as widening differentials in interest rates, inflation rates, and growth rates. Here the picture is less clear. In 2018, we witnessed a burst of dollar strength as tax cuts in the U.S. fueled stronger growth—which led to the Fed hiking interest rates and resulted in a potent combination of widening interest-rate and growth differentials. Those rate differentials have remained stable or closed somewhat during a sustained global easing cycle, removing a pillar of support for the dollar. As for the path of growth differentials, forecasting directionality right now is challenging as simultaneous growth shocks around the globe start to bite. Who will be the growth leaders over the next year…it’s probably too early to say.

The Longer-Term
Over the longer term, we view measures of value as influential in determining currency performance. So metrics such terms of trade and purchasing power parity (PPP) come into play. These metrics currently suggest that the dollar remains extremely overvalued, and therefore argues for the dollar to decline (Chart 3). With that said, the dollar has remained overvalued on a PPP basis for five years now, coinciding with—and arguably resulting from—the Trump candidacy and presidency. This implies that the 2020 election may play a significant role in determining the path of the dollar after November.

Graph: U.S. Dollar Value

CHART 3

Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

Other long-term factors to consider would include productivity differentials, structural reforms, foreign direct investment, and fiscal dynamics. These factors present arguments for both a stronger and weaker dollar. Bulls will point to the possible resumption of tensions between the U.S. and China post-COVID crisis as the catalyst for “de-globalization,” the large-scale onshoring of manufacturing operations back to the U.S. as a way to reduce the reliance on global supply chains, particularly in China. This would likely be hugely dollar bullish, boosting U.S. growth and productivity. On the other hand, the dollar bears will point to challenging fiscal dynamics in the U.S. where the 2019 approximate $1T fiscal deficit is estimated to explode to $3.7T this year (18% of GDP) and remain elevated at $2.1T in 2021 (10% of GDP).

Furthermore, the Fed is currently undergoing an expansion of its balance sheet that has no historic precedent. Chart 5 demonstrates the speed with which a declining balance sheet is now growing at a stunning rate, already at $6.5T, and likely to continue expanding to $9T and possibly beyond—an estimated 40% of GDP. We would expect the Fed balance sheet to pressure the dollar lower.

Graph: U.S. Condition of All Federal Reserve Banks Total Assets

CHART 5

Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

In summary, we believe the COVID-19 induced dollar liquidity crisis is over and we can be confident that the Fed will lean against further dollar demand, but the longer-term outlook remains clouded with uncertainty. Over the next few quarters as economies restart, we will be looking for clues on who are likely to be the winners and losers in what is expected to be an extended and uneven global recovery. Beyond that, in addition to valuation, politics, geopolitics, and fiscal dynamics will possibly come into play for the dollar’s trajectory. Will the dollar be king? Only time will tell.


Legg Mason Key risks and Disclaimers

Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance.

All investments involve risk, including possible loss of principal.

The value of investments and the income from them can go down as well as up and investors may not get back the amounts originally invested, and can be affected by changes in interest rates, in exchange rates, general market conditions, political, social and economic developments and other variable factors. Investment involves risks including but not limited to, possible delays in payments and loss of income or capital. Neither Legg Mason nor any of its affiliates guarantees any rate of return or the return of capital invested.

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.

Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice. Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not take into account the particular investment objectives, financial situation or needs of individual investors.

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MeDirect Disclaimers

This information has been accurately reproduced, as received from Legg Mason Investments (Europe) Limited. No information has been omitted which would render the reproduced information inaccurate or misleading. This information is being distributed by MeDirect Bank (Malta) plc to its customers. The information contained in this document is for general information purposes only and is not intended to provide legal or other professional advice nor does it commit MeDirect Bank (Malta) plc to any obligation whatsoever. The information available in this document is not intended to be a suggestion, recommendation or solicitation to buy, hold or sell, any securities and is not guaranteed as to accuracy or completeness.

The financial instruments discussed in the document may not be suitable for all investors and investors must make their own informed decisions and seek their own advice regarding the appropriateness of investing in financial instruments or implementing strategies discussed herein.

