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Investment Strategy amid a Global Currency War

Yifan Hu (PIIE)



Prime Minister Shinzo Abe has pressed the Bank of Japan (BOJ) to be more aggressive in combating deflation, in a step seen by some as part of the global currency wars. Policies of the new Japanese government include organization of a new stimulus package and the implementation of a true monetary revolution. By injecting huge amounts of liquidity into the economy to boost exports and increase imported inflation, the BOJ targets a depreciation of the Japanese yen. This strategy has also been implicitly adopted by the Federal Reserve, the European Central Bank (ECB), and the People's Bank of China (PBOC), which have kept a high level of liquidity in circulation in order to support their economies and avoid an overvaluation of their currencies. Emerging economies may also participate in the currency wars by accumulating foreign exchange reserves or establishing capital control measures in order to avoid an overly sharp appreciation of their currency.

In this context, the first arrow of Abenomics has a low chance of success in the long term. The second and third arrow of this policy mix relate to fiscal policy via the implementation of a stimulus package and the organization of structural reforms, including changes in tax law. Also at this level, the lack of coordination of economic policies at a global level could represent a significant obstacle to the success of the bold Japanese policy.

The global currency war will likely accentuate the differences of the three-speed world, the new global equilibrium identified by the International Monetary Fund (IMF). In this configuration, emerging economies are still going strong. Southeast Asia and Latin America might benefit from easier financing conditions linked to a wave of hot money, with a risk of overheating. China embodies this regime of high growth. The economic recovery is likely to accelerate for the second half of the year, if more critical supportive policies are announced to boost growth for the rest of the year. The United States and Canada embody a regime of mid-speed growth. The US economy depends on domestic conditions based on gradual recovery of the housing market and the progressive decline of the unemployment rate, resulting from implementation of a progressively more austere policy on the fiscal side, and a gradual preparation of an exit from the latest round of quantitative easing (QE3) on the monetary side. At the bottom of the ladder of the three-speed economy, Europe and Japan cannot escape a regime of low growth linked to the necessity of structural adjustments. In Europe, one of the rare engines of growth, the capacity of German and other Nordic economies to export globally is penalized by the depreciation of the Japanese yen. Despite the easing of the European monetary policy, the euro area will likely exit the recession with difficulty as austerity, although softened, will be maintained. The global currency war requires international investors to develop adapted strategies.

  • Asset allocation strategy across country. In the short term, the performance of the Japanese economy will be boosted by the aggressively expansionary stance of Abe's economic policy. During this time, Japanese stocks will outperform the market, the price of Japanese risk will decline, and stocks of Japanese main competitors will underperform. Over the medium term, the best strategy consists of being exposed to commodity exporter countries given the still growing excess of liquidity at a global level. Over the long term, the Japanese risks will materialize, and it will be time to sell the assets (acquired at a cheap price in the short-term period) hedging this risk.
  • Currency strategy. The strategy of carry trade, consisting of selling a low yield currency and buying assets in another currency paying higher interest rates, has historically taken the Japanese yen as a basis given the zero interest rate policy (ZIRP) implemented by the BOJ. The interest in such a strategy is even bigger now as the supplementary injections of the BOJ will maintain the Japanese yields at very low levels. At the same time, the appreciation of currencies relatively to the yen will boost the total return of assets owned in different currencies other than the yen. For identifying the most appropriate currencies to be bought under the carry trade strategy, I look for the ones that historically paid the highest returns. Emerging economies close to a situation of overheating, such as Turkey or New Zealand, can be targeted to develop these strategies as they will maintain a high level of interest rates and an appreciation of their currency. I recommend in particular an exposure to Australian and New Zealand dollars.
  • Bonds and equity strategy. The majority of international investors have concluded from the new policy announced by the Japanese government that large outflows from Japan would occur in the direction of markets paying higher returns in comparison to the Japanese market. Japanese investors, especially pension funds, will face low returns due to the accentuated pressure on government bond prices exerted by the BOJ QE program. Moreover, foreign assets, both bonds and stocks, have historically produced higher returns in comparison with Japanese assets. Thus, Japanese institutional investors' incentive to diversify their portfolios will be progressively stronger. Stocks will profit from a global thirst for high returns, especially among Japanese institutional investors. Canadian, Australian, and core European Treasury securities will benefit from this process, while emerging market bonds and stocks, high dividend stocks, high yield bonds, and multinational companies' securities will outperform the market.
  • Commodity strategy. With a more supportive policy to be seen in Japan and China in the second half of 2013, global demand should get stronger in the coming months, and commodities could once again undergo the influence of speculative positions. The growing importance of the shale gas and oil industry in North America and in the rest of the world has significantly changed the global energy landscape. The increase of supply suggests that we will have stable prices in the two coming years for gas and oil. With regards to precious metals, I expect gold prices to continue to trend upwards after normalization. Base metal prices should rebound in the second half of 2013 with infrastructure projects being developed in China. Food prices should be one of the main beneficiaries of the current context of excess liquidity as structural reforms will support household consumption in China. Global protectionism should continue to be active in this sector, and consumer sectors will continue to outperform the market in a defensive environment.
  • Global risk panorama. Japan, with its brinkmanship approach and explosive level of debt clearly represents the main risk in the medium term. As early as the first or second quarter of 2014, the Japanese economic policy could show its limits in combating inflation or supporting growth. Given the overly elevated level of public debt, further downward pressures could be exerted on the Japanese yen. Despite the European Stability Mechanism Outright Monetary Transaction (ESM OMT) stabilization framework and the political will to maintain euro area unity, a residual risk remains significant in the euro area amid continuing austerity measures, rising inflation, and deteriorating macroeconomic conditions. In the United States, the debt ceiling problem would remain in the medium to long term, with high probability of another downgrade. With hot money inflow amid global excess supply of liquidity, potential asset price bubbles in emerging markets are major risks in the future.

Yifan Hu, visiting fellow at the Peterson Institute, is also chief economist and head of research at Haitong International in Hong Kong.

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