Two factors have long framed how investors think about the outlook for financial markets: real economic growth and inflation.
Exchange rates have been important, but less fundamental and usually thought of as simply notable aftereffects of trade dynamics, money flows and central bank policies. Times have changed.
Foreign currency exposure, known as FX, is no longer a simple numéraire that can be hedged away or ignored; it has become an integral endogenous, and potentially a driving, force of our economic and financial systems.
PIMCO has described The New Neutral for the global economy for years to come in which tepid growth and inflation lead to low levels of interest rates, including policy rates, even as the business cycle advances. In the past, when real GDP and inflation were globally higher, nominal GDP could absorb a lot of the inherent FX volatility. In The New Neutral, FX considerations will weigh disproportionally on the investment climate and opportunities. Indeed, currencies are not less volatile than they used to be.
The first chart illustrates our unusual situation in which sharp movements in currency values can plunge global nominal GDP into negative territory, even though global real GDP and inflation are positive. In this case, global nominal GDP growth measured in U.S. dollars (USD) becomes negative.
A corollary is that central banks’ quantitative easing (QE) programs are not equal, as they lead to different FX outcomes. As illustrated in the second chart, QE outside the U.S. can lead to a stronger dollar, which can in effect reduce global growth from a USD perspective. While the QE may lead to a little more global growth and inflation than expected otherwise, the magnitude of the FX movement that such QE will produce is likely to have a far larger impact.
In the past, nominal economic cycles were dominated by real GDP and inflation and were rather smooth with long periods of expansion in between few recessions. In The New Neutral, when FX volatility is high relative to growth and inflation, the investment landscape is far more sensitive to the FX factor and sudden nominal recessions can pop in the middle of what we traditionally call expansions. The result is a more volatile environment, where the FX factor can overwhelm any traditional economic factor considerations. This is an unusual world; in the New Neutral, we are more likely than ever before to face nominal recessions and unruly nominal economic cycles.
It’s time to take FX seriously.
In Part II of this blog series, we will look at the micro aspect of this and how various asset classes are directly affected by the FX factor, emphasizing its role as a major determinant of investment outcomes.