Global trade patterns are changing, due to both a cyclical change (reflecting varying strengths of economies) together with a structural shift (reflecting the impact of higher oil prices). First, so far, trade regionalisation has helped the world to de-couple from a slowing US. However, we believe that sustained weakness in the US will eventually lead to a global slowdown, which in turn will boomerang back to undermine US growth. The trade patterns in the world help to explain why the global slowdown has occurred in such slow-motion. Second, with the elevation in oil prices, the world’s distribution of savings-investment (S-I) balances has become much broader and more diverse. In theory, this should lead to more currency volatility when there are disruptions to capital flows. The Cyclical Aspect of the Change Trade is an important variable for macroeconomists, not just because it is an important element in assessing the state of the economy in question; it is also a key piece of information for gauging the strength of the rest of the world. We make the following points: 1. German exports are dominated by EU demand. The EU-25 accounts for two-thirds of exports from Germany. While there is much talk about OPEC’s recycling of petrodollars into Europe, much of this export demand may be enjoyed by other European countries, as OPEC accounts for only 2% of Germany’s exports. Similarly, the US and Asia don’t seem to be such critical sources of demand for Germany. The fate of Germany’s exports, therefore, rests on the strength of demand from the EU-25, in contrast to popular opinion that somehow the US, Asia or the Middle East drive German exports. These latter three areas, combined, only make up a third of export demand from the EU-25. 2. EU demand for German exports has begun to falter. Until recently, Germany’s exports had remained strong, despite the fact that its exports to most parts of the world began to show a sharp weakening (decelerating growth). More recently, the rate of growth of Germany’s exports has been in decline since 2007 (7%Y in 4Q07, but 5%Y so far this year). The main driver behind this was the deterioration in demand within Europe. 3. Intra-Euroland divergence and global de-coupling. The divergence between the various Euroland economies has intensified in recent quarters. The above analysis shows that, over time, even Germany’s exports have begun to falter because of the likes of Italy, Ireland and Spain. The implication for the rest of the world (RoW) is that global economic de-coupling is likely to be a temporary phenomenon. Eventually, if the source of the economic slowdown is persistent and big enough, the world will eventually decelerate. We are indeed beginning to observe this process. At the beginning of the year, the strongly held consensus view was that a faltering US would very quickly lead to economic weakness in much of the RoW. That view has turned out to be rather erroneous. One reason why the global slowdown has taken place in super slow-motion is, in our view, due to large intra-regional trade. In the case of Germany, the US accounts for only 8% of its export market; the figures are similar for other European countries. It is no wonder then that a slowdown in the US has not led to an immediate slowdown in Euroland. We have underscored that the importance of trade regionalisation has perhaps not been fully appreciated by investors because trade globalisation has been such a dominant and popular concept in recent years. The reality is that the former has been more important than the latter, in relative terms, and is one main reason why global economic re-coupling has taken such a long time to materialise. The Structural Aspect of the Change In addition to cyclical developments, there has been an important structural change in global imbalances – the geographical distribution of savings-investment imbalances is much broader now than several years ago, i.e., more countries have C/A deficits, and the average sizes of the imbalances – surpluses or deficits – are bigger now across countries than several years back. Change in the C/A balance (as a percentage of GDP) for the selected countries is shown. For example, for the US, its C/A deficit was 4.4% of GDP in 2005, but expanded to 5.2% in 2007 – a 0.8pp increase. We make the following points: 1. The oil price rise has affected everyone. Oil prices were US$20 a barrel in 2002, and the extraordinary rise in oil prices since then has led to a massive transfer of savings from the oil consumers to the oil producers. Back in 2002, the US was by far the dominant C/A deficit country. In 2007, however, there were more C/A deficit countries, and the size of the C/A deficits and surpluses grew, as a percentage of GDP. 2. Globalisation may have more than offset the oil effect, in some cases. Having said the above, China, Malaysia, the Philippines and Hong Kong have registered net improvements in their C/A surplus positions during this time, suggesting that the positive effects on trade from globalisation over the 2002-07 period have overwhelmed the negative terms-of-trade effect all of these economies have suffered. 