Foreign exchange concerns lead investors to seek diversification

Tensions in currency markets represent collateral damage in what is primarily a credit crisis. Concerns over the Chinese renminbi, US dollar and euro are uppermost in most investors’ minds.

Daniel Murray, EFG Asset Management
We are facing a situation today in which many developed world economies are confronting the reality of a multi-year period of deleveraging. This will constrain private sector demand and dampen growth. A natural response is to seek a cheaper currency to try to stimulate foreign demand. Unfortunately it is impossible for all currencies to devalue at the same time.

The Chinese renminbi is the prime candidate against which other countries would like to devalue. However, the process is frustrated by the tightly controlled environment in which the renminbi trades. This puts pressure on the world’s major currencies to try to devalue against each other.

On a fundamental basis there is little to choose between major currencies – they are all unattractive. According to the IMF over 60% of the world’s currency reserves remain in US dollars. At the margin one would expect this to diminish, placing downward pressure on the dollar, augmented by the scale of quantitative easing carried out by the Fed.

Given the massive supply of US dollars in the world today, the US may well win the currency war, if we are allowed to call it that. However, this will turn out to be a Pyrrhic victory if it results in rising domestic US inflationary pressures without a coincident recovery in domestic demand.

Thanos Papasavvas, Investec Asset Management
The ‘currency wars’ phrase has captured the zeitgeist of the period but is nothing new. The central banks of Korea, Brazil and Israel have been intervening for some time to decelerate or stop the appreciation of their currency. Sino-US relations have been frosty on the issue of the renminbi for a number of years. Currency wars will remain with us as globalisation on the one hand and the differing economic cycles and policies on the other will maintain this conundrum as unresolved.

Unfortunately there is no pragmatic optimal solution. We believe the only way forward is a compromise on all sides. The US will need to compromise in terms of the speed of the rebalancing at the G20 level and the Chinese will have to compromise in terms of the magnitude of the currency appreciation they will be willing to accept. This in our view will keep market volatility levels elevated as policy makers’ comments and central bank interventions keep the element of surprise in the markets. It also increases the probability of a policy mistake.

More recently the euro debacle has eclipsed the currency wars debate as concerns on the sustainability of the single currency has monopolised the news headlines surrounding the financial markets. As and when this subsides, the focus will once again return to the global imbalances.

Elizabeth Para, Overlay Asset Management
While a country may be able to boost exports temporarily by debasing its currency or suppressing currency appreciation, investors need to consider the long-term impact of currency manipulation. In the long run a weak currency policy can artificially shelter inefficient domestic producers from the competitive forces which would normally incentivise companies to invest in research and development, technology and infrastructure in order to improve long-term productivity and international competitiveness.

In addition to company or economic fundamentals in the current environment, investors increasingly need to estimate the timing and magnitude of government intervention in currency markets, adding yet another layer of complexity to the investment process. Weak currency policies also impact real returns by importing inflation, reducing the attractiveness of fixed income investments in favour of real assets (for example, real estate, commodities, equities, inflation-linked bonds).

Two of the worries our clients are raising are concerns about concentrated exposure to the US dollar or euro and their desire to diversify currency risk and/or increase their exposure to emerging market currencies and the vulnerability of single currency strategies, such as US dollar equities, to currency depreciation. Regarding this we are seeing increased investor interest in reducing risk by hedging international currency exposures, in particular exposures to the currencies of deficit countries in developed markets.

Michael Beattie, Tradex Group
Fears over protectionism, exchange rate tensions and international currency wars do not factor heavily into our trading or investment decisions at this time, not least because the outcomes of such developments are notoriously hard to predict. We believe an international currency war leading to a generalised depreciation in global currencies is a remote possibility, albeit one we monitor closely.

If governments start manipulating currencies on a global level, it will lead to a spike in volatility in the foreign exchange (FX) markets. We believe nimble, short-term discretionary traders could profit in such a scenario, provided volatility does not get out of hand. If volatility spikes to extreme levels and the historical patterns and correlations between currencies break down, it could create a potentially dangerous environment for systematic FX traders and commodity trading advisers.

The dollar remains a safe haven currency and while we agree it may be overvalued from a structural perspective, in the event of a sovereign debt default in Europe or the less likely eventuality of a currency war, the dollar could appreciate as investors seek a safe haven. Gold could also benefit for the same reason. There could also be trouble in store for the US if Asia strikes back against perceived currency manipulation by refusing to purchase Treasuries, which in turn could force the Federal Reserve to raise rates.

We continue to focus on more liquid strategies that allow investors to manage risk and exit positions effectively. We have, in some cases, also opted to invest in gold-denominated shares of hedge funds where this option is offered as a hedge against currency risk.

Michael Hart, Roubini Global Economics
The term ‘currency war’ is misleading in several ways. Currencies are not at the source of the financial crisis. Tensions in currency markets represent collateral damage in what is primarily a credit crisis. So-called crisis solutions that target currencies miss the point. In particular approaches that attempt to fix currencies, be it to each other or to gold, seem particularly wrongheaded: world currencies require more flexibility, not less.

There is not so much ‘war’ as currency depreciation in developed markets being the natural byproduct of extraordinarily accommodative monetary policies. Only in Switzerland has the exchange rate been an explicit policy target. In emerging markets there is a justified preoccupation with rapid appreciation. This partly reflects the stronger fundamentals there and partly the effects of the global funding equation. But attempts to curtail these upward pressures should not be seen solely through the currency lens. They are part and parcel of attempts to capture slices of a stagnant global demand pie.

Should we expect a new round of competitive devaluations? It is clear currencies, as far as they can be determined by policy, represent one element in the arsenal of policymakers. They represent both a very visible and quickly deployable policy measure. This makes resorting to them both attractive and easily subject to criticism. Policymakers by and large understand that they are facing structural shifts of a tectonic nature. It would make little sense to paint the roof while the walls of the house are collapsing.