J.P. Morgan Private Bank Q2 2013 Currency Outlook: The Two Sides of USD Diversification

Dubai, United Arab Emirates, 8^th May 2013

Sara Yates, Global Currency Strategist at J.P. Morgan Private Bank, provides a macroeconomic overview, offers an outlook on USD diversification, highlights what she believes are good carry currencies and summarises the case for Asian currency in the year ahead.

The past 30 years have largely been a story of a declining USD. We believe this year will be different. This means that now, more than ever, investors need to carefully select the currencies they buy and the currencies they fund from.

JPY will be the weakest currency in 2013. We believe this will be a two-part story. The first part will be JPY weakness arising from the policy paradigm shift in Japan, which includes the Bank of Japan aggressively loosening monetary policy to try to achieve 2% inflation in two years. The second part will be USD strength. We believe that after a moderation in Q2, the U.S. economy will strengthen, supporting U.S. yields and the USD.

In an environment of rising U.S. yields, we see limited scope for EM FX to outperform the USD. Rather, we believe the lion's share of a currency's return will come from its carry. But with theory suggesting that carry strategies do not work in the long run, selection is key. Our favourite carry currencies are the INR, MXN, BRL and CLP.

Finally, we look at factors we believe are overlooked value and carry opportunities in Asia.

Macro Overview: Gradually Making Headway
The macroeconomic backdrop is evolving much as we expected at the start of this year; global growth is firming, monetary policy remains accommodative, and globally inflation remains largely benign. Moreover, risks of country events spilling over and derailing the global economy have declined. That is why, in our opinion,  the market's concerns about the ramifications of the Cyprus "bail-in" have seen euro-area worries rise, but not global worries.

Despite uncertainty about the U.S. fiscal outlook and the expiry of the payroll tax cuts, the U.S. economy was surprisingly resilient in Q1 with strong retail data suggesting the U.S. consumer carried on regardless. With an already low U.S. savings rate, we expect the sequester cuts to drag on U.S. prospects in Q2 as consumers adjust to their changed incomes. Unlike previous years, however, we expect the deceleration in Q2 to be modest and short lived. We continue to expect the U.S. to be an important driver of global growth this year.

Going into Q1 we were unconvinced about European growth prospects. We were right. According to survey data, economic conditions in the euro area have deteriorated this year. We expect more of the same in Q2 and believe the ECB's bias is towards looser policy. In our opinion, economic stabilisation and a clearer political landscape will be reserved for Q3 at the earliest. However, we believe the most aggressive loosening policy will come from the Bank of Japan- although we only expect developed markets to grow at 0.9% this year.  On the other hand, China will continue to grow at around 8% this year.

USD Diversification
We believe the USD unlikely to be the weakest currency this year, expecting the JPY to achieve that accolade instead. In such an environment, USD diversification is as much about what non-USD currencies investors buy as it is about what other currencies they fund from.  

·         USD - The USD should stay supported against low-yielding G4 currencies this year.

·         JPY - We expect the JPY to be the weakest currency this year.  Japanese yields are already low and we think the main impetus for further JPY weakness will come from increased domestic participation.  Longer term, we expect the JPY to continue to underperform as firmer U.S. growth in the second half of the year supports U.S. yields and a stronger USD.

·         GBP & EUR - Just looking at European data and the loosening bias it implies suggests a weaker EUR and GBP versus the USD. However, the near-term moderation of the U.S. economy and potential flows into Europe on the back of loose external policy may limit the downside for the EUR and GBP.  In fact, we believe how EURUSD and GBPUSD perform is likely to depend on how dovishly the ECB and BoE act.

·         CHF - We think the CHF is another good alternative funding currency to the USD. Unlike the EUR, we expect the CHF to underperform the USD in the second half of 2013. Switzerland remains expensive on a purchasing power parity basis. We expect this to gradually unwind this year, helped by further deflation and a stronger USD in the second half.

Carry Currencies: Sorting the Wheat from the Chaff
As well as diversifying away from the USD as a funding currency, it remains as important as ever to diversify out of USDs and into currencies that offer a better expected return. Our favourite carry currencies are the INR, CLP, BRL and MXN:

·         INR - Offers a great carry that may not be around for long. With the authorities pushing ahead with their fiscal austerity programme, there is scope for the Indian central bank to cut the repo rate. With less carry, the country's poor fundamentals would make the currency less appealing.

·         CLP - Is an excellent currency to hold for long-term carry. Chilean activity is robust and the central bank expects the economy to grow at 4.5 to5.5% this year. With relatively low inflation, CLP offers the highest real carry in our currency universe.

·         MXN - Remains a great currency long. Domestically, survey evidence suggests growth is solid, while inflation is benign. Other positives include robust macro-financial fundamentals. And with Pena's government pushing through structural reforms at a rapid pace, we see scope for FDI flows to increase, potentially helping USDMXN push below 12. 

·         BRL - We think the high and potentially rising carry makes it an attractive currency to hold for now.

Emerging Markets Asia
In Asia, we believe the market has overreacted to the impact a weaker JPY could have on other currencies in the region. We see value and carry opportunities in many Asian currencies. Our preferred Asian longs are KRW, CNY, MYR and INR.

·         KRW - A weaker JPY and elevated geopolitical concerns dragged on the KRW's performance in Q1. While we expect JPY weakness to continue, we believe a run of resilient Korean economic data will lessen market concerns about possible intervention to protect the economy. The supplementary budget is likely to be another positive in the second half. In the very near term, however, concerns about North Korea are likely to remain a drag. We expect the current U.S.-South Korean manoeuvres to end by the start of May. After that, the geo-political noise may subside somewhat, providing scope for USDKRW to move lower.

·         CNY & CNH - With the economy expected to grow at around 8% this year, a large current account surplus and inflows likely to continue we expect the authorities to allow the CNY to drift higher versus the USD this year. In fact, we believe the possibility of strong inflows on the back of externally loose monetary policy poses upside risks to inflation and may encourage the authorities to let the currency appreciate sooner or by more than our forecast.

·         MYR - Robust growth, a current account surplus and a cheap valuation are just some of the reasons we like this currency. We expect the upcoming elections to result in the incumbent remaining in power. Assuming this occurs, we expect the MYR to strengthen as political uncertainty fades. The possibility of an alternative outcome is a downside risk to our forecast.

·         INR - The INR's high interest rate combined with our expectation for a sideways move in the currency makes this an attractive carry currency, in our opinion.

- Ends -

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