According to the Chinese calendar, 2020 is the Year of the Rat.
The Rat is the first of all Chinese Zodiac animals. According to one myth, the Jade Emperor decided that the order of the Zodiac would be decided by the order in which the twelve animals arrived to his party. The Rat tricked the Ox into giving him a ride. Then, just as they arrived at the finish line, the Rat jumped down and landed ahead of Ox, becoming first. Some might say that the Chinese economy has been piggy-backing on the US economy for years, and is very close to reaching a jumping off point and taking the lead economically. Let’s see what the rat tells us about how we should manage our risks in his year.
What are the markets indicating?
We’ve looked to see whether there is any historical significance from a market standpoint that will give an indication as to what we can expect this year. In the 4 Years of the Rat for which we have market data, the S&P has rallied in three of them, and the USD has appreciated in three of those years as well (albeit not the same years). Based on this very small sample size, one might conclude that the equity markets have a high probability of remaining buoyant, as does the USD. However, other signals are conflicting.
An inverted yield curve has historically been a very good predictor of an impending recession. As can be seen by chart one below, which shows the 10 year yield minus the 2 year yield for the world’s major economies, fears of a recession grew until the beginning of the third quarter of last year, but then the curves started steepening again. This is a strong indication that the market outlook for global growth has improved over since September of last year.
What about those who run the companies that drive the economy?
Contrast the positive outlook evidenced by the steepening of the yield curves with a recently released report showing that CEOs around the world have grown significantly more concerned about a global slowdown over the past 2 years. In a survey undertaken by PricewaterhouseCoopers, more than half of the 1851 CEOs from 83 countries see the pace of expansion slowing, which is the most since PwC began the annual survey in 2012. This is a 10-fold increase since 2018, and is the highest pessimism figure since 2009.
How about the economists?
The President of the World Economic Forum, which just kicked off in Davos today, stated that the world is “faced with a synchronized slowdown in the global economy
[and is also faced]
with a situation where the ammunition that we have to fight a potential global recession is more limited”. That outlook doesn’t necessarily reflect market pricing in either the yield curve or the levels of the equity markets.
What does the Year of the Rat have in store for the USD?
Based on the concerns above, perhaps the equity markets won’t fare quite as well as current pricing would suggest, but what about the USD? In 2019 the IMF stated that the USD was overvalued by between 6% and 12%, and the dollar is at the same level today as when they made that statement, so there is definitely downside potential. However, under- and over-valuations in currencies can persist for many years before correcting. Those who pay attention to market cycles point out that the USD bull market has lasted longer than any other USD cycle to date, and that it is very likely to come to an end soon as a result.
Many other players in the market believe that the USD remains supported by interest rate differentials with its major trading partners, and that the tariffs which remain in place are USD supportive. In short, there are arguments on both sides of the USD outlook discussion so forecasting direction is quite challenging.
So what does this mean for your currency risk in the Year of the Rat?
Uncertainty abounds, which means that a prudent approach to hedging your risk is protecting the downside whilst allowing for participation in the upside. This is true whether your risk is to a stronger USD or a weaker USD. The best way to put this protection in place is with the use of currency options. Options prices are at near historic lows, but this situation cannot last forever, so adding some optionality to your hedging program is a prudent step to take. Whether you can do so in the current regulatory environment depends on your regulatory status, making this decision even more complicated. Give your risk advisor a call to discuss whether making an adjustment to your current hedging approach makes sense for your specific situation.
Let’s hope that the Year of the Rat is a good one!