Which currencies should you be buying now?

Spending a bit of time looking at your portfolio’s currency exposure could be very profitable, says John Stepek. Here, he looks at the best way to invest in currencies.

You probably don't spend much time thinking about foreign exchange movements. After all, as long as you are earning money in the same currency that you pay the bills, why worry? But spending a bit of time looking at your portfolio's currency exposure could be very profitable.

To get an idea of the kind of impact currency movements can have on your wealth, let's look at a subject close to everyone's heart: UK house prices. According to Halifax, from the August 2007 peak, prices have fallen by 18% from £199,612 back then to £163,803 now. That's nasty, but it's not the pile-up many of us were expecting.

But this hides the fact that the pound is far weaker now than it was then. Measured in euros, British house prices are down by around 31%. In US dollars, it's 34%. In Japanese yen, British house prices have more than halved, falling by about 54%.

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We're not saying you should take up currency speculation. And you certainly shouldn't take out a foreign-currency mortgage. But it does show why it can be worth getting exposure to more than just sterling assets when you're saving for your future. So where should you be raising your exposure and which currencies should you be avoiding?

Europe's endgame

Let's start with the region uppermost in most investors' minds right now: Europe. For the third year running, we're hearing about a crisis in the eurozone. Much of the region is now mired in recession and the problem isn't going away it's spreading. Even in Germany's mighty manufacturing sector, conditions are the worst they've been in nearly three years, according to the most recent survey data.

The European Central Bank's (ECB) decision to lend money to troubled regional banks to buy their own governments' bonds through its Long-Term Refinancing Operations (LTRO) triggered a bout of optimism during the first quarter. But this has worn off, as it became clear that the LTRO was yet another temporary fix, and not a forerunner to full-blown quantitative easing (QE).

MoneyWeek videosWhat is the LTRO?Tim Bennett explains how Europe's 'long term refinancing operation' (LTRO) is supposed to work.Watch all of Tim's videos here

The big mystery has been the strength of the euro during this time. In 2010, the euro fell to below 1.20 to the US dollar. But since recovering from that panic, it has largely fluctuated around the 1.30 mark. There are two main reasons for this.

First, unlike the world's other major central banks, the ECB hasn't embarked on full-blown money-printing. Indeed, the key eurozone interest rate remains at 1%, compared to 0.5% for Britain and America.

Second, troubled European banks have been attempting to shrink their balance sheets by calling in loans from overseas where they can and repatriating the money into the eurozone. This increases demand for euros, though not for any positive reason.

However, the euro's remarkable sticking power might be close to exhausted. Currently, Spain is the focus of most investors' concerns, but bond yields in Italy are rising too. With elections in France and Greece imminent, the scope for political upsets is significant. Policymakers have been left bickering over growth' versus austerity'.

You could read reams of pompous economic commentary on this topic until it was coming out of your ears. But to save you the bother, it boils down to this: either Germany agrees to bail out its more troubled neighbours at the risk of fuelling inflation in its own country, or we see more defaults in the eurozone.

Option one would probably involve money-printing by the ECB. Option two would likely involve a eurozone-wide banking crisis, and one or more countries leaving the euro. You can see why, when push comes to shove, the path of least resistance could eventually be for Germany to agree to money-printing, particularly as its own economy runs into trouble. It may well take a while to get to that point, and it's by no means a foregone conclusion. But we can expect a lot of scares in the meantime, and if this does all end in ECB money-printing, the euro's long phase of gravity-defying will finally be over.

Given the euro is the world's most important international currency behind the dollar, turmoil in the region has an impact on currency flows in other parts of the world. As worried Europeans swap their euros for other currencies and real' assets, the Swiss central bank has already felt forced to act to prevent its currency from strengthening further. It has said it won't allow the euro to weaken beyond SFr1.20, and so far it's done a good job of defending that peg.

Safe-haven sterling?

This has left the pound in the odd position of being a safe haven' for capital fleeing the eurozone. As a result, sterling has reached its highest levels this year against both the euro and the dollar. So can British investors expect to get a lot more for their money overseas this year?