If you invest in this product you may lose some or all of the money you invest. The value of your investment may go down as well as up. A commission or sales fee may be charged at the time of the initial purchase for an investment and may be deducted from the invested amount therefore lowering the size of your investment. Any income you get from this investment may go down as well as up. This product may be affected by changes in currency exchange rate movements thereby affecting your investment return therefrom. The performance figures quoted refer to the past and past performance is not a guarantee of future performance or a reliable guide to future performance. Any decision to invest should always be based upon the details contained in the Prospectus and Key Investor Information Document (KIID), which may be obtained from MeDirect Bank (Malta) plc.

Exploring Mutual Funds – Important Documents

Ray Calleja

An article written by Ray Calleja: Head – Private Clients, MeDirect


Before investing in any mutual fund, you need to consider what are the fund’s investment objectives, the risks involved, the fees and expenses that you need to pay.

MeDirect offers a wide selection of over 500 mutual funds through its online trading platform. You can access a wide range of information by clicking on the fund name, including all the Legal Documents of the fund. You have access to the most recent prospectus for any given fund as well as its most recent annual and semi-annual reports plus the Key Investor Information Document (KIID). MeDirect also makes the Morningstar report available for your perusal.

In this article we will go over the important documents that are associated with mutual funds. Unfortunately, for the common investor, these documents are packed with legal jargon and very detailed information to fulfil the disclosure requirements with the Regulators and protect the funds from legal liability. Nevertheless, these documents are important for mutual fund investors.

UCITS regulatory framework

The Undertakings for the Collective Investment in Transferable Securities (UCITS) is a regulatory framework of the European Commission that creates a harmonised regime throughout Europe for the management and sale of mutual funds. UCITS funds can be registered in Europe and sold to investors worldwide using unified regulatory and investor protection requirements. UCITS fund providers who meet the standards are exempt from having to apply for national regulation in individual European countries.

The Key Investor Information Document (KIID)

The KIID is a two-page document introduced by Directive 2009/65/EC (UCITS IV) aiming to simplify and standardise the basic information provided by the UCITS to investors. Its form is standardised in terms of both the size as well as the content. The accuracy and standardisation of the provided information helps investors identify differences between UCITS and compare them. A UCITS must update its KIID on an annual basis for each sub-fund / standalone fund within 35 business days of the end of each calendar year. 

The document describes the key information for a Fund, such as the nature of the Fund, its charges, and the risks associated with investing in it. Information contained in the KIIDs is required by law and enables easy fund comparison across different asset management companies. Each share class of every mutual fund OEIC (open-ended investment company) will have a KIID.

The Prospectus

While the KIID may be considered as the equivalent to the Summary Prospectus in the United States, here we will examine the contents of the full Prospectus. This is known as the statutory prospectus, i.e. the traditional, long-form prospectus with which most of us are familiar with. 

Regulators stipulate that mutual funds must include important information in the prospectus, including:

1. Investment Objective or goals. Is the fund seeking to make money over a long-term period of time through capital growth? Or is it trying to provide its shareholders with regular income? If you’re investing at a relatively younger age you will probably go for the former. But if you are looking for regular income you will go for the latter.

2. Strategy for reaching those goals. The prospectus also describes the types of stocks, bonds, or other securities, which the fund will invest in. Equity funds state what kinds of companies they look for, such as small, medium or large. Bond funds specify what sort of bonds they generally hold, such as Treasury, investment grade or high yield bonds etc. For example, the fund may choose to focus on one or more industries, geographic regions, or types of securities.  Most restrictions placed on the fund are also mentioned in the prospectus, including references to short or long selling, leveraged purchases, and so on.

3. Principal Risks of investing in the fund. Every investment has risks associated with it, which may lead to financial loss, and a prospectus must state and explain these risks. The fund must satisfy your investment objective and match your risk tolerance, which depends on several factors, including your financial situation, age and family commitments. The types of risks to which a fund is subject vary considerably with the nature of its investments. Some of the more common risks for funds include Market risk (such as a decline in markets where it invests); Business risk (the fund may invest in a company that goes out of business); Credit risk (the fund may invest in bonds issued by a company which may be unable to meet its interest or capital payments); Interest Rate risk (the value of bonds which the fund invests in may fall due to rising interest rates); Inflation risk (the value of bonds which the funds invests in may also fall as a result of price increases due to inflation) and Concentration risk (the fund may invest in one particular industry, sector or geographical area thus exposing itself to a greater risk if that sector or area suffers an economic downturn).

