Follow the fundamentals: mispricing in currency markets

Sally Rose

By

19/05/2017

Most institutional investors are missing the opportunity to make money from exploiting fundamental mispricing in global currency markets, argues William Blair partner and co-portfolio manager, dynamic asset allocation strategies, Thomas Clarke.

Even big, sophisticated, global pension funds have a tendency to be spooked by the short-term volatility in foreign exchange markets and underestimate the degree to which movements in currency valuations are underpinned by fundamental drivers.

Clarke said there were two main factors to watch to understand whether a currency is trading at a significant premium or discount to its fundamental value: purchasing power parity and real interest rates.

“There’s a lot of talk at the moment about the challenges of investing in an uncertain world, but uncertainty is actually normal,” he said. “Sure, there are lots of things going on that have never happened before – like central banks figuring out how to unwind quantitative easing – but what influences currencies and exchange rates over the long term is not new, and over the long term it’s not that uncertain either.”

Clarke was speaking at the Investment Magazine Fiduciary Investors Symposium, held in the Blue Mountains, NSW, May 15-17, 2017. He said currencies “get bad press” as an asset class because there is much focus on short-term drivers of volatility.

“But there are fundamental drivers of long-term value…In real terms, currencies have a stable real value that they revert to,” he said. “There are big swings and these sometimes do last a few years, but the same is true of equities and bonds. Over the medium-term, currencies correct.”

In fact, Clarke said, currency markets tend to revert to fundamental value more quickly than other major asset classes.

“Currencies might have big spikes or lows but they do typically revert back to their fundamental value within three to five years; whereas, equity and bond markets typically take about five to seven years. That shorter time horizon means you get paid quicker.”

The two currencies Clarke thinks offer the best value for investors at the moment, because they are trading so far below their fundamental value, are the Mexican Peso and the Philippine Peso.

The two currencies he thinks offer the worst value to investors at the moment, because they are trading so far above their fundamental value, are the Swiss Franc and the New Zealand Dollar.