Cover story: Bastions of safety no more?

This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on September 24, 2018 - September 30, 2018.
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It has been a roller-coaster ride for the global financial markets this year. Rising trade tensions, greater geopolitical risks, slowing growth and higher interest rates are all coming together to make it an even more challenging year for investors.

The unravelling Turkish lira crisis saw the currency plunge 17% in August. From January to August, the lira lost 44% of its value, making it the worst performing currency in the world so far this year. This has put financial markets on edge and the contagion is spreading to other emerging-market currencies.

On Aug 31, the Argentine peso tumbled almost 12% while the Indonesian rupiah fell to its lowest since 1998. The Indian rupee has plummeted to a record 71 against the US dollar. Market observers have warned that this could cause a ripple effect across Asian economies, and beyond.

Indeed, there have been warnings of a major financial storm for some time now and investors are getting jittery. Amid this volatility, are traditional safe-haven currencies such as the US dollar, yen, euro and Swiss franc still a refuge for investors?

There is a growing view that there has been a shift in the perception of what constitutes safe-haven currencies as the traditional ones are no longer as compelling. A case in point is  when the Dow Jones Industrial Average and the S&P 500 recorded one of their sharpest dives since 2011 in February, the US dollar did not see the kind of activity that it used to.

Stephen Innes, head of trading for Asia-Pacific at currency solution provider Oanda, is of the view that traditional go-to currencies such as the yen and Swiss franc have lost some of their appeal. “We saw an escalation in regional tensions during the Korean peninsula crisis last year, which was a big deal for investors initially. When the rockets started firing, the markets immediately went to the yen, which traditionally has been a safe haven,” he says.

“They do this simply because of the proximity of Korea to Japan and the fact that there is strength in the yen. It is the typical go-to trade when risk aversion happens. Japanese traders are so prominent internationally that they too want to defend any heightened risk aversion and bring funds back home,” he adds.

“However, what we have seen lately is that this energy has somewhat weakened, in the sense that safe-haven currencies no longer have the same appeal they used to, perhaps because the political tensions occurring right now seem to have a very short shelf life. They can dissolve very quickly. So, when traders start to see risk aversion, they start buying risk-averse assets instead (such as US bonds), and that is supporting the overall markets.

“We have seen many crises over the last few years and traders are taking the view of, ‘Okay, we have seen that before. What’s next?’”

When traders and investors buy into risk aversion, they bypass the need to park their money in safe-haven currencies, says Innes. “Typical safe havens have lost their lustre. Take gold, which used to have a huge safe-haven appeal. But now, investors do not seem to care that much,” he adds.

“This seems to be the case with safe-haven currencies. Investors are quite comfortable parking their money in the US dollar now because of the rising interest rates and US equity markets do not seem to want to stop moving up.”

The Swiss franc — long considered a safe haven currency — has gone through upheavals of its own. In 2015, the Swiss National Bank shocked financial markets when it removed its currency peg to the euro.

The panic reaction to the “Frankenshock” saw the Swiss currency surge 30% against the euro and sent stocks plunging. So far this year, even with the rising trade war tensions, analysts observe that the Swiss franc has weakened against the euro.

Innes points out that currencies such as the Swiss franc, euro and pound sterling are not performing like they did in the past. “While I think the Swiss franc has some safe-haven appeal due to its neutrality in Europe, the appeal has diminished as markets are still suffering due to the fallout from the Swiss National Bank crisis. Confidence has been impacted.”

On the other hand, the euro is vulnerable to political risk after Brexit. The recent turbulence seen by the Turkish lira further undermines the stability of the euro.

It has also been a rocky ride for the pound sterling following the Brexit referendum. “Obviously, Brexit has put the clamp on the pound. I do like the pound, but it is something we have to look at opportunistically. For instance, we saw a massive run on the pound overnight (on Aug 30),” says Innes.

Vasu Menon, OCBC Singapore vice-president and senior investment strategist, says the 2008 global financial crisis eroded the safe-haven status of developed market currencies such as the US dollar, euro and pound sterling. “However, the yen has benefited to some extent because of the erosion of confidence in its peers. No doubt, the Japanese government is heavily indebted, but traders are comfortable as most of its debt is domestically owned. Also, Japan has a sizeable trade surplus, which is supportive of the yen’s safe-haven status,” he adds.

Menon notes that the yen and Swiss franc have behaved like safe-haven currencies, more so than the US dollar in recent years. “This is unlikely to change in the coming years, given the political uncertainty in the US and President Donald Trump’s aggressive tax cuts, which could boost the US budget deficit and even the trade deficit, both of which could weigh on the US dollar’s safe-haven status,” he says.

