On the Money with Dynamic Funds

PARTICIPANTS

Eric Souders
Portfolio Manager and Director, Payden & Rygel Investment Management

Lloyd Perruzza
Head of National Accounts

Speaker: You're listening to On the Money with Dynamic Funds. From market insights and analysis to personal finance, investing, and beyond, On the Money covers it all, because when it comes to your money, we're on it.

Lloyd Perruzza: Welcome to another edition of On the Money. I'm your host, Lloyd Perruzza, Head of National Accounts, VP Managed Assets and Fixed Income Strategy for Dynamic Funds. As we've all witnessed the dramatic rise in interest rates since February 2022, we are now watching significant changes present themselves in global currencies in 2024. Whether you have an investment exposed to foreign currencies, a vacation property in another country, or possibly a student you are supporting that is studying abroad, we are seeing seismic shifts unfold in currencies around the world.

Your exposure may even be impacted day to day in more practical ways, be it imported food and refined fuels from the US, cars from Japan, or electronics from China. As a small, export-driven economy, currency values likely matter way more to Canadians than our neighbors to the south. In this regard, we couldn't be more fortunate here at Dynamic Funds to have one such southern neighbor joining us today, who can help us sort out where currencies are and where they might be going.

Specifically, I'm joined today by Eric Souders, a Portfolio Manager and Director at Payden & Rygel, which is one of the world's most storied and prestigious global bond managers. For decades, they have very successfully managed global bonds and currency exposure for some of the most discerning organizations like the NFL, Apple, Facebook, Disney, and many more.

For context, they currently manage over $160 billion in US dollars, not loonies. Eric, in particular, manages our top-performing Dynamic Global Fixed Income Fund, and he has well over a decade of successfully managing money in this space, which gives us the perfect guest to help us unpack the world of global currencies. Welcome, Eric.

Eric Souders: Thank you, Lloyd. Looking forward to it.

Lloyd: We really appreciate you taking the time with us. Let's have at it. As we have a diverse audience of investors and advisors, let's just quickly start a ground zero for everyone by providing an understanding of why currency exposure is important to investors like you.

Eric: I think that as it pertains to currencies, we think of three things, which is the market scope, return profile, and then risk management. Those three buckets, we think, are very critical when considering currency management within an investment context.

Market scope. Currencies are actually the largest and most liquid market in the world, so systematically extremely important from a global standpoint. From a returns perspective, I think a couple of things very interesting here. Currency returns, they can show a very high level of volatility. In some circumstances, that volatility can actually dominate your return from a traditional fixed-income perspective.

For example, over the last 15 years, the volatility of total returns on a global aggregate bond universe, measured in Canadian dollar terms, and fully exposed to the currency risk of that global benchmark, was twice as volatile as the total return on that same bond universe fully hedged. Currency volatility can be significantly impactful with respect to just returns.

The second thing, I think, in terms of that returns bucket, Lloyd, is being exposed to a currency doesn't necessarily mean you have incremental risk in a global bond portfolio. What I mean by that in particular is, depending upon the base currency of the investor, currency exposures can actually act as a diversifier and reduce your overall risk. I think, from a return standpoint, it's just understanding that currencies can be quite volatile, particularly if they're unhedged, but certain currencies can actually provide a source of diversification within a total return context, which I think we'll begin to unpack as we make our way around the globe a bit later.

The final category I mentioned was risk management. Understanding currency, how do they interact with bonds and managing exposures is critical to managing a multi-currency bond portfolio. The main tool is to hedge currency risk back to the base currency. When we think about managing portfolios, our primary course of action is to bring any currency risk back to that base currency just to reduce unwarranted volatility. Again, I think, finally, currency from a risk management standpoint, it can actually reduce your overall volatility depending upon how you use it within a portfolio over long periods of time.

Lloyd: It's clearly important for your firm's outperformance to get the global currency right. How do you evaluate the prospect of a currency?

Eric: Multifaceted, similar to how we would evaluate credit markets or interest rate markets. You're thinking about a variety of different things when evaluating a specific currency. I think, for us, we're always going to have a macroeconomic, fundamentally driven view and approach. That's at the heart of what we do. It's not a quantitative model, it is going to be fundamentally driven.

Thinking about things like developed markets versus emerging markets, what sorts of differentials are occurring in those different categories? Is it a short-term opportunity that we're looking for in the currency market or is it something longer-term and more strategic? When evaluating a currency more specifically, I think, the first thing we look at is the fundamentals of the currency. What's driving the currency's performance? Is it interest rate differentials? Is it risk appetite? Is it the commodity complex? Is it geopolitics?

There's a lot of different variables that can obviously influence a particular currency. When we've established a baseline regarding what regime we're in, we can then better evaluate the factors that we consider and how those factors will drive currency performance going forward, such as economic trajectory, central bank outlook, fair value, et cetera, et cetera.

