Rebalancing

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.