The Global Strategist If A Picture is Worth A Thousand Words
In the light of the recent G7 statement on exchange rates, we would make two observations. First, if this G7 statement on exchange rates proves to be a major watershed event for the dollar, it may also prove to be a major watershed event for the symbiotic relationship between Asia and America.
In our view a post-bubble US recession has been largely avoided by the willingness of Asia to extend cheap credit to the US government and US consumer. What we see today is the mother of all vendor-financing deals. Asian saving has helped fund tax cuts and credit growth in America, which in turn has supported US consumption of Asian manufactured goods. An important part of this mechanism has been Asian Central Bank buying of US fixed income paper in an attempt to prevent their currencies from appreciating against the US dollar. This relationship has benefited both regions. America needs Asian saving as much as Asia's manufacturers need American consumption. Why the G7 statement is potentially so important is because it could mark the beginning of the end for this dynamic. What worries investors is that this could undermine the current locomotive of global demand before domestic demand recovers in Asia and Europe. If this adjustment is not managed smoothly and gradually, it could quickly come to be seen as a deflationary, unless rapid attempts are made to stimulate consumers in Europe and Asia. European fiscal and monetary straitjackets severely limit the scope for a stronger European consumer. That leaves Asian domestic demand to pick up the slack. Strategically this is where we would increase our equity exposure on an unhedged basis. If the US-Asia dynamic survives intact, they benefit from increased job creation in the export industries; if it breaks down, policy will be directed to stimulate Asian domestic demand - although this is unlikely to be a seamless transition.
Secondly, if we are going to see more exchange-rate flexibility, particularly between Asia and America, we are probably also going to see more exchange-rate volatility. The rise in globalization in the 1990s was associated with declining exchange-rate volatility. Increasing exchange-rate volatility would be one sign that the pendulum might swing back to a world that is going to become more regional than global. Certainly, the economics of globalization are not certainly not helped by increased currency volatility. Increased currency volatility would also argue for increased diversification into international equities. You may also see sector rotation within the regions become more independent. But perhaps the most important implication is the investors are going to have to manage their FX risk more actively. In short, FX could become an important source of alpha for both bond and equity portfolios.