Maybe just to contextualize, Lloyd, I think an example today, we think that the regime that we're in is one that's more growth-orientated in nature. Particularly in developed markets where growth divergence is clearly building, especially thinking about countries like the US where, both realized growth has been very solid. I think the prospects for growth, going forward, remains elevated versus other DM countries.

This current growth regime that we're in, it differs materially relative to where we were in the post-2022 regime, which was more inflationary in nature. Then it was more inflation divergence. It was more pronounced between EM and DM. Those are the building blocks of our process.

Lloyd: Now that we have a good beat on how you evaluate a currency's prospects, let's light this candle and dive right into your firm's thoughts on the prospects for the king of all currencies, the US dollar, especially in relation to the Canadian dollar. Specifically, I think it's understanding your near, mid, and long-term expectations will be most helpful and why you think the way you think.

Eric: You hit on something really important, which I think is timeframe. I mentioned that in part of the process discussion, short-term, medium-term, long-term. The prospects for currencies can be very, very different across those timeframes. I think, for the US dollar, our view, at this point, it's hard to be bearish on the US dollar. Something we talk about is the US dollar smile. We think that US dollar smile is very valid in the current regime.

Just a reminder what the US dollar smile is, it's really an idea framed around the notion that the US dollar can perform well versus other currencies in two very, very different scenarios. One of those scenarios would be a risk-off environment, where the US dollar tends to be a safe haven. The other scenario would be when there's good prospects for growth, particularly in the US. That's both sides of the smile. One side is when the US is performing better from a growth standpoint. The other side of the smile is when there's risk-off in markets.

We obviously don't think we're in a risk-off environment right now. We think we're more in a US exceptionalism growth divergence market, so at the left-hand portion of that smile. We think it's hard to be bearish on the dollar. The rest of the world, especially in developed markets, the reality is it's just struggling to generate good real GDP growth in a world of higher rates and reasonably elevated inflation.

The US dollar and the US economy has outperformed peers, which has, again, driven that US exceptionalism narrative. I think that, equally, to the extent that, central bank policy ends up being too restrictive, there is some sort of credit event, there is some sort of economic downturn, the US dollar probably acts as a bit of a safe haven.

One thing that we're thinking about, you talked about longer term. The US economy is now a net exporter of energy, and so much less vulnerable today to commodity shocks relative to the past. I think, in summary, in the short term, US exceptionalism, US growth divergence is the name of the game. In the medium term, it's hard to see the US dollar sell-off sustainably, versus peers like the Bank of Canada, which probably should be cutting, and we think will likely cut before the US.

Long-term, you've got, again, structural things like the US being a net exporter of energy, and then clearly, you've got the US election coming up later in the year. That is a bit of a wild card. For now, even though we're biased, we are based in the US in Payden & Rygel, we think it's hard to make the case against the dollar.

Lloyd: That's extremely helpful, Eric. Sticking with North America now, and a bit of a selfish question, my father is spending a lot of time in Mexico these days, and I keep getting asked about the peso. Also in the news, we're seeing, as an example, that Mexico just passed China in trade with the United States. I'm curious what your thought is on the peso.

Eric: Yes, Mexico is indeed now the top exporter of goods to the US. That number is around $475 billion. I think, interestingly, that number is up 5% versus 2022, when compared to China, which is now the second largest exporter of goods to the US. That number is at $427 billion, which is down 20% from 2022. A pretty big differential in terms of trajectory between Mexico becoming more of an important partner, China less important.

For what it's worth, Lloyd, Canada is in third place there, so Canada also a very important exporter to the US. I think, Mexico, just to make a comment there, just structurally, they've gone from being a major exporter of oil and energy to a major auto exporter over the last few years, especially to the US, alongside other areas like computers, for example. I'd say, interestingly, Mexico is also the second largest importer of goods from the US, so a really important trade partner in both directions. Just slightly below Canada, and then well ahead of China.

Just to make a China comment, I know we'll probably unpack it a little bit more later, but I think it's relevant here. Although exports are down dramatically to the US, I mentioned 20% decline over the last 12 or so months, the US still remains, by far, the largest trading partner with China, and China has actually increased its global trade footprint. Despite doing 20% less business with the US, China's net exports globally have actually gone up, and that's largely because of the tremendous push out of China in the electric vehicle space, and then also just green-orientated goods.

China's made a big, big push on the green energy side over the last several years. I think the peso, specifically, it's a really high-carry currency. What do we mean by high carry? It just means that interest rates there are elevated relative to the prevailing level of inflation. In Mexico, their policy rate is 11%, their inflation rate is running around 5%. You have pretty high, elevated, what we call real interest rates in Mexico, and growth there has been very durable, and actually a bit surprising, I think, to the upside over a number of quarters.

