Currency movements often produce a wild ride for investors, but 2016 was a year for the ages. The pound sterling tumbled to a 30-year low, the euro declined sharply in the fourth quarter, and the U.S. dollar staged a remarkable bull run.
What’s in store for 2017? In my view, the roller coaster won’t stop, but the ride should be less bumpy. That’s important because currency fluctuations can have a big impact on investment results. In 2016, for instance, European stocks enjoyed a robust 7% gain in local currency terms. But for dollar-based investors, currency movements eliminated all of those gains, producing a loss of –0.4%.
Here are my thoughts on the outlook for select global currencies this year:
U.S. Dollar Nearing a Peak
A strong acceleration in U.S. economic growth — perhaps influenced by the policies of the new U.S. president — could drive the dollar a bit higher, but probably not by more than 5% or so. The dollar is on the last legs of a multiyear bull run, in my opinion, after rising more than 30% since 2011. Calling a peak is always difficult, but it’s obvious that a lot of good news on the U.S. economy is already baked in to the current dollar price. The dollar is overvalued by about 10%, in my estimation, so there are limits to how much further this bull can run. I think the dollar entering a consolidation phase this year would not be surprising.
Euro Recovery on the Horizon
If one accepts the premise that the dollar is expensive, then that means some other currencies are undervalued. The euro has been cheap for several years, in my view, but the stage is set for a recovery. Growth in the euro-area economy is starting to firm up. And inflation is beginning to rise, albeit from very low, deflationary levels. If these trends continue, then the European Central Bank is likely to start reducing its bond-buying program, which should allow the euro to appreciate. However, I think this won’t happen until the second half of 2017, after the French and German elections. Once the political uncertainty declines, the euro will be in a good position to rise.
Pound Sterling Bottoming Out
There is still a high degree of uncertainty surrounding the U.K.’s departure from the European Union, a process that is expected to take two years. The current value of the pound, which is down 15% against the dollar since last summer, already incorporates some “hard Brexit” risks. As long as this uncertainty continues, there isn’t much reason for the pound to move a lot higher, but I also don’t see it falling much more from here. The pound’s valuation is attractive today, but there is little reason to be optimistic until we know how the U.K. will be treated outside the EU.
Yen Remains Undervalued for Now
The yen experienced a true roller-coaster ride in 2016, essentially making a round trip and ending up close to where it started. The yen’s valuation is cheap, but it is trading at such levels due to the Bank of Japan’s very aggressive asset purchase program, combined with yield curve control measures. Given the upward pressure on global interest rates, the risk is that markets will test the central bank’s ability to keep Japanese interest rates low. Any sign that the BOJ’s willingness and ability to keep rates low is fading will quickly trigger a stronger yen.