3. Large net dis-saving in some countries. At the other end of the spectrum, net commodity exporters such as New Zealand, South Africa and Russia all suffered a deterioration in their net trade positions. This is because their imports have risen by more than the positive commodity price rise. 4. Higher currency volatility in the future? The more pronounced/exaggerated distribution of surpluses and deficits suggests that sudden shifts in capital flows could lead to volatility in the currency markets. We are of the opinion that all countries with large C/A deficits could see their currencies weaken in the period ahead. The USD may be an exception, mainly because its C/A deficit has continued to improve and that much of the bad news has probably been priced in. Bottom Line (1) The world is starting to re-couple and slow with the US. This whole process has taken place in much slower motion than many had expected because of trade regionalisation. (2) The world’s distribution of imbalances has become significantly more pronounced than five years ago. This should in theory lead to greater currency volatility. Appendix 1: The Curious Rise in Germany’s Savings Rate The savings-investment balances are diverse within Euroland, with Germany enjoying a dramatic improvement since the launch of the euro, while Italy’s savings balance has deteriorated steadily since the late 1990s. We intend to look into this interesting and important trend in greater detail in the future, but here are some thoughts we have: • Corporate savings are driving Germany’s overall savings. As is the case in other export powerhouses in the world such as China and Japan, the improvement in overall savings of Germany has arisen primarily from healthy corporate earnings and savings, and not as much from household savings. In fact, during this period, household savings have been relatively stable. Government savings have also helped this trend, but were not the primary driver. • The EMU has enhanced the stability of financing of the Euro-zone savings imbalances. The symbiotic relationship between the US and China is even more compelling than that between Germany and Italy. But in the absence of a de jure currency union for the US and China, the financing of the US C/A deficit has been less stable than has been the case for the Euro-zone. In fact, in the Euro-zone, the financing of imbalances is mechanical and certain. One reason is that, with a common currency, the liquidity and depth of the financial markets in the Euro-zone are enhanced, and excess savings in countries like Germany can be retained within the EUR markets, providing the financing for the likes of Italy. Bottom Line The EMU may have indeed enhanced the financing of imbalances for the member countries, as excess savings from Germany are efficiently intermediated within the EUR markets. Appendix 2: Oil and the US Trade Balance This should be a familiar point by now. However, we just want to document the divergent trends in the US oil and non-oil trade deficits. The US has enjoyed a dramatic improvement in its non-oil trade balance since 2006. The non-oil trade balance is now around 3.0% of GDP – roughly the same as in 2001 or 1999. As the US economy continues to slow, we ought to see this trend extend for a while longer, until the rest of the world also slows by the same extent as the US. On the other hand, the oil price rise has drastically exacerbated the US oil trade deficit. The US consumes around 22 mbpd of crude oil, 14 mbpd of which are imported. The impact of the rise in oil prices since 2-t002 is evident. In fact, the oil trade deficit is now close to half of the overall US trade deficit. Back in 1999, the oil trade deficit was only 17% of the overall deficit. This feature of the US trade balance is, in our view, one reason why there is a negative correlation between oil prices and the dollar – high oil prices disguise the improvement in the US trade balance. But if oil prices continue to normalise, investors may have a greater appreciation for the improving trend in the US trade balance, and the USD could be rewarded as a result. Bottom Line Falling oil prices should further support the dollar, as the oil price rise has been one key reason why the overall US trade balance has not improved as sharply.
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The Dollar to Rally by Default, Not by Merit
August 01, 2008
By Stephen Jen & Luca Bindelli | London
Summary and Conclusions We continue to believe that the dollar is seriously undervalued and, now that the global economy is less divergent than in 1H08, it will be more difficult for it to weaken further, even if the US economy slows further in the coming quarters. In fact, in the quarters ahead, there will be as many opportunities for many other economies to underwhelm as there will be for the US to disappoint, in our view. We continue to expect to see a tentative and asynchronous recovery in the dollar, more by default than on merit. (This is exactly the reverse of what happened to the EUR in 2004-06, that it rallied hard, despite the fact that Euroland economy was rather lacklustre.) The US Economic Outlook Is Not Positive Our US economics team is looking for the US to enter a technical recession in 4Q08 and 1Q09, but expects the FFR to stay at 2.00%. We don’t dispute this outlook. Detailed 2Q GDP data released earlier today suggest that much of the upside surprise to US growth in 2Q was due to trade. When the rest of the world slows later this year, the US is likely to lose this source of support. In a way, in 1H, the US has been coupled to the RoW, not the other way around. But the World Is Finally Not Diverging from the US Economy The IMF’s World Economic Outlook (WEO) has tried to avoid the use of the terms ‘coupling’ and ‘de-coupling’. Instead, it prefers to use terms ‘diverging’ and ‘converging’. We also think that the latter terms may be more appropriate. In 1H, due to trade regionalisation, monetary easing through USD pegs and other factors, much of the world diverged from the US (see Why Is the World Slowing in Super Slow-Motion?, July 31, 2008, and Dollar Smiling Against EM, Still Frowning Against EUR, July 3, 2008). However, we are starting to see signs of economic weakness in many parts of the world. Part of this turn in the global economic cycle has been due to the oil effect, monetary tightening, trade and negative equity and housing wealth. Four Currency Trades We believe that we are at an important inflection point for the currency markets – that the dollar may be forming a multi-year bottom against the majors and may also rally against some EM currencies. However, for the dollar to rally hard, we may need to see outright rate hikes from the Fed, which is unlikely until next year. Thus, any rally in the dollar will likely be powered by worse news elsewhere. This is why we see a hesitant and asynchronous USD recovery