Maybe that shouldn't be so surprising, given, again, Mexico's connectivity to the US, and the fact that US growth has remained very, very resilient. Growth prospects in Mexico are good. Now with all that said, from a valuation standpoint, the Mexican peso, we think, is a bit overvalued. We feel like it's one of those currencies in EM where you should probably be a little bit cautious at this point, just given the optimism priced into that particular currency.

It's hard to make the case against the peso medium to longer term. Again, I think this just ties back into time frames. Short-term, we're less constructive on the peso, but medium to long term, as that relationship with the US strengthens, we think the peso looks attractive.

Lloyd: Hopefully, vacations do become a little bit more affordable, but in the interim, probably just jump across the pond, if that's okay, Eric. I'd be curious to hear your thoughts around the euro. Obviously, there's been a great deal of activity on the continent since the invasion of the Ukraine. Whatever you can share with us there would be appreciated.

Eric: Sure. That's an area where, unfortunately, for Europe, obviously, a lot of headwinds. You named a couple of them; sovereign debt crisis there, Brexit, a lot of these structural things that they've had to deal with really over the last 5 to 10 years. I think, given Germany was in a recession last year, Russia-Ukraine conflict that continues, there doesn't seem to be a real end in sight, then now you've got Middle Eastern tensions, those have obviously risen.

Europe's a pretty big importer of energy, so that's problematic for them. I think the Chinese recovery that has been pretty disappointing, that's pretty key for Europe, because Europe is a really big exporter to China. I think you just have several ingredients, so to speak, coming together that are working against Europe from a growth standpoint. Now, with all that said, the euro has been surprisingly resilient. In fact, year to date, it's been trading in like a 5% range versus the dollar.

We haven't seen significant depreciation in the euro, given some of these growth headwinds. For us, what does that mean? It suggests that we think a lot of pessimism is priced in to the European market, specifically the currency. Recent data on more of a real-time basis, actually suggests things are getting a little bit better in Europe. PMIs have improved, growth seems to be. There seems to be some growth impulse. That could be supportive for the euro near term. That's near term. We think a lot of pessimism, growth looks pretty good near term, the euro should probably do okay versus the dollar and other developed currencies in the near term.

Medium term, we still struggle to see how the euro really rallies materially from here without some of these big external factors that you mentioned, Lloyd, that I've mentioned as well. These factors need to improve; Russia-Ukraine, China's economic outlook, and I think just better political and policy unification on the continent to the extent that that's feasible. In the end, I think the overall bias would be to sell any near-term strength in the euro and be more cautious medium to long term, just given some of those structural headwinds.

Lloyd: Now that we've got the euro covered, Eric, I'd be curious to hear your quick thoughts on the British pound.

Eric: Sure. I think that the British pound has several elements that are similar to what we've talked about with respect to the euro. Structural challenges, things that the UK collectively have gone through the last 5 to 10 years, a sovereign debt crisis, Brexit, et cetera. That's not to speak of, I think, the LDI crisis that they had to endure over the last few years as well.

Similar to the euro, a lot of negativity, Lloyd, is priced into the pound. It's remained in a really tight trading range so far this year. The UK is coming out of recession. I think that near-term, you have a setup where growth prospects are looking a little bit better. A lot of negativity is priced in. The pound probably looks okay near term. Longer term, we think the path for the sterling is weaker. Fundamentals are not great. Productivity growth has been pretty low. You've just got limited fiscal headroom, given the political environment there. I think that the pound looks fine near term, and it's going to have some challenges over the medium to longer term.

Lloyd: In the interest of time, why don't we work our way around and take a look at the Far East, and get your short takes, given you already gave us your thoughts on China, on the yuan?

Eric: Yes, sure. I think that the short take is that the yuan is at the weakest level that it's been since the authorities got rid of their currency pegs in 2010. I think the starting point there is really relevant. We've seen very low inflation and even deflation in China for the last four years. The authorities should be cutting rates there. They haven't. They obviously are trying to defend the currency. They're trying to defend the banking system there.

We are beginning to see a bit of a cyclical upturn. We've got high interest rates, high real interest rates in China. We've also seen a pretty positive real GDP growth. I think that, for us, China, in the near term, actually presents a pretty interesting opportunity. There's a lot of short interest in the currency. Inflation is quite low and growth looks pretty solid. We like the yuan in the short term. Then longer term, I just think that the growth that we've talked about with respect to China, the relevance it plays with respect to global trade makes the yuan look attractive long term as well.

Lloyd: Probably the next economy we'd want to take a look at would be Japan. We have not seen this interest in activity in the yen in, it seems like, 30 years. What are your thoughts around that?

