Investors caught in currency war crossfire

Date: Friday, October 8, 2010
Author: Daniel Bases, Reuters

Investors looking to defend their portfolios while a global currency war brews are bringing the equivalent of a knife to a bazooka battle, and the best hope for survival is to duck and cover.

A sampling of top performing U.S. fund managers shows a penchant for holding euros over the U.S. dollar, for lack of a better alternative, with managers admitting there are few foxholes to find refuge from idiosyncratic government action.

Government efforts to weaken their currencies in a "beggar-thy-neighbor" fashion in order to protect local =industries are not a long-term solution to weak global economic conditions, World Bank President Robert Zoellick said on Thursday.

James Melcher, founder and president of macro-global hedge fund Balestra Capital Ltd in New York, said a currency war is already underway, but so far it is being conducted in a "gentlemanly" manner.

"I think the gloves may come off. As long as it is central bankers talking, they go back and forth and can usually work things out... Except you get the voters or the guys running the manufacturing plants or the workers and unions and they start screaming, and the politicians cave in," he said.

"That's why I am worried about trade wars. I think there is a very good chance that you'll find, in effect, trade wars, competitive devaluations, tariff barriers and other restraints of trade," said Melcher, one of the few investors who correctly forecast the housing and sovereign debt crises.

Ceasefire

There is an unspoken ceasefire underway while the world's finance ministers and central bankers meet in Washington Oct 8-10 for the meetings of the International Monetary Fund and World Bank, as they hash out possible solutions.

In the developed markets, the accepted wisdom on Wall Street is the U.S. Federal Reserve will soon unveil new quantitative easing measures because interest rates are already at zero. Japan intervened last month for the first time in six years to weaken the export-crimping strength of the yen.

In the emerging markets, China is perpetually accused of keeping its currency artificially weak, and Brazil doubled the tax foreign investors pay to buy local fixed income assets to slow the real's appreciation. Vietnam has devalued its currency several times in the past year.

Melcher, long a fan of gold, says holding it may be an effective way to protect "against some of the coming global turmoil, although it may be technically overbought right now."

Spot gold is off a record high $1,364.60 set on Thursday, but up 15.5 percent since late August.

"In the past, when we enter periods where there do seem to be unusual events like competitive devaluations or quantitative easing, we tend to put less emphasis or reliance on our models and just take some risk off the table," said Bill Nemerever, co-manager of the GMO global fixed income group.

Nemerever, who eschews gold, said the model-driven investment style changes daily but points to "a bit" of an underweight in the U.S. dollar and an overweight of the euro.

"Things have gotten a little more difficult and in a sense more political than financial." he said, adding that what keeps him up at night is the political risk of countries doing "something dramatic and sudden," which cannot be modeled.

Investors had as of Sept 28 made a massive move against the U.S. dollar, lifting the net short position, which bets on further greenback weakness, to $22 billion, the biggest since at least mid-2008, according to Thomson Reuters data.

Daily foreign exchange trading volumes are close to $4 trillion, according to the Bank of International Settlements.

GMO's international bond fund (GMIBX.O) rose 11.99 percent last quarter, among the top five in the category, according to Lipper, a Thomson Reuters company.

EURO POLICY

The Fed is prepared to put money into the U.S. economy by buying up bonds and other assets. That has depressed the U.S. dollar to 15-year lows versus the yen and an all-time low against the Swiss franc.

In contrast, the European Central Bank is removing economic stimulus while leaving interest rates steady at 1 percent.

ECB President Jean-Claude Trichet on Thursday said exchange rates should reflect economic fundamentals and that sudden swings were harmful to growth, in a pointed reference to countries intervening to keep their currencies low.

"I think there is a lot of value in currencies like the euro, which is unlikely to devalue... Trichet has been very vocal in saying one of the risks is the taking of protectionist measures," said Kieran Osborne, co-portfolio manager of the Merk Absolute Return Currency fund, based in Mountain View, California.

Merk's fund (MERKX.O) rose 9.05 percent last quarter.

"From an investor standpoint it is harder and harder to find an asset that holds intrinsic value," Osborne said, highlighting why gold continues to rise.

Some fund managers don't bother to place currency hedges.

"It is accepted industry practice that nobody hedges," said Ralf Scherschmidt, international equity portfolio manager at Oberweis Asset Management in Chicago. (OBIOX.O)

Scherschmidt, whose fund was a top performer last quarter in the international small-cap and mid-cap growth category with a 25 percent return, said hedging a portfolio with tens, if not hundreds, of stocks is not cost-effective.

"I'm guessing here it would reduce portfolio returns three to four percent a year just through the cost of constantly hedging," he said, adding the hedging takes away from stock selection.

But if there was a full-blown war, he said, "you would probably have to ride it out in the long run because it is nearly impossible to predict which country would do it and by how much."