Saturday 16 December 2017

Paul Somerville: Huge currency moves causing havoc with equity prices and returns

A trader wears a Dow 22,000 points hat on the floor at the closing bell of the Dow Jones Industrial Average at the New York Stock Exchange Photo: AFP/Getty
A trader wears a Dow 22,000 points hat on the floor at the closing bell of the Dow Jones Industrial Average at the New York Stock Exchange Photo: AFP/Getty

Paul Somerville

Foreign exchange (FX) moves are having a material effect on equity prices and real returns for equity investors across the globe. This week the euro hit a nearly three year high versus the dollar , near €1.19. It is up 14pc in 2017. The dollar is hitting a 31-month low against a basket of currencies - the dollar is on the floor.

Irish investors positioned in the US shares indices may be enjoying the equity rally to all-time highs as the Dow Jones topped 22,000 for the first time ever last week. But while you may feel better no money has been made in real euro terms if invested here in 2017. The move in the euro has wiped out all gains and more of the US index fund, in euro terms. If you bought the Dow or S+P 500 index at the start of 2017 and decide now is a good time to "take profit" after the rise you will find that you have actually lost money in real terms. Currency moves have more than wiped out your gains.

Conversely while equity markets have been performing well in general, EU equity indices have recently been performing poorly due to the strength of the euro. The German DAX in particular has been suffering. Performing well earlier in the year, it has fallen 900 points from its highs as the currency increasingly has an effect. Its returns in percentage terms are much lower than the USA indices but in real terms Irish investors were still better off holding EU equities in first half of 2017.

So what is next?

A column penned for this paper earlier this year entitled "Believing the consensus on the strong dollar may be costly" made a highly contrarian call which proved to be extremely accurate. At that time you could not find an FX analyst who did not think the dollar was set to soar and the euro plummet. The exact opposite occurred. Now the analyst community has turned full circle .The consensus has moved from "hating" the euro to embracing it. If you have been unfortunate enough to watch financial TV this week you would have seen analyst after analyst troop on to explain why the dollar is now set to plummet and the euro soar. Not much use after the 14pc move has occurred. We would respectfully disagree again with this current consensus view. Our suggestion is the bulk of the euro vs dollar move higher is done for the moment and there is a very large chance of some retracement.

Just as the start of the year proved a great time to be selling dollars totally against consensus, we would suggest this is a very good opportunity to buy dollars. Your friendly FX bank analyst is not there to help you; he is there to help the bank.

Any correction in euro strength we would expect also to have a material effect on equity investments. If the euro is to retrace somewhat we would expect EU equity indices to outperform the global benchmarks in the second half of 2017. They have outperformed in real terms in first half of 2017 they may outperform in percentage terms also in the second half. Those investors interested in chasing the global share rally higher may be better staying with EU equities and hope for a tailwind from FX markets also.

Snapchat does a 'Britvic'

The shares of Snap Inc the US technology and social media company and owner of Snapchat performed a "Britvic55" this week. That is they have fallen 55pc from their all-time highs. This is some achievement for a company that only listed on the stock exchange in March. It shows just how overhyped this company was. We referred to it at the time as similar to the "cabbage patch doll" frenzy of 1983 and warned against investing - the valuation was simply ridiculous. It was pushed and promoted the by US financial media which lured someretail investors to get involved and unfortunately for them they did .

Morgan Stanley, the lead underwriter on the IPO, has now slashed its price target from $28 to $16. It is hilarious they could have such a different view of the stock just five months after its listing and shows exactly how Wall street works. In fact many analysts have done the same, hyping up the stock for business then cutting price targets as they realised the stock was hopelessly overvalued. Many price targets are now where the stock is trading and some are lower. The stock has few friends. This week the lock-up period for employees to sell their shares expired meaning a fresh wave of selling. Unfortunately for them they are selling at $13 not $29.

Also there is a massive "short interest" in the stock. This means there are a huge amount of bets outstanding that the share price will go lower. Whatever you may think of the valuation and fundamentals of the company, investors should be aware that when there is a huge amount of people/hedge funds betting against a company the share price can do strange things. A staggering 28pc of shares are 'short'. With so much bad news in the stock we would suggest the stock price is more likely to rally than fall further in the short term. Any positive news is likely to see a massive bounce as those 'short' are forced to close positions. In summary if you are a very high risk investor (and have no potential heart conditions) buying share of Snap here may look in hindsight like a very good entry point. Obviously it is a very high risk bet.

Choose debt, choose ECB 'heroin'

I am lucky to be old enough to remember the debt crisis of 2008. It seems many others are not.

It may be a surprise to some that it was caused by a tsunami of debt. Central bankers seem to have forgotten. While the Fed has been raising rates and contemplating navigating a path to lower its colossal balance sheet (which they will never be able to do), the ECB and other central banks have been on a roll. Central banks have bought a record $1.5trn worth of assets in 2017 thus far. That means central banks are now injecting a record $300bn of liquidity per month. The actions of central banks are now having an enormous distorting effect on every asset class and every economy around the world. Stock markets are soaring and consumer confidence and other sentiment indicators are hitting unprecedented levels. Politicians are claiming credit for improving conditions as if they have something to do with it. Consumers are feeling more cheerful and could not care less why.

It is extraordinary that a very small group of unelected individuals (mostly emanating from one or two very similar financial institutions) are carrying out the biggest financial experiment in global history and nobody questions their methods or ultimate goals.

The ECB balance sheet hit a fresh record of €4,200bn this week .This equates to almost 40pc of Eurozone GDP. History, I fear, will wonder why nobody even stopped to ask why. As Mark 'Rent-boy' Renton sums up in the movie Trainspotting: "And the reason? There are no reasons. Who needs reasons when you've got heroin?"

Paul Sommerville is ceo of Sommerville Advisory Markets.

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