That depends. We suspect the pound could well see further gains against the euro. However, it could be less resilient against the US dollar, for example. For one thing, Britain's economy continues to struggle. We apparently slipped back into recession during the first quarter of the year, and a recession in Europe is hardly going to be good news for us it's one of our biggest markets, after all.

Also, sterling's recent perkiness has come about in part because the Bank of England worried by just how persistent British inflation is seems to have pulled back a little from the idea of doing more QE. One of the Monetary Policy Committee's biggest advocates of more QE, Adam Posen, stopped pressing the case for extra money-printing at the most recent rate-setting meeting, surprising markets.

There's no guarantee this will continue, particularly if the economic data don't improve. So while we're in no great rush to dump sterling (as was the case before the crash when it was trading at $2 to the pound), we don't think it's going to be the strongest currency either.

Avoid Australia

Of course, the slump in Europe has a much wider knock-on impact beyond Britain's shores. Europe's ongoing stagnation has been bad news for China the European Union is China's biggest customer. That means that even if it wanted to, China can't go back to its old growth model of exporting cheap goods to Western consumers. So it's left with a plan to become a more consumer-oriented economy.

But encouraging a consumer boom at a time when the property market (which is where a lot of Chinese consumers put their savings) is collapsing will be hard if not impossible. That suggests, as we've regularly noted, that the Chinese currency the yuan/renminbi isn't a one-way bet by any means.

But you don't need to worry about exactly how hard a landing China will suffer to realise one thing: the country's rampant demand for commodities has to slow down, and that in turn is bound to be bad news for one very specific Western economy Australia.

As Dylan Grice put it in a recent note, Australia is "a credit bubble built on a commodity bull market built on a much bigger Chinese credit bubble". As if to emphasise the point, Australian mining tycoon Clive Palmer declared this week that he plans to build and launch a replica of the Titanic. Publicity stunt or not, it's still a classic top of the market' story.

Signs of trouble have been building for some time in the Australian economy. As well as being heavily reliant on exporting raw materials to China, Australia has also suffered a rampant housing bubble, which is already in the process of bursting prices have in fact been in decline for five quarters in a row, and are now down 6.1% from the peak. New sales are at an 18-year low. Given that, as Anthony Doyle of M&G points out, one in seven Australians owns an investment property, more than 60% of whom reported a taxable loss in the 2009-2010 tax year, this does not bode well for the health of the Australian consumer.

The Reserve Bank of Australia is trying to bolster the economy. It's one of the few central banks with any room to cut interest rates. It cut its key lending rate in both November and December, and then this week slashed it by half a percentage point to 3.75%. The move was larger than markets had expected, and so sent the Australian dollar lower. But at around US$1.03 compared to an all-time record of just over US$1.10, the Aussie is still high by historical standards. The threat of further rate cuts can only hit the currency harder, as falling yields will diminish the appeal of Australian government bonds to foreign buyers. That's a potentially serious problem foreigners hold more than 80% of outstanding Australian government debt.

Australia is not the only commodity currency'. However, it seems to us that it's the most vulnerable. Canada has a housing bubble too, and as such, we wouldn't be desperately keen on its currency either but on the upside, its main export market is America, which looks a lot healthier than China does.

King dollar

So what's the outlook for the US currency? The dollar has had a fairly mediocre start to 2012 on a trade-weighted basis, the currency is a little lower than it was at the start of January. And there are plenty of reasons to be wary. Politically speaking, the country is paralysed, with Republicans and Democrats pursuing their own bad-tempered mini-version of the eurozone debate over austerity versus growth.

The housing market remains fragile, and although we would argue that it has probably now bottomed, that doesn't mean it will rebound to full health in the near future. Like most other Western countries, the US has a huge national debt, and the need to deal with unaffordable healthcare and retirement promises.

But the US currency has a number of other things going for it in the longer term. As James Ferguson wrote in a recent issue, one of the biggest is shale oil and gas. This would help the US to cut energy prices, reduce its oil imports, and become more attractive as a location for manufacturers.Even the largely bearish Sean Corrigan of Diapason notes that, in large part due to shale, "it does appear that the States is the least sick of all the major countries at the moment".

