Global bonds and currencies
The ugly contest

As the global economic crisis continues to unfold and to broaden, it has been hard to find a currency that can do well. Rather than looking for currencies that will shine, we are forced to judge a 'least ugly' contest.

Global growth collapsed in the fourth quarter and is set to be equally weak in the first half of 2009. The numbers so far reflect that gross domestic product shrank in the fourth quarter at an annual rate of 12.7% in Japan, 8.2% in Germany, 5.9% in the UK and 3.8% in the US. The industrial production numbers highlight the plight of industry, with output down 21% in Japan, 12% in Germany, 10% in the US and 9% in the UK. The macroeconomic rationale for owning the major currencies has not been compelling, and interest-rate support has been equally weak, with short-rate differentials converging towards zero. Three-month rates are 0.28% in Japan, 0.30% in the US, 0.66% in the UK and 0.85% in the eurozone. We are now on planet 'ZIRP' (zero-interest-rate policy) and, as a result, the major currencies have been range-bound since the beginning of the year, with the US dollar coming out on top.

There are some signs that last year's trends are behind us. The relentless appreciation of the yen in 2008 severely damaged the Japanese economy, and Japanese exports have collapsed (the six-month annualised rate is now an astonishing -63.5%) as a result of the strong currency, with the two principal areas of decline being exports to the US and to Eastern Europe/ Russia. The blind rush to repatriate assets has eased and Japanese domestic investors are increasingly selling domestic equities and buying overseas bonds. The lack of leverage in the Japanese economy does lend support in this deleveraging world, but it seems that the currency has been driven too high in the near term.

In the yen, we now have an ugly currency contender and we are looking for less ugly currencies into which to switch. Our attention has turned to looking for survivors in the world of declining global trade. A country that can survive needs to have sufficient fiscal firepower to maintain domestic demand and perhaps to invest for the future. Some further monetary policy flexibility is also a desired area of support for an economy and its currency.

The Norwegian krone is one of our old favourite currencies as Norway's large sovereign wealth fund gives the economy huge support and central bank rates are at a lofty 3.5%. Last year, the krone was vulnerable to the decline in the oil price given that oil is Norway's principal export. Since December, the oil price seems to have found a floor and should at least prove not to be a negative influence in the period ahead. We have increased our exposure to the krone, but we have limited the overall position to a level that still allows us to exit the market easily.

As we scout around for other currencies that have good fiscal/monetary support, the job gets harder. We have also increased our exposure to the Australian dollar on the same grounds as having raised exposure to the Norwegian krone (although the positives are not as compelling). Following the boom years of the commodity cycle, the Australian government is in the enviable position of entering this crisis with a very low debt/GDP ratio, which means that, as the domestic housing market deflates, the authorities are able to raise government borrowing and boost domestic demand. They also have scope to employ monetary policy, with central bank rates at 3.25%.

The tide is turning against the yen owing to the significant damage done to the Japanese economy, and some of the other supposedly safe-haven currencies have their problems too. The Swiss franc can occasionally be undermined by its reliance on the Swiss financial sector, but these concerns may have been priced in and we have switched some of our yen exposure into the relatively safe haven of Swiss francs.

Sterling is showing potential and its decline against the euro in particular has raised some European eyebrows. We have raised the weighting of sterling owing to its relative cheapness; if the UK had a manufacturing base, it might have been able to benefit more from a weak currency. A sustained recovery in sterling relies on a resolution to the UK banking crisis.

That leaves the US dollar, which is still the reserve currency of the world and which does have the advantage of a new administration. So far, the market has been disappointed by the ideas coming from the US administration, but the US dollar has remained one of the strongest currencies so far this year. The budget deficit is expected to grow by 12.3% this year according to Obama's recent big budget proposals, which is a worrying statistic when viewed in isolation. The trade balance is improving and moved from a monthly average of $60bn to less than $40bn during 2008 as the consumer retrenched.

The deleveraging story keeps us out of emerging-market currencies for now as the shift towards domestically focused policies continues. The more that taxpayers are involved in banking, the more domestically focused lending will become. Those currencies of economies with high borrowings in other currencies will remain vulnerable.

A balanced currency allocation is the best approach in this ugly contest. For the time being, the winners will be hard to find and may continue to come from some of the smaller economies that have been more frugal and less leveraged in the past. We are marginally overweight the US dollar and underweight the yen and euro, and we have a spread of holdings in Australian and Canadian dollars, the Norwegian krone and the Swiss franc.