The balance of global currencies is set to shift bringing with it problems for global markets, which investors should brace for, according to a new report by UBS Wealth Management Reasearch.
In a global economy, there are few topics more compelling themes for investors today than Currencies.
In the report, UBS Wealth Management Research predicts a significant increase in the value of the currencies of certain Asian and oil-producing countries. Currencies that are pegged at competitive rates to the US dollar may appreciate sharply to stamp out domestic inflation.
The new report says that this could drag on global growth, as Asian exports become less competitive. China, for instance, has become a global manufacturing powerhouse, but a rising Chinese yuan will hurt Chinese exports.
Production capacity outside Asia will be unable, initially, to meet demand. These shifts should eventually benefit other regions particularly the Eurozone, but also the US as their industries adjust to take up the slack.
In the short term, a sharp appreciation of today’s weak currencies could slow global economic growth and fuel a further pickup in inflation. Developed countries’ bond markets would likely weaken as inflation increases. UBS WM Research believes the risk of a sharp currency appreciation is not reflected in the price of many emerging market equities and real estate at present.
Several emerging market currencies are either pegged to, or in a managed relationship with, the US dollar, especially the Chinese yuan, other major Asian currencies, and most of the currencies of the Gulf Cooperation Council. Because their currencies are tied to the US dollar at competitive rates, these countries have enjoyed strong economic growth, high and increasing current account surpluses, enormous foreign exchange reserve accumulation, and buoyant financial and real estate markets.
Overall, the combination of steadily accumulating foreign exchange reserves, strong demand for currencies of commodity-exporting countries, and the extended success of “carry trades” have produced profound misalignments in currency markets.
By the end of 2007, inflation was also beginning to accelerate in countries with pegged currencies. An increasingly accommodative US monetary policy, designed to stimulate domestic economic growth, has served only to add to inflation pressures in these countries and to escalate the reserve accumulation problem.
According to the report, authorities may need to permit their currencies to appreciate against the US dollar as a way to tighten monetary policy and keep inflation contained.
A sudden appreciation of US dollar-pegged currencies would likely have negative consequences for the global economy, according to UBS Wealth Management Research. Ultimately, the structural realignment of manufacturing and production centers resulting from changes in competitiveness would take time to unfold, making a near-term reduction in global growth and an increase in inflation likely.
Europe would eventually benefit from a depegging of Asian currencies versus the US dollar, as a more competitive euro bolsters Eurozone exporters. A slower currency adjustment, meanwhile, would shield Asian economies from painful adjustments in the short term, but may also lead to more problems, such as asset price bubbles, in the longer run.
The threat of depegging and the risks of present currency imbalances are not reflected in the price of higher-risk assets, such as emerging market equities and real estate, and certain commodities, such as base metals and energy. Developed countries’ bonds are poorly positioned for a potential increase in global inflation rates. And while developed country equity markets are not expensive on a historical basis, past comparisons may not be relevant during periods when the global risk premium is rising.
Overall, UBS Wealth Management Research recommends that investors remain alert to opportunities that might arise from a delayed adjustment to currency shifts, but to hold a broadly diversified and defensive portfolio that protects against the risks posed by these imbalances