The world has entered a period of massive change. For longer than any of us can remember the global economy has been dominated by the institutions, businesses and consumers of the West. This dominance is now threatened by an unhealthy combination of excessive debt, deflating property bubbles and the credit crunch.

But as the star of the West falls, so that of the East continues to rise, as the likes of China and India strive to restore former economic glories. This seismic shift is a once in a lifetime event that is creating great risk as well as opportunity.

With so much going on this is not a time to be driving whilst looking in the rear view mirror. Yet that is exactly what many investment managers are doing.

I have previously often talked about the symbiotic relationship between East and West, sometimes referred to as ‘Bretton Woods II’ or the ‘circle of manipulation’. There are still a large number of countries that continue to operate a fixed or managed currency peg with the US dollar. This policy is designed to deliver economic stability and to give export companies the best opportunity to sell into the lucrative US market.

Asia lending US cheap money to buy exports

Many of these countries have large current account surpluses, which under normal circumstances would result in stronger currencies. To prevent this from happening, the Central Banks of Asia and the Middle East have bought huge amounts of US dollars, which have been parked in the US bond market, thereby keeping borrowing costs low. Low interest rates have fuelled a borrowing binge, which resulted in a big surge in imported consumer goods (mainly from Asia) and rising property prices. In effect, Asia was lending America cheap money to buy its exports.

Although this cosy relationship appeared to be to the benefit of both parties, we said that ultimately it would prove unsustainable. We saw two potential weak links in the chain. First, there was the property market, where rising prices ended up pricing the first-time buyer off the ladder. Second, there was the inflationary consequence in the East of printing lots of money to buy US dollars. In fact, the first is serving to expose the second.

The bursting of the US property bubble and the associated credit crunch have seen the Federal Reserve slash interest rates to prevent the economy sliding into a deep recession. Parts of Asia and the Middle East have followed suit to protect their currency pegs (otherwise inflows of money would have cause their currencies to appreciate). Lower interest rates could not have come at a worse time for them. Take for instance Singapore with a growth rate of six percent per annum. Their inflation rate is 6.5 percent (it was only 0.3 percent just over a year ago) and yet they have interest rates of less than 2 percent. Such low real interest rates merely exacerbate the inflation problem.

Some countries, like Singapore, are attempting to combat the inflation threat by allowing their currencies to edge higher versus the US dollar. But it may not be enough. And the more that the Fed cuts US interest rates, the more untenable their currency regimes become.

China is the key player in the region. Prime Minister Wen Jiabao recently said that getting inflation under control was their number one priority. To date, their policy has involved mild currency strength combined with rising interest rates and increased reserve requirements for the banks (which limit their ability to lend). They are clearly reluctant to ‘rock the boat’, but should rising inflation threaten social and economic stability, we believe that they will not hesitate to revalue the Yuan more aggressively. Such a move would trigger a wholesale revaluation of currencies in the region.

Stronger Asian currencies would be bad for the Western consumer

Much stronger Asian currencies would be bad news for the Western consumer given that it would mean:

• Higher borrowing costs due to imported inflation and smaller inflows of Asian foreign exchange reserves into US Treasuries.

• Lower real incomes due to the rising cost of imported Asian manufactured goods.

• Bigger energy and food bills as stronger currencies fuel Asia’s appetite for commodities.

Clearly it’s not all bad news. Stronger Asian currencies will present selected Western companies with a wonderful export opportunity. But our feeling is that the losers will likely outnumber the winners, at least in the medium term.

What does all this mean for the investor? In short, we are seeing the Asian crisis in reverse. When Asia got into trouble in the late 90s, the strong dollar triggered a consumer boom in America and a big jump in share prices. America boomed while Asia struggled. Now the boot is on the other foot and we are entering a phase (lasting several years) where making money will be about investing in Asia and in those companies that sell to the Asian consumer.

All of which brings us neatly back to our opening theme. The investment industry remains fixated by benchmarks and the contents therein. The problem is that benchmarks are inherently backward looking, because the shares and markets that have performed best in the past are the ones that have the biggest weightings today. Take for instance the MSCI World Index, which is dominated by companies that are reliant on the Western consumer. In contrast, Asia — and companies that have something to sell to Asia — are barely represented at all. So the message to investors is quite clear. The world is entering a period of massive change and only those who ignore benchmarks and invest in an unconstrained manner will be able to thrive.

Peter Lucas is Ashburton’s Global Investment Strategist