8th November 2010
Global trade imbalances have been on and off the political agenda for years, but it's now all coming to a head and investors need to make sure they are ready for the fallout.
The root cause of the problem is that countries like the US and the UK borrow from the rest of the world so they can import more than they export. This means they have run up large deficits.
On the flip side are the surplus countries like China and much of the rest of Asia that make the goods that we buy.
In the wake of the global recession most countries want to export more so as to help their economies to recover. This has led some to claim that their currencies are too strong and making their exports uncompetitive.
In particular the US would like to see the dollar depreciate against the Yuan, but the Chinese have pegged their currency to the greenback to stop it becoming too strong. This has led to a war of words that is spilling over into economic policy.
What can countries do to reduce their deficits?
To date the main response has been Quantitative Easing (QE). America's latest tranche of $600 billion over the next six to 12 months aims to stimulate the economy in part by reducing the value of the dollar.
Clive Dennis, currency manager at Schroders, says that the more the US government prints money the more it encourages investors to sell dollars.
"The QE debate is mainly centred on the US, UK and Japan. It is less likely that the euro will join in as unless there's another sovereign debt crisis the next move will be some kind of exit strategy."
If the QE forces down the dollar sterling exchange rate then a UK based investor with US holdings would be worse off, unless the stimulus improves the local market returns for that particular asset.
Printing money puts upwards pressure on all the other currencies, especially those in Asia and the big commodity producers like Australia.
"The Asian countries will take steps to try to slow the appreciation of their currencies, but it is difficult to reverse because of their strong economic growth and current account surpluses.
"Tighter fiscal policy would probably be the best option to dampen their economies and keep inflation under control but there seems little appetite for this," explains Dennis.
The upshot is that investments in Asia should continue to benefit from the buoyant local market conditions, whilst also appreciating in sterling terms.
The Bank of England has recently rejected any further QE, but Dennis thinks there is a quite a high chance of the UK embarking on another round next year.
"Inflation is currently on the high side of the target and GDP has been strengthening, so in the short-term there has been little need of more economic stimulus.
"We think that the severe fiscal tightening in 2011 will result in sub-trend growth next year and this may prompt the Bank to print more money."
Philip Poole, head of macro investment strategy at HSBC, says that currencies have become a more important part of the investment decision.
"We are in an environment where the expectation of further QE in America has been putting upwards pressure on those Emerging Market currencies with yield potential."
In the long-run he believes there is scope for further Emerging Market currency appreciation. Currently he is more comfortable with an exposure to investments in countries like Korea, Singapore and Malaysia, than with places such as Russia or Turkey.
"It is worth looking at the underlying reasons for the currency movements. Some exchange rates have mainly been driven by short-term capital flows. These can quickly reverse, which makes the associated currencies potentially vulnerable to a shock."
He says that Brazil looks overvalued in spite of the steps taken by the government to counter its currency appreciation, whereas the strength of the Mexican Peso looks more sustainable.
Whenever you invest overseas you acquire an implicit exposure to that currency. So a UK based investor who buys a US stock would see the sterling value of his exposure fluctuate in accordance with the exchange rate.
If over his holding period the dollar weakened against sterling this would reduce his final return as the repatriated proceeds would be worth less when translated back into pounds. Should the dollar strengthen it would have the opposite effect.
Investing in an overseas company or market index is a much more complex proposition than just thinking that it is only exposed to that particular country's currency.
Poole explains that an investment in indices like the DAX or the CAC would provide a much purer exposure to the local German or French markets than a holding in the FTSE or the Swiss Market Index would to the UK and Switzerland.
"This is because these markets are home to a large number of multinationals that derive much of their revenues from abroad."
Companies like HSBC, Standard Chartered, Unilever and Nestle typically make more than half their earnings in the Emerging Markets. These offer an alternative way to benefit from exposure to the growth of the consumer in the region as distinct from a direct investment in the local market.
This means that UK investors including fund managers like Ben Wallace, who runs Gartmore UK Absolute Return, have to be aware of the impact of currency fluctuations on their portfolio.
In a recent interview with FT Adviser he said that although he does not want to make a call on currency, it is important that there is no mismatch in the fund which determines that all the long positions are in dollars and the shorts are in other currencies.
"We won't have more than 20% of the risk in the fund exposed to external factors such as currency or oil price. For example if we like oil companies, airlines and oil exploration, the thing that moves all those sectors is oil price.
"If we like the idea that is fine, but we can't have more than 20% exposure."