Currency markets are treacherous places

The ability to unlearn past habits is a vital ingredient in investment success. The behaviour of both equities and bonds since the start of the year bears witness to this fundamental truth. I am thinking in particular of how we view international correlations between markets and the impact of currency movements on portfolio returns.

For most of my career, correlations between the big developed world stock markets have been strong and have tended to become stronger, despite divergences in the underlying economies. What happened on Wall Street was usually more important for returns in the UK than events in the UK economy. The same point applied, though less powerfully, to Germany and France.

Japan, admittedly, lived in a more closed environment and tended to be a law unto itself. But since 2000 it has joined the rest of the world. Correlations strengthened as foreign investors played a greater role in Japanese equities.

A mindset forged against that background could not be less helpful in steering a course through global markets this year. There are huge divergences between economic circumstances in the US and the UK on the one hand, and the eurozone and Japan on the other.

These differences have prompted divergent monetary policy responses. The US and UK have been in the vanguard with quantitative easing, while Japan's move to QE came late and the eurozone's even later. Currency markets are responding to these divergences, expecting tightening to come first in the US and soon after in the UK. Meantime, eurozone and Japanese equities have outpaced the equity markets of the economic front runners.

A significant point is that central banks, with policy interest rates at negligible or even negative levels, are being forced to rely increasingly on currency depreciation to loosen monetary policy. The result is that currency swings and roundabouts can become a more important determinant of returns than the behaviour of the underlying investments. That is even more true of bonds, where exchange rate volatility is now a paramount concern.

The challenge this poses to investors is most obvious in the eurozone. Since the start of the year, equities, fuelled by the prospect of QE, boomed, while the euro sank. For dollar investors a bull market in local currency terms was simply lost in translation. The same pattern has been repeated around the world with variations. In Japan, for example, the QE-inspired equity surge still delivered to US and other foreign investors because the damage of yen depreciation was more than offset by a government-directed shift by public sector pension funds out of bonds into equities.

This, then, is a world where local and hedged equity returns tend to be stronger than unhedged foreign returns. The key to success is to avoid losing what you make on the investment by misjudging the currency and vice versa.

Yet this central bank-dominated market does not feel healthy. Too much of the stock market gains in the loose monetary policy countries are coming from the impact of depreciation on exporters' earnings rather than improved operating performance. Such translation gains can quickly evaporate. It is also a complex world. US companies that lose from a strong dollar may make offsetting gains by borrowing at negligible cost in the eurozone bond markets.

The risk in this new investment paradigm is that the simplistic equation of loose monetary policy with a weak currency and strong policy with currency appreciation, having worked well for a time, may stop working. Currency markets are treacherous places, where consistent outperformance is, I suspect, even rarer than in equity and bond markets. Shocks, whether from policy mistakes, geopolitical risk or unexpected economic setbacks, could yet wrongfoot investors who have profited handsomely from the new paradigm so far in 2015.

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