The US Federal Reserve is the only central bank to have raised interest rates several times in the past two years, Menon points out. Still, the US dollar has lost 8% of its value on a trade-weighted basis since end-2016.

“This was partly because other central banks have signalled their intention to tighten monetary policy down the road. Consequently, monetary policy divergence, which was a factor supporting the greenback’s sharp gain between 2014 and 2016, has given way to monetary policy convergence,” says Menon.

Paul Gambles, co-founder and managing partner of Bangkok-based MBMG group and chief investment officer at MBMG Investment Advisory, concurs that the status of traditional safe-haven currencies has been affected. However, it is a still-evolving development, he adds.

“We believe that for now, the US dollar remains a beneficiary of any flight to safety. This year, we have already seen a feedback loop, where uncertainty has seen flows into the dollar, which has created stresses in the emerging markets because the extra demand for the greenback has created tighter liquidity for the US dollar,” says Gambles.

“This has created even greater uncertainty, especially in the emerging markets. However, the status of the yen, pound sterling, euro and Swiss franc is far less clear. Japan’s broken financial plumbing means that unprecedented moves either way in the yen are likely. The pound has been marked down, probably excessively so, in relation to Brexit.”

He believes that the biggest question mark remains over the euro. “It has effectively become the anti-dollar. But with so many structural cracks in the eurozone widening every day, there is a real risk that the euro’s days are numbered,” he says.

“[If that happens] for the Swiss franc, the question is whether the capital flight to Switzerland will outweigh the contagion from a collapsing Europe. Again, we would see this as a bet that is best avoided and we would respect the high probability of a resurgent greenback in the next crisis.”

MBMG Group provides services ranging from investment advisory and insurance to estate planning and property solutions.

Not everyone agrees that traditional safe havens are no longer effective. Danny Chang, head of managed investments and product management at Standard Chartered Bank Malaysia, is one of them.

“Different safe-haven currencies or assets — such as gold or US government bonds — will outperform during different risk modes. It really depends on the key drivers of that particular currency/asset,” he says.

“The US dollar, euro, pound sterling, yen and renminbi are part of the basket of currencies that form the international reserve assets for the International Monetary Fund’s (IMF) account. The account plays a role in providing extra liquidity or acts to supplement IMF country members’ reserves in the event of a potential financial crisis. These currencies are widely seen as safe havens and further underscore their chosen position in the IMF account.”


Unwinding of carry trades

Marshall Gittler, chief strategist and head of education at application-based foreign-exchange signals provider ACLS Global, argues that currencies such as the yen and Swiss franc remain safe havens, although not for the reasons that people think. “The yen tends to appreciate when Japanese investors get nervous. They have huge investments overseas. So, when they get frightened about overseas conditions — or even about domestic ones — they tend to dial down their risk profile a bit, which means hedging their overseas assets,” he says.

“This causes the yen to appreciate. The phenomenon is well known, so other people tend to jump on the bandwagon in times of stress,” he adds.

“The Swiss franc is also considered a safe haven. Here, too, the ultimate reason is the behaviour of its domestic investors. The country has a huge current account surplus, estimated at around 13% of its gross domestic product, which means it has to recycle that inflow through portfolio investments outside the country. When investors there get nervous about the global outlook, they prefer to keep their money at home. So, the Swiss franc appreciates.”

Gittler says what is perceived as a safe haven may sometimes be just the unwinding of carry trades. “The yen and Swiss franc are currencies with the lowest interest rates historically. So, they are often used as funding currencies for carry trades [people borrow yen or Swiss franc to invest in the Australian dollar, Turkish lira or other high-yield currencies]. When the markets become uncertain, they tend to take some risk off the table by unwinding those trades,” he adds.

“That means these currencies often appreciate during risk-averse periods, not necessarily because they are safe but because they have low interest rates. One proof of why this may be is that safe-haven currencies tend to appreciate much more rapidly during times of risk aversion than they depreciate during times of relative calm. That is, the currencies tend to move asymmetrically — they are much more volatile on the upside than the downside. They respond much more to risk aversion than they do to risk seeking.”

In contrast, the US dollar is usually not a funding currency as its interest rates are not among the lowest in the G10 countries. “That makes it a purer ‘safe haven’ — people buy the US dollar when they are worried about serious, long-term problems. Oddly enough, the currency can appreciate even when the source of those problems is the US economy, like during the 2008 global financial crisis,” says Gittler.

While the Swiss franc and yen certainly are the pre-eminent indicators of short-term risk aversion in the forex market, the problem with both currencies is that their interest rates are abysmally low. “The Bank of Japan is still pegging the 10-year Japanese government bond yields at about 0.1% while Swiss bond yields are negative out to 10 years (10-year yields are -0.09%). In fact, Swiss yields are the lowest in recorded history,” says Gittler.