in the quarters ahead. As our colleague Sophia Drossos points out in her note USD: Bumpy Road to Recovery (July 31, 2008), the near-term volatility will open up tactical trading opportunities for both USD bulls and bears. But in this note we focus on medium-term USD bullish views, as that is how we see the trend developing. We have four trades in mind: • Trade 1. Long USD/AXJ. We have, since May, been warning that USD/AXJ’s down-trend in recent years would be interrupted, as the world slows under the weight of the US economy and high oil prices (see Dollar Smirks in Asia, May 1, 2008). Even with the recent correction in oil prices, we believe that the energy subsidies are still too large and policymakers in AXJ will take the opportunity of lower oil prices to further unwind these subsidies. While countries may differ on their relative ability and willingness to maintain these subsidies, the oil price surge, in our view, is significant, and will eventually lead to serious consequences over time. All energy consumers should be hurt by energy prices. But since Asian countries are some of the heaviest energy users in the world, we believe that their currencies will eventually reflect this. The terms-of-trade (ToT) shock is another measure of the severity of the energy and food price impact. Asia ranks quite low on the ToT measure (see Winners and Losers from Terms-of-Trade Shocks, July 24, 2008). Inflation control is another challenge that AXJ will face. But our view is that, when push comes to shove, Asia will almost always choose to protect growth rather than stabilise inflation. China has already made this policy switch. We believe that most other AXJ economies will do the same in the quarters ahead, including the so-far-hawkish RBI. USD/AXJ should drift higher, therefore, partly because of this prospective shift in policy focus to protect growth. USD/INR, in our view, has the most upside risk among the AXJ currencies. The Greater Chinese Currencies (CNY, HKD, TWD and SGD) will outperform the rest, in our view. • Trade 2. Buy USD/JPY on dips. While spikes in risk-aversion or heavy sell-offs in AUD and NZD may lead to temporary downside spikes in USD/JPY, these would be great opportunities to buy USD/JPY on a 6- to 12- month horizon. Capital outflows are a structural trend in Japan. Retail investors will likely stay outside the JPY market and continue to reduce Japan’s financial ‘home bias’. At the same time, sovereign institutional funds such as the GPIF, Yucho Bank, and Kampo will likely continue to diversify out of JPY assets. Finally, the negative terms-of-trade shock associated with the oil price rise is severe for Japan, and should be reflected in the value of the JPY. • Trade 3. EUR/USD, GBP/USD, NZD/USD and AUD/USD should drift lower, eventually. The dollar is likely to be forming a multi-year bottom against the majors. The inability of EUR/USD to hold above 1.60 two weeks ago, when news on the US economy was terrible, is important, as it may reflect the extreme misalignment of EUR/USD. With the European economy slowing, the refi rate may very well be at its cycle peak, but the FFR may be at its cycle trough. It looks much more difficult for EUR/USD to rise significantly further without triggering a policy response from either the ECB or the US officials. At the same time, the economies of the UK, New Zealand and, more recently, Australia have begun to struggle almost as much as the US. A more dovish interest rate outlook in these economies should lead to varying degrees of currency weakness against the dollar. While the positive ToT shock Australia has enjoyed may help cushion the AUD, and the BoE’s hawkish stance may help limit the downside risks to cable, the USD will likely outperform EUR, GBP, NZD and AUD in the quarters ahead, to varying extents. • Trade 4. Long the RUB and the GCC currencies. These are the major beneficiaries of the oil effect. Of the two, RUB is a more immediate trade, and a trade that has a limited ‘shelf-life’. High inflation may eventually force the CBR to contemplate further widening in the RUB band. But with real imports growing at more than 30% a year, it is possible that Russia’s C/A surplus may disappear in 3-5 years’ time. In contrast, the GCC currencies – also beneficiaries of high oil prices – will likely offer great medium-term trading opportunities, with an uncertain short-term outlook. In our view, we will likely see a repeat of what has happened to the RMB since 2005, with the GCC eventually (most likely under a common currency union) adopting a BBC (basket-band-and crawl) regime like China has. This GCC trade will be a multi-year trade with a strongly asymmetric risk profile. Four Paths of Falling Dominos The ordinal ranking of currencies we first proposed in Four Fall-Lines of Dominos: An Ordinal Ranking (May 1, 2008) is still very relevant, in our view, as the table ranks currencies along four important dimensions. We replicate the table and show the ordinal (qualitative) ranking of currencies on four measures: (i) the size of the C/A deficit (a measure of vulnerability to sudden stops in capital flows); (ii) the extent to which the economy in question has a housing-excess consumption problem; (iii) the size of the commodity trade balance (a measure of how vulnerable a country would be in the event of corrections in commodity prices); and (iv) trade exposure to the US. Factors (i), (ii) and (iv) have become more important. A genuine turn in commodity prices would also be important for factor (iii). A more synchronised global economic slowdown should make these four measures more important drivers of exchange rates. Bottom Line We believe that we are at an important inflection point for the currency markets. For the first time since the financial crisis began a year ago, much of the world is converging to the path of the US economy. This will make it more difficult for the under-valued USD to sell off further. In fact, there are many currencies that look even more vulnerable than the dollar.
