Welcome to Soundbites – weekly insights on market trends, and investment strategies, brought to you by Investment Executive, and powered by Canada Life.

For today’s soundbites, we discuss global currency markets with Anujeet Sareen, portfolio manager with Brandywine Global Investment Management. He talks about Covid’s impact on currencies, which currencies he likes, and which he’s avoiding, and we started by asking why currency valuations tend to revert to the mean.

Anujeet Sareen (AS): The most fundamental concept in currencies is purchasing power parity. The notion that you cannot sell some type of a tradeable good at a different price in different countries. When it comes to most developed-market currencies, differences in inflation are trivial. So, you can certainly observe empirically that currencies have tended to mean-revert, once you adjust for inflation difference. Currencies are macro assets. They impact the economy. So, if a currency weakens enough, there are certain things that will tend to follow. Export growth will tend to improve because exporters are now more competitive. The same time, import growth will tend to weaken because now foreign goods are more expensive. So, you get an overall improvement in the trade balance, and that increases profits, which will lead to more investment spending, employment growth, wage growth, and ultimately some pressure on inflation, and that tends to lead to a central bank that raises interest rates. You will then attract foreign capital into the country. So, it’s this interaction that pulls it back to its longer-term average.

Where this has worked out well for investors recently.

AS: A good example of this would be the Mexican peso going back a few years. So, if you recall, the Mexican peso weakened quite substantially for a variety of reasons, one of which was tremendous amount of fear on what a Trump presidency might mean for NAFTA, and the new president that was coming to power in Mexico’s case — AMLO [Andrés Manuel López Obrador] — was also someone that was far less friendly to the business sector, and so that would also discourage capital from going into Mexico. The currency weakened sharply during that time, and it elicited the kind of reaction we like to see: a big improvement in the trade balance, Americans started going down to Mexico in larger numbers on vacation. We also saw a subsequent rise in inflation. And so, the central bank raised rates, and that’s what made us interested in buying Mexican peso-denominated assets. And that has worked out well quite well. The Mexican peso has been the best performing currency in the world the last five years.

Where Covid is still impacting currencies.

AS: Covid hasn’t gone away. And where it is still showing up in market pricing would be in the emerging-market world, and it’s because they just simply don’t have the resources from a medical perspective, from a vaccine supply perspective, to bring their economy full back online. This is true of a number of Latin American currencies like the Chilean peso, the Brazilian real. These currencies are undervalued today. I think the market is still hesitant because Covid risks are still here. Until those places hit some type of herd immunity, I think people are still hesitating to make those investments.

Where else he finds opportunities.

AS: If we look over to Europe, currencies like the Polish zloty and Hungarian forint are still at weaker levels than they were pre-Covid and there is scope for these markets to recover further as activity normalizes. They’ve already raised interest rates. Poland has benefited, in an indirect fashion, from Brexit. And so, they have both a strong economy and a strong external trade position, and we think that’s going to lead to currency strength.

What currencies he’s avoiding.

AS: Currencies such as the Turkish lira, the Argentinian peso, these are countries that one could easily argue have an undervalued currency. The biggest constraint really is governance. You have leadership in Turkey that has certainly pursued some very unorthodox policies, they have politicized the central bank, which is undermining trust in the currency itself. Argentina has some similar issues but has some additional issues with respect to some long-term debt. And so, for us, while the currency is undervalued, those governance factors really dissuade us from having exposure there.

And finally, what’s the bottom line here?

AS: Currencies are volatile assets. And so having a disciplined approach that is very patient until you reach [valuation] extremes is important. One is really paid to be patient and look for dislocations before investing.

Well, those are today’s Soundbites, brought to you by Investment Executive, and powered by Canada Life. Our thanks again to Anujeet Sareen of Brandywine Global Investment Management.

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