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.

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.

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.