Build walls and slash taxes. It sounds like economic balm.
But there’s a dark side to protectionism, infrastructure spending and tax cuts, warns Luc de la Durantaye, head of asset allocation and currency management at CIBC Asset Management: inflation.
Inflation will prop up the U.S. dollar, which is already overvalued, he says. And the Federal Reserve will have to raise rates to manage inflation—with a December hike a foregone conclusion, according to the CME Group’s Fed fund futures tracking tool.
“We’ve got to think about the feedback loop,” he says. “There cannot continually be a rise in interest rates and strong U.S. dollar. That tightens financial conditions and makes life for corporations and consumers tougher.”
That being said, de la Durantaye has a “large long U.S. dollar position.” But he’s watching the allocation. “We’re monitoring the level of yields and steepness of the curve.” His target for the U.S. 10-year Treasury is between 225 and 250 basis points. Beyond that, “as the U.S. dollar strengthens and yields continue to rise, the U.S. equity market will start buckling down.”
When yields peak, “that will be the sign [for us to] start lightening up on the U.S. dollar. And depending on how much the emerging currencies have corrected, then we would go back in bigger percentages to some of our better-ranked and higher-yielding currencies.”
While he’s not ready to do this yet, “there’s a limit to how much the dollar can rally and yields can rise. There’s a limit to how much fiscal spending can add in terms of growth. And the higher the inflation, the lower [a company’s] price-earnings [ratio]. So that trade-off is just putting a cap on equity markets, which will put a cap on the dollar.”
Stephen Lingard, senior vice-president and portfolio manager, Franklin Templeton Solutions, warns that “some of the inflation emerging is underappreciated, so we get more protection holding inflation-protected securities. We’re leaving that exposure unhedged, as well as U.S. investment-grade securities.”
But Lingard has begun to hedge other fixed income in his multi-asset portfolios back to the Canadian dollar. “We’re [about] 50% hedged on fixed income,” he says. “Our most conservative strategy has 75% Canadian dollar, and as much as 15% U.S. dollar risk. We’d hedge back another 5% of that.” The reason? The Canadian dollar could still weaken, but “we’re recognizing we’re seven or eight innings in this weakness, and we’re adding back some hedges on a gradual basis. We’d never put all our hedges back on at once.”
More on the loonie’s direction
Lingard sees the Canadian dollar “range-bound” to $1.35 per U.S. dollar. His research has shown that “when the Fed begins to raise interest rates, that tends to mark the peak in the U.S. dollar.” That’s because global growth has likely improved, and the U.S. dollar is no longer needed as a safe haven, he hypothesizes.
De la Durantaye’s call for the loonie is between $1.37 and $1.40 per U.S. dollar. “You might get an undershoot of the Canadian dollar that would be related to an overshoot on the U.S. dollar,” he says. “That would be a place where the Canadian dollar would stop depreciating.” He says this in part because he doesn’t think oil prices will go below US$40.
He adds that oil producers have been ramping up in anticipation of an OPEC output agreement on November 30. He says oil has become a more competitive market, with the supply curve flattening out. “Production will adapt a bit more naturally. That means oil prices will be less volatile than historically.” He sees a range of US$40 to US$60 per barrel, instead of US$30 to US$90.
So far, the effects of stronger oil on the CAD have been muted. “That suggests there may be some underlying strength in the U.S. dollar absent that,” Lingard says.
World currencies to watch
Lingard’s mainly unhedged in equities, except for Japanese stocks. “We have a positive view on Japanese equities, but we do not want the currency exposure,” he says. “We’re hedging out over half of that yen exposure. That’s the only way the asset class makes sense to us.”
As for emerging markets bonds and stocks, “those are very difficult to hedge,” says Lingard. “It’s very costly, sometimes there aren’t even contracts.” So while he’s mostly unhedged, he manages the exposures. He notes that while the JP Morgan Emerging Market Currency Index is down about 4% since November 8, it’s up 10% since the beginning of year.
As for de la Durantaye, he likes the Brazilian real, Colombian peso and South African rand because they’re high-yielding currencies relative to the loonie. Despite some corrections post-election, “over time, you can still get a higher return if you hold them for a period of six to 12 months,” he says. That’s in part because Brazil has fewer trade links to the U.S. than Mexico and other countries. And Colombia is readjusting to lower oil prices more quickly than Canada, due to its lower production costs.
“Asian currencies are at risk, particularly the lower-yielding ones with [U.S.] trade [being] important to them,” de la Durantaye says. He cites China, Korea, Taiwan and Malaysia as “most at risk.” He’s also concerned about the Singapore dollar, given that the economy is trade-oriented.
Like Brazil, currencies in economies that are sheltered from the impacts of U.S. trade protectionism—such as India and Indonesia—should fare better.