Eric: Yes, Japan has been pretty sleepy across the board for 30 years; inflation, growth, the equity market. I think, authorities, Lloyd, are stuck between a bit of a rock and a hard place. You've got a weak currency, but they're unwilling to let government bond yields move higher than anything but really a snail's pace. They've been intervening in the rates and even FX market to protect FX weakening and then rates moving higher.

Ultimately, I think that the yen, it'll struggle to perform until the Bank of Japan accelerates the rates normalization process, or we get a large rally in global rates. It's really, one of two things need to happen. We do think there's good reason for the Bank of Japan to normalize rates at a faster pace as the 2% inflation target, it's far more sustainable than any point over the last 30 years.

Wage inflation is at 30-year highs. Current intervention, it can be successful squeezing out speculative short positions. We've seen a bit of that. Interest rate differentials between Japan and the US, for example, they're so substantial that really the Bank of Japan, again, they're in a really difficult position where either rates need to rise, or the currency needs to continue devaluing.

For us, what that's meant is being a bit on the sidelines in terms of getting involved in the currency. I think this speaks back to the process. If you don't have a great handle on what policy intervention might look like and you're in unprecedented territory, especially as it pertains to a currency, sometimes waiting and seeing is the best approach, versus trying to make any sort of decision in that particular area.

For us, the interest rate market looks more compelling. We think rates need to go higher. The currency probably needs to weaken, but it's a situation that's a bit tricky just given the intervention that is in front of us from the Bank of Japan.

Lloyd: Before we were to step away from all these individual currencies, I'd be curious to hear if there's anything we missed, because I think we've hit on all the majors. Anything you think we should share with the audience as we close out our tour of global currencies?

Eric: Other parts of the emerging market complex, we think, look pretty interesting. Emerging markets is a large area. There's over 80 countries in the emerging-market universe. I think that the word emerging today means something different than it meant 30 years ago. A lot of these economies are far less emerging. Obviously, China is one we've talked about. Mexico is one we've talked about. Brazil is another one. I think Colombia is another one. Other parts of Eastern Asia, pretty developed economies.

When we think about currency performance, emerging markets for us is a pretty interesting opportunity set, especially as these economies become more developed in nature. I think you could make the case that some of the developed economies are looking more emerging market in nature. The UK, for example, has had significant difficulty containing inflation. They've got fiscal problems and limitations there. They've got a lot of external dependencies. I think that's just something for the audience to think about is just the idea of developed versus emerging markets. Those words developed and emerging, to us, they mean different things today relative to what they may have meant 30 years ago. We're looking for some, I think, interesting opportunities in the emerging-market space.

Lloyd: I appreciate that. Thank you so much, Eric. As we're running close on the clock here, probably good just to get your closing thoughts, Eric, on the overall idea of the currency complex or anything else you'd want to share with our audience today.

Eric: When people talk about broad currency markets, they typically cite the Dixie, especially when thinking about the dollar. The Dixie is actually an index of the dollar relative to a basket of foreign currencies. We know that, right? That should be a pretty logical starting point. It turns out that that basket is very heavily skewed to three currencies—the euro, the British pound, and the yen. In fact, the euro is about 60% of that basket. The yen is 14% and the British pound is 12%.

You have almost 80% exposure in that Dixie to just three currencies. I think this just ties into some things that we've talked about, which is the currency market is really broad. It's not just the dollar, it's not just the euro, or the sterling, or the yen. When thinking about the Dixie and dollar performance, I just say, beware that really is just facing three pretty dominant currencies in that particular basket. That's the fun fact I want to leave the audience with.

I think, away from that, just thinking about what role does currency play within a portfolio. Some of the things you hit on, Lloyd, if you're Canadian, do you want that currency risk? Do you want US dollars? Perhaps you do. If you're building a broad portfolio, potentially currency exposure can reduce the volatility of that portfolio. I think it's just understanding what role currency risk plays in a particular portfolio and then having an awareness of how that role can evolve over time.

Currencies like the euro or the sterling, which, 20 or 30 years ago, probably meant something different with respect to just the role they played in portfolios, the volatility that they're exhibiting in portfolios, and things of that nature. I think step 1 is just determining what role currency plays, and then, talking to your advisor about how that can fit into what your portfolio looks like broadly. I would just leave the audience with those closing thoughts.

Lloyd: That was wonderful, Eric. Our sincere thanks to you and to all of our listeners for their time. This has been another edition of On the Money. On behalf of all of us at Dynamic Funds, we wish you continued good health and safety. Thanks again for joining us.

Speaker: You've been listening to another edition of On the Money with Dynamic Funds. For more information on Dynamic and our complete lineup of actively managed funds, contact your financial advisor or visit our website at dynamic.ca. Thanks for joining us.

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