“That means people have to be really, really scared to invest in these currencies for the longer term. Sure, they are okay for a hedge when the markets get volatile and you want to park your money somewhere temporarily until the event blows over. But I cannot see long-term money moving into investments like these. As a result, I don’t think the US dollar’s position as the safest of the safe havens is in doubt.”

Last year, Bank of America Merrill Lynch said the US dollar had not behaved like a safe-haven currency since 2014 as it showed a tendency to fall rather than rise during periods of uncertainty. “Perhaps, unsurprisingly, this coincided with the end of Fed [quantitative easing] and the emergence of more aggressive easing by the European Central Bank and Bank of Japan,” its strategist Adarsh Sinha was quoted as saying.

Menon points out that monetary policy and the political situation in the US have affected the dollar’s position as a safe haven. “Several credit rating agencies around the world have downgraded their credit rating of the US, including Standard & Poor’s, which reduced its rating from AAA to AA+ on Aug 5, 2011.

“This, coupled with the political upheaval seen in the US over the past few years which resulted in the unexpected victory of Trump, has eroded some confidence. Also, monetary policy divergence — which was a factor supporting the greenback between 2014 and 2016 — has given way to monetary policy convergence, causing the US dollar to lose some of its shine and safe-haven status.”

However, that seems to have changed recently as the US dollar looks set to reclaim its safe-haven status, say experts. Gambles says, as MBMG had expected, the dollar has bounced back strongly since end-February and is clearly the most popular safe haven.

“If anything, it may be too popular and the recent managed depreciation of the renminbi by the People’s Bank of China (PBOC) has perhaps driven the dollar too high too soon. So, in the short term, it may wobble. But in the next crisis, it will be the most certain source of inflows for the reasons outlined above,” he adds.

Innes believes that the US dollar is still the go-to currency because the economic climate in the US is quite favourable. “The uncertainty over the trade war has made the US dollar the main safe haven. But I think this is due to the demand for US dollar-denominated bonds as large funds seek safety under their umbrella,” he says.

However, Innes cautions that this could change if market conditions evolve. “All things being equal, there is a chance that we could see the markets revert back to traditional safe havens. But right now, those are not factoring in the markets,” he says.

“The possible catalysts for this reversion is when you see the relative economy start to pick up in Europe and Japan. Then, the monetary policies will adjust and interest rates will start to go up. When there is more appeal for the currencies, there could be some appeal for them as a safe haven.”


New safe havens in Asia?

There is a view that investors today may have more choice in terms of investing their money in safe-haven assets.

In recent years, China has introduced measures to liberalise and open up its markets. The Bond Connect programme, which began trading in July last year, allows foreigners to buy and sell Mainland China bonds. In July this year, the China Securities Regulatory Commission announced that it would further liberalise the rules for foreign investors to trade the country’s A-shares listed in Shanghai and Shenzhen.

Another key measure was the introduction of the yuan-denominated crude oil futures contracts in March. These contracts, priced in yuan, have earned the moniker “petro-yuan”. At the same time, China is trying to convince its main oil suppliers such as Saudi Arabia and Iran to accept the yuan for their oil.

However, it will be some time before the yuan truly becomes a safe-haven currency, says OCBC’s Menon. “If China frees currency trading, internationalises the yuan and opens up its capital markets, the yuan could pose a threat to the US dollar over the long term.”

Standard Chartered’s Chang believes that the launch of the International Energy Exchange contracts is a step in the right direction, but he doesn’t think the yuan can replace the US dollar in the near term. “For petro-yuan to challenge the petro-dollar, the yuan would have to be freely convertible, and that takes time. For now, the world is still largely dependent on US-dollar financing,” he says.

At some point, the yuan will replace the euro as the anti-dollar, says Gambles. “Later, it will rival the dollar for global reserve currency status. And after that, it will likely become a safe-haven currency. China would like to accelerate the ascent of the yuan [to reserve status], but this will either be a gradual process of many years or possible decades, or it will come suddenly and dramatically if the euro fails.”

The Singapore dollar has drawn safe-haven seekers in the region for many years, due to its high current account surplus, low external debt and stable economy. Analysts note that the “Asian Swiss franc” has risen in times of uncertainty. When North Korea fired a missile in August last year, the currency strengthened and Singapore dollar-denominated bonds saw record inflows.

This level of confidence spilled over to the Singapore Exchange, with the Straits Times Index rising 18.1% last year — its biggest annual gain since 2012. Market experts attribute this to the city state’s strong economic recovery and currency.

“Its current account surplus is 19% of its GDP — the largest in the world (excluding oil-producing countries). That means domestic investors have had to recycle the inflow of foreign exchange by investing abroad, as shown by the large financial account outflow. Furthermore, the strong legal system and famously impartial judicial system [as long as you are not against the government] make it truly a safe haven for much of the capital flight from the region,” says Gambles.


