The current debate about currency wars, the G20 meeting, QE2 (quantitative easing by the US Fed), it all makes for great Op-ed opportunities and commentary. One relevant question we prefer to focus on is that of asset pricing implications (preferably in the medium-term) and how to position our portfolios accordingly. This note is not a deep treaty on these international monetary matters, but tries to reach a view of the world we can implement in portfolio design. Let us structure this in three steps: the debate, the noise, and the substance.

The debate

At least on the surface this is a debate about global imbalances, which for the most part are characterized by current account balances. Countries with secular current account deficits are countries that consume more than what they produce, for which they need to constantly borrow from the rest of the world. Countries with current account surpluses are countries that consume way less than what they produce, constantly saving, which in the aggregate for such country means accumulating foreign assets. To the extent that those imbalances are the result of artificial exchange rate or monetary policies, those are imbalances that “artificially” push capital into places where it produces excesses of some kind (which get called bubbles at some point).

There are at least 5 types of countries in this issue: The US, Europe, China, Asia, and the advanced EM. Let us look at each concisely (more descriptively, leaving the analysis for the last section):

–       The US is maybe the elephant in the room, showing current account deficits for many years now, which nowadays are mostly the result of the fiscal deficit (which means the private sector is roughly consuming as much as it produces). It does not exercise an artificial exchange rate policy, at least not explicitly, but its monetary and fiscal policies clearly point in the same direction: a weaker dollar. Being the issuer of the world’s reserve currency (and the largest economy), it has more leeway than any other country in terms of what is a sustainable current account deficit and how much seignorage it can charge for the use of its currency.

–       Europe presents itself as one thanks to the euro, but it is far from being a uniform economic story (as we learnt earlier this year). The euro is clearly undervalued if it was only Germany’s currency, while being clearly overvalued if it was just Greece’s currency. However, besides being united with poorer more inefficient countries, Germany does not have an exchange rate policy that prevents the euro from appreciating. The euro does not enjoy the leeway the dollar has, as it has not matched the dollar in terms of its reserve and international exchange use.

–       China has had current account surpluses for a long time, and many argue it is the result of a severely undervalued currency. It does have a fixed exchange rate, it does export a lot thanks to its low costs, and going through a tremendous economic transformation which usually produce high investment rates that tend to be funded by foreign capital. However, it does show a very low consumption rate (as a percentage of GDP), in part due to a very low share of labor income in the economy, but also due to the typically high Asian savings rates.

–       The rest of Asia is a more flexible and smaller variant of China. Most countries have a higher GDP per capita than China (are farther along in the development path), but are obviously significantly smaller. Most countries have somewhat more flexible exchange rates, but have sustained fairly undervalued currencies through different policies (mostly reserve accumulation). Most countries have high savings rates and small governments, which means they run secular current account surpluses.

–       The advanced emerging countries are a way of grouping the most successful and attractive of the so-called emerging markets (the likes of Brazil, Colombia, South Africa, Mexico, Turkey, etc.). These are countries that have usually had current account deficits but less so recently. These are the developing countries that are succeeding or converging, which means they get flooded with capital inflows in the current environment, forcing them to think of how to prevent excessive currency appreciation and current account deficits.

The noise

The currency wars issue has generated multiple commentaries and policy proposals, some of which are just short-term noise. Additionally, some of the policy responses that countries do implement are short-term fixes that eventually fade in front of fundamental economic forces. Thus, the characterization of noise is maybe pretentious, as it also encompasses some relevant and market moving events, which we believe cannot dominate in the medium-term. However, they still merit careful consideration for portfolio design, but under the understanding that they are not perennial trends.

Exchange rates will trend to their equilibrium levels (that warranted by the underlying fundamentals, like productivity growth differentials, growth, capital flows, etc.), and policies that try to prevent that will produce collateral damage that ultimately produce equilibrium exchange rates, at least in real terms. In other words, if a country keeps a fixed exchange rate at a level that undervalues its currency, it would most likely get inflation towards an appreciation of the real exchange rate. Thus, exchange rate and capital markets measures that countries are putting up will only slow down this process, produce collateral damage (inefficiencies, misallocation of resources), and end up with equilibrium exchange rates in real terms.

Thus, I would group into noise all artificial policies that do not address the fundamentals underlying the imbalances. We are bound to see many initiatives with short-term impact but no real medium-term value: exchange rate controls (like many countries are gradually introducing in new forms), as well as rhetorical policy initiatives as the one being pushed by US Treasury Secretary Geithner for current account targets. Actually, QE (I or II) are tremendous market events, but tend to fade, as artificial monetary effects cannot be sustained forever. True, in the short-term some can produce tremendous market moves, but cannot improve fundamentals (and sometimes they can deteriorate them).

Though policy makers cannot rule on real variables with nominal efforts, they can clearly impose real restrictions with real effects. If these currency wars lead into trade restrictions, which are bound to produce a chain reaction of similar policies, real effects would follow. This is a real risk in this currency wars. If a meaningfully large country responds with trade tariffs, others could follow, and that would lead to a very damaging reduction in world trade. This is one area where the limit between noise and substance lies.

The substance

When designing portfolios for the medium-term one cannot rely in rightly pinpointing a sequence of booms or bubbles. We should rely on assessing the fundamental underlying forces that drive asset prices, aiming to preserve the real acquisition power of capital and build returns over that.

QE2 can generate a 1-2 month equity rally, a recovery in the euro, as well as a rally in US Treasuries. But the question is what happens next, what is the ultimate goal, and what could be real lasting responses from others in the world. The value of the dollar will depend on the US fiscal sustainability, as lasting equity valuations will depend on global growth.

The US seems to have embarked in a beggar-thy-neighbor policy, weakening its currency with the hope that it would bring some of the growth in the rest of the world into the US (through higher exports). At the same time, this policy would also help with respect to its fiscal malaise (debasing its currency reduces the real size of debt and helps reducing the size of government), as we pointed out a long time ago (among others, we discussed this strategy in January of last year in the post “Will Ben get us all before Sam gets some of us?“). We do not believe that QE2 can have a meaningful growth effect on the US, and can only have a lasting effect on the dollar if the Fed can keep the QEs coming (QE3, QE4, etc.). We certainly hope not.

The real value of the dollar depends on the fiscal sustainability of the US. To the extent the new congress and the White House manage to work towards a smaller fiscal deficit, especially through a smaller government and more efficient taxes, the medium-term of the dollar shows a return to value. If the US continues to show its inability or lack of willingness to work hard towards a better fiscal picture, the weak dollar trend is likely to be sustained. It is important to keep in mind that the dollar seems already cheap relative to other currencies, and that a slow trend from here would most likely be the result of productivity growth differentials and fiscal underperformance.

Thus, G20 debates that are bound to reach no conclusion can produce short term jitters, but only if it degenerates in a trade-war it can have serious lasting effects. The substantive issues for portfolio design are: the European debt problems and their emerging restructuring approach, the US fiscal picture, and growth. Because of the risks in the first two, we maintain a cautiously optimistic approach.