As for the threat of further QE, much as Federal Reserve chief Ben Bernanke might like to print more money, he'll need more of an excuse to do it. Indeed, while the official line from the Fed is that US interest rates will remain on hold until late 2014 at least, some members think that rates could rise as soon as next year.

Share prices which Bernanke has picked out as being one of the key targets of QE are hovering around a four-year high. With this being an election year, a move to loosen monetary policy at key points in the campaigning is very politically loaded.

Even if the economy weakens and the Fed restarts the presses, it may not affect the dollar much beyond the short term. Currencies are a relative game. If America slows again, that's bad news for the rest of us too. It would be very surprising to see QE3 in America and for nothing to follow in Britain, for example. In all, we still think the dollar is worth having exposure to. We look at how to get that below.

The best ways to bag a currency

If you are interested in betting on currencies directly, then the easiest way to do it is via spread betting. Do bear in mind that spread betting is extremely risky. You are using leverage, which means that you can lose far more than your initial stake if a position moves against you indeed your losses are theoretically unlimited.

Foreign-exchange markets also move much faster than investors who are more accustomed to stockmarkets may be used to. So if you decide to go ahead, make sure you use stop-losses, and have a good understanding of how the market works before you do so. You can sign up for our free MoneyWeek Trader email to get a better idea of how spread betting works, and how to minimise your losses and run your profits.

If you don't like the idea of using leverage, you could use an exchange-traded product (ETP) instead. We've mentioned the Short Australian Dollar Long US Dollar fund (LSE: SAUP) in the past. It won't perfectly track the spot price performance of the Aussie against the US dollar the index it tracks is based on futures instead but it gives a reasonable approximation.

The biggest potential problem for British investors is that the product is US-dollar-based. This means you also have exposure to the pound/dollar exchange rate. So if the pound strengthens against the US dollar by more than the Aussie falls against the dollar, it could end up cancelling out or reversing any gains in the ETP. We're more bullish on the US dollar than the pound, so this doesn't necessarily mean you should avoid the ETP, but it's something to be aware of.

One currency we haven't mentioned above is the Japanese yen. Like the Australian dollar, the yen is very strong in historic terms, at a near-record high against the US dollar. Unlike Australia, Japanese interest rates are as low as they can go.

Under political pressure, the Bank of Japan (BoJ) has recently come out and said it is aiming for a 1% inflation rate, by expanding the amount of QE it does, and weakening the yen. A weaker currency would be great news for Japanese stocks, which already look cheap. The trouble is, Japan has been in the doldrums for so long, that markets have no faith that the BoJ can actually weaken the yen.

So what should you do? Well, this is why we suggest that you don't hedge your yen exposure when you buy into Japan. If the yen does weaken significantly, we'd expect the gains in the market to offset your exchange-rate losses. And if the BoJ fails to spark inflation, and the yen stays strong, then it'll offset any losses in the stockmarket. Investment trusts we like include the JP Morgan Japanese Trust (LSE: JFJ), currently trading on a discount of around 11%.

As for the dollar, many of the FTSE 100 blue chips we've recommended in the past, such as BAE Systems (LSE: BA), offerdollar exposure through their global sales revenues. As far as the American stockmarket goes, it looks expensive in cyclically adjusted p/e terms, so we'd be more inclined to wait for a Europe-inspired correction before buying in.

However, if you're looking for more direct exposure to both the dollar and to the big energy story of the day, one option for the more adventurous investor is to look at stocks in the natural gas sector. One promising-looking option is Encana (NYSE: ECA), which pays a dividend of around 3.8%.

Finally, save a corner of your portfolio (say 10%) for gold. If the global economy recovers, the gold price may well fall, but the gains in the rest of your portfolio should offset that. And in a less optimistic scenario, you'll be glad you held it.

The era of money-printing is by no means over, and gold remains the best insurance at a time when almost all fiat currencies are being manipulated to a greater or lesser extent by their issuing central banks and governments.

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.