The bank notes that prior to the credit crunch foreign exchange markets enjoyed a long period of relative calm. But then the financial crisis rocked global markets, sending volatility surging into the stratosphere. “Over the next ten years investors should expect foreign exchange rates to remain highly volatile,” UBS’s Mansoor Mohi-uddin warns.
There are two reasons why this will happen. Firstly, uneven growth rates – with developed markets lagging behind emerging markets – and secondly, unpredictable economic policy.
The chart on the right shows that growth in emerging markets is expected to top more than 6 per cent per annum by 2011, whereas developed markets will struggle to reach even half of that. This is a big departure from what UBS calls the “strong and synchronised expansion the global economy experienced before 2007”, which helped to suppress volatility.
Globally, less predictable fiscal and monetary policy are also expected to weigh on the financial markets. The Federal Reserve, the European Central Bank and the Bank of England have all been at pains to insist on their commitments to keeping interest rates low as the world emerges from recession. However, there is uncertainty about how long interest rates should remain this low, especially since Australia, Norway and many emerging market nations have started to raise rates. Likewise, fiscal policy is also highly uncertain. Debt levels in many G7 nations are at unsustainably high levels, but governments have to balance tighter fiscal policies without choking off economic growth.
All of this leaves currencies in a catch-22 situation. Investors are likely to sell a currency if a country posts low growth caused by tight fiscal policy, but they will also sell it if fiscal policy is not tight enough and debt levels remain too high.
But higher volatility can also be an opportunity for investors, so where will the profits of the future be found? Edwin Gutierrez, emerging markets portfolio manager at Aberdeen Asset Management, says that the biggest theme in forex markets in the next five years will be a revaluation of the Chinese renminbi. When this happens most analysts expect other Asian currencies to perform well, but Gutierrez says that other emerging markets’ currencies could enjoy a surprise boost. “The Mexican peso could be a strong performer since, like China, it also exports to the US. If the renminbi appreciated then Mexico’s authorities might be less averse to peso appreciation since it would have less of an impact on its export business.”
A fall in the dollar is another long-term theme, according to Hardeep Dogra, a fund manager at Schroders. He notes that there are lots of factors propping up the dollar right now, especially risk aversion, however these should evaporate over time and the dollar’s longer-term trend could be lower. “Everyone is focusing on Europe’s fiscal woes, but actually the fiscal situation in the US is also poor. I am of the opinion that when risk aversion eventually dissipates, the dollar could enter a phase of decline.”
So if higher volatility is likely to be the norm rather than the exception going forward, investors need to look to emerging markets where economic fundamentals support currency outperformance.