Investment Strategies

Guest Comment: Pictet Asset Management Examines Reality, Risks Of "Currency Wars"

Luca Paolini Pictet Asset Management Pictet Asset Management 28 February 2013

Guest Comment: Pictet Asset Management Examines Reality, Risks Of

Luca Paolini, chief strategist, Pictet Asset Management, casts his eye over the hot topic of whether the world economy will witness “currency wars” and what are the drivers behind heightened forex movements.

Editor’s note: In this article, Luca Paolini, chief strategist, Pictet Asset Management, casts his eye over the hot topic of whether the world economy will witness “currency wars” and what are the drivers behind heightened forex movements. As ever, while the views here are not necessarily shared by this publication, we are pleased to share these insights. If readers have comments, do contact us.

Since Brazil warned in 2010 that the world was lurching towards a currency war, it would seem that this prediction has come to pass.

What began with the Swiss National Bank’s move to stem a rise in the Swiss franc in 2011 has since evolved into a broader currency devaluation effort involving the Bank of Japan and, most recently, the European Central Bank. The trend testifies to the fact that the developed world is running out of fiscal and monetary options to lift growth: currency manipulation has become the policy tool of last resort.

Yet should this stimulus effort develop into a full-blown currency war, it would carry significant risks. For countries actively engaged in competitive devaluation, the threat of a spike in inflation through higher import prices looms large. But it is the risk currency wars pose to the global economy that is particularly troubling. As policymakers learned to their cost in the Great Depression of the 1930s - when a clutch of countries came off the Gold Standard - competitive devaluations can lead to damaging trade wars that serve to prolong economic downturns. Foreign exchange volatility hampers trade, business investment and household spending.


However, at Pictet Asset Management, we would argue that what the world is witnessing now is not so much the beginning of a currency war but rather the start of a much-needed economic rebalancing - a welcome shift that redistributes growth away from countries which are booming, and possibly risk overheating, into ones whose economies are lagging.

The fact is that much of the developed world needs weaker currencies to delever – and the volatility that is beginning to emerge in the currency market is a sign that countries are at different stages in that currency-driven deleveraging process, with the US and Switzerland leading where others will follow.

The process will also have implications for emerging markets. Despite protestations from the likes of South Korea, which has seen its currency rise sharply, this rebalancing will lead to the steady appreciation of emerging market currencies – the superior debt dynamics and growth prospects of the emerging world require that.

Currency rebalancing and equity markets

For global equity investors, this rebalancing means that currency will become a far more important source of total return. Because equity markets and currencies become negatively correlated during periods of currency revaluation, as has been the case with both Japan and Switzerland, the hedging of foreign exchange exposure becomes an essential tool. Un-hedged equity investors neglect currency risks at their cost.

Complicating matters further is the fact that countries differ in their inclination and capacity to engage in currency devaluation. Currency interventions are typically most successful in countries that possess certain characteristics.

Those who have a large export sector relative to GDP, exhibit high degree of economic slack, and possess effective channels through which to transmit monetary policy are better placed to pursue a devaluation policy.

It is interesting to see that the eurozone, with some of the weakest fundamentals and the most to gain from depreciation, appears to be running counter to this framework, with the single currency having appreciated strongly in recent months. This has left the euro roughly 8 per cent overvalued relative to OECD measures of purchasing power parity, and at around fair value by our models.

The depreciation of the Japanese yen, meanwhile, indicates that the market may be already be pricing in the shift in Japan’s inflation dynamics relative to other countries, which affects equilibrium levels for the currency. A distinctive dynamic of the yen’s depreciation is that it is most acute against the currencies of its major trading competitors in Asia rather than the euro or the dollar.

Emerging markets appear less willing to devalue their currencies - chiefly because they have lower output gaps and suffer from infrastructure bottlenecks that are potential sources of inflation.

China, for instance, is willing to let its currency rise in order to boost domestic consumption and stave off protectionism, while India is keen to maintain a strong rupee to prevent a large oil import bill from feeding inflationary pressures. Thus, we have seen more idiosyncratic currency moves in emerging markets, shifts which are more in line with countries’ individual fundamentals. The Korean Won and the Taiwanese dollar are exceptions as they have borne the brunt of yen depreciation.

Investment conclusions

While there will be “winners” and “losers” from competitive devaluations, it is important for investors to view these phenomena as a part of a long-term cycle. The US and Switzerland were the first major developed economies to use monetary policy to weaken their currencies; other major economies are following in their wake.

The eurozone and Japan - which both need to de-lever to restore their competitiveness - have been laggards in this process.

In Europe, while the influential Bundesbank has prevented the ECB from pursuing a policy of devaluation, we believe its resistance will soon weaken in the face of economic realities. The euro’s remarkable resilience amid the sovereign debt crisis casts a long shadow over the region’s economic prospects – a 10 per cent appreciation in the currency reduces its growth rate by 0.7 percentage points, according to the OECD and lowers corporate earnings growth by some 3 percentage points, our own models show.

For these reasons, the PAM Strategy Unit has maintained a short position in the euro.

We also stay short the yen, as there is a commitment across the policymaking spectrum to shift to a higher inflation target. What is more, narrowing current account surpluses should also play a part in keeping the currency weak.

When it comes to currency positioning in emerging markets, we are taking a more differentiated approach; we are short the Korean won and Taiwanese dollar for tactical reasons; we are positive on Mexican peso in the medium term as the country benefits from improving terms of trade and rising external demand in the shape of a healthier US economy.

We are also long the Chinese renminbi. Elsewhere, we have chosen to adopt a more tactical stance on Latin American and EMEA currencies. Over a five-year horizon, however, we expect emerging currencies to gain around 1.5 per cent per year against the US dollar to reflect their growing contribution to world trade and growth.

We are neutral on gold in the short term, but are positive in the medium term, as it is the best hedge against large-scale currency depreciation through central bank balance sheet expansion; gold also serves as a diversifier as it exhibits a very low correlation with bond and equity markets.

In equity markets, we are long the Japanese market, while hedging yen exposure, and short euro zone equities, partly as a result of our currency views.

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