4. The Fund’s fees and expenses. Each mutual fund has different fees for the investor to pay. A table in every prospectus makes it easy to compare the cost of one fund with another. You will be told, in percentage terms, the amount deducted from the fund’s return each year to pay for things such as management and distribution fees.

5. Its Past Performance. We keep hearing the disclaimer that “Past performance is no guarantee of future returns.” However, a fund’s record can still give you an idea of how consistent its performance has been. The prospectus will include:  (a) a bar chart displaying the fund’s investment performance for the previous ten years (or since the fund’s creation if the fund has less than ten years of performance history), which gives a clear picture of the fund’s ups and downs over time; (b) a table comparing the fund’s performance over the previous ten years relative to a broad-based securities market index or other benchmarks to provide return information; and (c) the fund’s performance for its best and worst calendar quarters.

6. Management. The management of the fund is an important element in determining its investment success.  The prospectus will describe: (a) the investment adviser (and any sub-advisers the investment adviser may employ) and (b) the individual portfolio manager(s) employed by the investment adviser. Consider the fund manager’s tenure if it is relatively short, the fund’s past record may have been achieved under someone else. Find out whether the fund manager has run other funds in the past. A glance at those funds could give you some clues about the manager’s investment style and capabilities.

Shareholder Information
The prospectus will contain other useful information for shareholders, including information about: 

  • buying and selling fund shares.  Typically, funds will permit investors to buy and sell shares either directly or by contacting a broker, such as MeDirect.  Purchases and redemptions are made at the net asset value next calculated by the fund, which is calculated after receiving your order.  As explained in previous articles the fund’s net asset value per share is the market value of the fund’s assets, minus fund expenses and any other liabilities, divided by the number of fund shares outstanding.  Funds are required to pay redemptions within seven calendar days, but some funds pay redemptions within one or two business days.   
  • distributing dividends. Typically, funds will offer different options for payments of dividends from the fund’s portfolio holdings.  For example, many funds will allow investors to withdraw their dividends (e.g. at MeDirect we pay dividends into a client’s investment cash account for funds held with us under nominee) or to automatically reinvest the dividends in the fund. 
  • exchanging shares between funds. Many funds are offered within a family of funds and you may be able to exchange your shares in a fund with shares of another fund in the same fund family.  An exchange is usually subject to a fee, and may require you to pay taxes.

Shareholder Reports

Mutual funds must provide reports to their shareholders on a semi-annual basis. The semi-annual report covers the first six months of the fund’s fiscal year, while the annual report covers the fund’s entire fiscal year. Some fund houses publish these reports quarterly. Mutual funds that are registered with the Securities and Exchange Commission (SEC) in the US or The European Securities and Markets Authority (ESMA) prepare their own shareholder reports and file them with the respective regulators. So long as these funds disclose the information that the latter require in the shareholder report, they can decide how to organize and present the information within the report.

Recent Fund Performance

You will find the fund management’s discussion near the front of the annual report. Here the fund manager discusses the fund’s individual stocks and/or bonds that the fund owns and the industries in which the fund is invested. There will be a discussion on the performance during the fiscal year in light of market conditions and other factors that may have influenced the fund’s investment return for the year. The fund manager will usually point out which holdings of the fund contributed significantly to the fund’s performance and which holdings detracted significantly from that performance. Finally, most managers will give you an indication of what you can expect from the fund in the future, given an unchanged strategy.

In addition, a line graph comparing the performance during the last 10 years (or for the life of the fund, if shorter) of a hypothetical $10,000 initial investment against an index is provided. A quick glance at the graph will tell you whether the fund’s performance has been steady or volatile over the 10-year period (or over the life of the fund, if shorter). For example, if the slope of the line is gradual, with occasional ups and downs, it suggests that fund performance has been relatively stable. If, on the other hand, the slope of the line is choppy, with numerous peaks and troughs, it suggests that the fund has been volatile. Compare the slope of that line with the line representing the index to which the fund is being compared.

