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24th August 2015

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James Yardley, Senior Research Analyst

The Secret Currency War

Since the financial crisis, countries have secretly been trying to devalue their currencies to make their economies more competitive. For a long while China was the punching bag in a secret currency war. The United States, UK, Europe and Japan all engaged in quantitative easing (QE) and devalued their currencies versus China. This helped their economies stay competitive and enabled them to export billions of pounds worth of goods to China. Chinas internal growth was able to absorb the deflationary weakness of the rest of the world for the past few years. Now that’s no longer the case and China is fighting back. A week or so ago, China shocked world markets by devaluing its currency. Stephen King, an economist at HSBC, warns that the Yuan devaluation breaks the last line of global economic defence. 'World authorities have run out of ammunition as rates remain stuck at zero'.*

China's weaker currency has two important effects. Firstly, all the goods the world imports from China just got cheaper. Secondly, China is the world's largest buyer of commodities. The weaker Yuan means all these commodities just became more expensive for Chinese companies to buy. So, demand for these commodities (which had already fallen heavily) will now fall even further. That drives down the price of food, oil, iron ore and all other commodities for everyone. The combination of the two effects means China's recent devaluation will effectively export deflation to the rest of the world whilst boosting growth in its own economy.

So now central banks in other areas of the world have two good reasons to keep interest rates lower for longer – to keep their own currencies reasonably valued in order to protect their exporters (raising your interest rates increases the value of your currency, decreasing the global competitiveness of your exporters) and to counter the deflationary threat.

There are some hopes that the United States may be able to pick up from where China left off and act as a new line of defence. The United States economy has recovered from the financial crisis and is now growing, even if that growth is sub-par. The Fed has ended its own QE programme and the US is expected to raise interest rates before the end of this year or early next year(although this is now less likely following the Chinese move). This expectation has caused the dollar to strengthen. Unlike some countries, the US economy is less affected by changes to its currency because so much of its consumption is domestic. If the Fed allows the rate rise to go ahead the US may become the new punching bag. Countries will be able to export their deflation to the United States and the global economy may yet escape a deflationary spiral. However, given that core inflation remains so low in the US, (it is currently 1.76%**), I am sceptical as to whether or not this can happen. Toby Hayes, manager of Franklin Diversified Income, says ‘Earth really needs another planet to devalue against, but unfortunately we don't have one’.

John Pattullo, manager of the Henderson Strategic bond fund, thinks the world will continue to experience deflation as technology drives prices lower. UBER (a taxi hailing app) and Airbnb (a website where people rent their own homes) are examples of the sort of technology which is driving this.

QE Failing

Quantitative easing (QE) has been hailed as a fantastic success which led the global economy and stock markets out of the financial crisis. However, amidst the celebrations, we have forgotten that QE has failed in its primary objective; to increase inflation. Despite huge money printing programmes from the Japan, the US and now Europe we cannot get away from the fact that inflation is still dangerously low. Doomsday scenarios of hyperinflation have so far proved unfounded.

The major world economies are drowning in debt, which they are unable to inflate away. There is a risk we could fall into a deflationary cycle, the like of which Japan has been suffering from for the past two decades. How high this risk actually is is difficult to say, but what is certain is that Chinas devaluation has increased it. The one asset class that can do well in this environment is one we have not liked for some time: bonds

For a couple of years now, commentators and investors, including the Chelsea Research team have been arguing that bonds are expensive. We even recently raised the risk rating on our bond funds to reflect our concerns about valuations and liquidity.

Strategic Bond Funds

So should we be investing in bonds? Overall we still dislike the asset class other than as a source of income. Bond markets have been artificially distorted by central banks and they have been in a bull market for thirty years. There's no doubt they are expensive but they would be one of the few asset classes which would do well in a deflationary environment. We prefer Absolute Return funds, for example the Elite rated Old Mutual Global Equity Absolute Return has a low correlation to other markets.

If you are going to include bonds as part of a balanced income portfolio we prefer strategic bond funds as they have the flexibility and tools to react quickly and have also typically been less volatile than some other bond funds. We like the Henderson Strategic Bond fund managed by John Pattullo and Jenna Barnard. The fund has been very consistent, it has returned 18.92% over the past three years versus a sector return of 15.66%***. Its yield is currently a healthy 4.80%.

*http://www.telegraph.co.uk/finance/economics/11625098/HSBC-fears-world-recession-with-no-lifeboats-left.html

**http://www.advisorperspectives.com/dshort/updates/CPI-Headline-and-Core.php

***FE Analytics 19/08/2015

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. James' views are his own and do not constitute financial advice.


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