Impact on investors

What does the changing perception of what constitutes safe-haven currencies mean for the financial markets and investment assets?

Stephen Innes, head of trading for Asia-Pacific at currency solution provider Oanda, says it has become more challenging to hedge financial risks with traditional safe havens not reacting the way they once did. “We have seen safe havens perform quite well in the past when risk escalates. But now, it gets to the point where it would only be a knee-jerk reaction and then the problem dissipates. Sometimes investors can get caught in these knee-jerk reactions when they move into these safe havens while traders are sitting at the bottom, waiting to taking advantage of the depressed levels,” he adds.

“Provided that the US economy is going to be robust, the markets are pretty comfortable buying risk at any juncture, even political or a big escalation in tensions in the Middle East or another escalation in the Korean peninsula. If there is a sell-off in the markets, I think investors — knowing that this will probably be part of the global growth in the next few years — are still willing to buy, even in risky markets. I think investors have deeper pockets these days, whereas the Asian economies are nowhere nearly as risky as they were 10 years ago.”

That is why typical riskier currencies still have appeal in the markets when they are wobbly, says Innes. There are no huge sell-offs like before and this translates into less of a need to retreat to safe havens for institutional investors.

“Markets and investors tend not to be panicky now. As the US economy is doing so well, what investors are willing to do is continue adding US dollars when there is risk,” he says.

“Investors are now ready to see the light at the end of the tunnel and actively re-engage local economies again, realising that we are not going to have another Asian financial crisis. The economies are sturdier and the currencies are a lot better.”

He adds that investors are looking for opportunities to re-engage risker assets such as those in emerging markets, like China. “Investors are set to re-engage with the likes of Malaysian stocks and Asian markets. These are so-called riskier markets, but there is still a lot of appetite and anticipation that Asian markets will continue to grow.

“There is going to be wealth creation [in this space]. What is going to happen ultimately is that people will get wealthier. And as they do so, their appetite for more expensive products will grow. This adds to the underlying economic fundamentals [of a country] on the base level. That is why people are maintaining a bullish attitude despite the fact that trade tensions could escalate.”

However, if there is a meltdown in the global equity markets, the flows will go back into traditional safe havens such as the yen because ultimately, that big shake in the markets will still result in investors trying to find a safe hiding place, says Innes. “That is when traditional safe havens will come back to the fore again. Right now, that is not happening,” he adds.

“We are not seeing negativity in the equity markets, especially with the economic policies put together by the Trump administration, like tax breaks for large corporates which, in theory, should bump up corporate profits over the next couple of quarters. So, investors still feel comfortable buying into the US markets.”

Vasu Menon, OCBC Singapore vice-president and senior investment strategist, says volatility returned to the markets this year after a period of unusual complacency last year. This should be supportive of safe-haven currencies such as the yen.

“However, risk and uncertainty are not the only factors that will affect currency values, as we have seen with the yen’s weakness in recent months despite the macro uncertainties. Ultimately, currency markets are driven by a whole host of factors, including the monetary policy direction, the state of the economy, the balance of payments and political stability. Investors should take these factors into account when making investment decisions on currencies,” says Menon.

Paul Gambles, co-founder and managing partner of Bangkok-based MBMG group and chief investment officer at MBMG Investment Advisory, says the direction of the US dollar and the implications this has for emerging-market (EM) liquidity is the single biggest economic and capital market driver in EMs. “In particular, we have seen ‘fragile’ EMs with structural deficits [Turkey, Argentina and Venezuela] really suffer. In the region, the biggest worry remains that Indonesia will join that group,” he adds.

“Regional and global capital and financial markets definitely need a weaker dollar that is right for financing and liquidity, but a stronger one for trade. Obviously, you cannot have both and this perhaps makes the next market correction inevitable.”

Danny Chang, head of managed investments and product management at Standard Chartered Bank Malaysia, says retail investors should stay diversified across different subsets of asset classes that have a higher probability of outperforming, such as emerging-market US dollar-denominated debt, local currency sovereign bonds and Asia ex-Japan equities. “Today, investors can participate in one asset class with a different currency exposure via the mutual fund route,” he adds.

“Traditionally, those investing in Asian equities may be exposed to the currencies of the individual markets such as the Singapore dollar, Hong Kong dollar and Thai baht. With the advent of multi-currency share classes, investors are now able to invest in a basket of Asian equities via a fund that may be denominated in the Australian, US or Singapore dollar, the pound sterling and even the euro for as little as US$1,000 [may vary according to the fund]. These foreign currency share classes are typically offered on a hedge basis, which means investors minimise their foreign-exchange conversion risk.”