Underneath the line graph will be a table showing the fund’s annualized (or average annual) returns for 1-, 5-, and 10-year (or for the life of the fund, if shorter) periods. You must pay attention to the fund’s 5- and 10-year returns. If the fund’s returns were high in the past year but unimpressive in the past five or 10 years (or over the life of the fund, if shorter), it is possible that the past year’s outperformance may not last. On the other hand, if the fund experienced consistently steady returns in the past five or 10 years, but suffered a sharp loss in the past year, it may be unclear as to whether the recent loss signals the beginning of a trend or is an isolated occurrence.

Portfolio Holdings

Funds often list the portfolio’s largest holdings and provide some information about what these companies do or why the manager owns them. Some reports will also indicate, through a chart or table, the sectors where the fund has considerably and relatively high exposure.

This general overview is complemented by a complete list of the fund’s portfolio holdings including stocks, bonds, and cash as at the end of the reporting period of the report. These holdings are usually segmented by industry and also by country, where relevant. Such a listing is useful since you will be able to tell whether the fund is holding many names in one industry or making a few large selected choices.

Footnotes

In the footnotes, you can find out if fund managers are practicing such strategies as shorting stocks or hedging exposure to foreign currency, which can significantly affect the fund’s performance. Footnotes can also provide insights into particular portfolio holdings. For instance, they may designate certain holdings as illiquid securities.

Financial Statements

A fund’s annual report concludes with its financial statements. There will be a lot of data here and this is the main source for third party reports.

Investors would want to check the breakdown of the fund’s expenses, including management fees. Related to expenses is the fund’s turnover ratio – how often shares are traded. If there’s a big change in any of these numbers over time, or they appear larger than those of the fund’s peers, inquire as to why. In addition, you can find out how much in unrealized or undistributed capital gains you’re facing, using the Statement of Assets and Liabilities. A gain is unrealised when a stock has gone up but the fund hasn’t sold it. As soon as the fund sells the stock, it becomes a “realized” gain, which has to be distributed to shareholders, which we discussed in a previous article.

Conclusion

While a few individual investors like to evaluate all or most of these legal documents, which can also be obtained directly from the respective fund house via its website or by a simple request by email, MeDirect also provides its customers with the Morningstar reports, which should be given extra weight since they provide a thorough analysis from a highly world-renowned third-party independent source. These reports are available in the information section in the Legal Documents part, along with the KIID, Prospectus and Annual/Semi-Annual Report on MeDirect’s public and private website. These reports from Morningstar do a good job of clarifying long lists of data and putting it into context, in a very easy to understand manner.

The importance of comparing a mutual fund with others that have similar investment approaches cannot be overstated. You should evaluate how its costs compare, if its performance is competitive, and if it provides sufficient compensation for the risks it is taking on.


The above is for informative purposes only and should not be construed as an offer to sell or solicitation of an offer to subscribe for or purchase any investment. The information provided is subject to change without notice and does not constitute investment advice. MeDirect Bank (Malta) plc has based this document on information obtained from sources it believes to be reliable but which have not been independently verified and therefore does not provide any guarantees, representations or warranties.


MeDirect Bank (Malta) plc, company registration number C34125, is licensed by the Malta Financial Services Authority under the Banking Act (Cap. 371) and the Investment Services Act (Cap. 370).

The financial instruments discussed may not be suitable for all investors and investors must make their own informed decisions and seek their own advice regarding the appropriateness of investing in financial instruments or implementing strategies discussed herein.

If you invest in any of the products discussed you may lose some or all of the money you invest. The value of your investment may go down as well as up. A commission or sales fee may be charged at the time of the initial purchase for an investment and may be deducted from the invested amount therefore lowering the size of your investment. Any income you get from this investment may go down as well as up. This product may be affected by changes in currency exchange rate movements thereby affecting your investment return therefrom. The performance figures quoted refer to the past and past performance is not a guarantee of future performance or a reliable guide to future performance. Any decision to invest in a mutual fund should always be based upon the details contained in the Prospectus and Key Investor Information Document (KIID), which may be obtained from MeDirect Bank (Malta) plc.

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