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All Is Over: 2Q GDP Preview and Sharp Outlook Revision
August 01, 2008
By Takehiro Sato & Takeshi Yamaguchi | Tokyo
Lowering Our 2008-09 Outlook We now take the view that GDP is likely to have fallen much further in April-June than in our last forecast of June 11, and we therefore slash our outlook ahead of the release on August 13. The cut in our forecast mainly reflects the lower launch pad, especially for the fiscal year. We expect a real growth rate of +1.0% for 2008 (+0.6% for F3/09) to sharply fall short of the government’s and BoJ’s revised projections. We also revise down 2009 after reflecting a tempered outlook for the US and Asia, and now forecast growth of +0.2% for 2009 (+0.6% for F3/2010). Although energy quotes have fallen back and are encouraging some in the stock market to take a more positive view, it has limited downward pressure on consumer prices, and there is a lingering risk of corporate earnings falling short of expectations due to the possibility of steeper production cutbacks. Consequently, a mild sales stagnation and a delay of the improvement of cost structure leads us to revise down our corporate earnings outlook, sharply to -20% in F3/09, while they are likely to show a modest bounce-back by 3% in F3/10. Assumptions Behind Our Forecasts Our forecasts for the global economy reflect the views of the respective regions. In the US, from the GDP perspective, we expect a recession to be averted in 1H08 by the tax refund effect and higher withdrawal of consumer credit. Indeed, our US economics team revises up the outlook for 2008. However, our US team anticipates a recessionary phase for GDP as well from Oct-Dec 2008 to Jan-Mar 2009, as tax refund effects fade and the credit crunch bites harder. The lower launch pad for the full year puts the outlook of +0.7% for 2009 below consensus. Emerging economies will also likely see a shift from mild decoupling towards mild recoupling, centered on Asia. Thus, our China and non-Japan Asia economics teams also cut their long-upheld forecasts on July 18. As before, our assumptions for the oil price are based on the futures contracts immediately prior to our revisions (in this case, July 30), while for forex rates, we use the same assumptions as our currency strategy team. April-June Quarter GDP GDP lost two engines in April-June – the export and personal consumption that drove high growth in January-March – and the annualized growth rate is likely to have turned negative at -3.4% saar, which is likely to offset the buoyant growth of the previous quarter almost completely. Among demand items, the net external demand contribution will probably have fallen to around nil, hurt by steep falls in exports to Asia and Europe in the June trade data. Discrepancies in reporting timing of the customs-posted FX rate for the trade data (the conversion rate for export and import values) and the actual rate used in the export/import deflator data mean that real exports for January-March may have been overstated, and conversely, the figure could be understated for April-June. In terms of the trend, however, exports are still slowing. Domestic demand, too, may well have started making a negative contribution due to a combination of slowing capital investment and falling personal consumption. Personal consumption (-0.6%Q) is likely to have turned negative for the first time in seven quarters due to falling real disposable incomes with cost-push inflation, and worsening consumer sentiment. The decline is likely to gain further momentum from a reflexive fall following the leap-year effect in January-March. Capex (-2.0%Q) should also have eased due to narrower corporate margins. Residential investment (-0.1%Q) is likely to lose momentum compared to a brisk rebound in January-March. Meanwhile, worsening terms of trade alongside rising import prices are likely to have become even more apparent. Growth in real GDI adjusted for trading losses was probably even lower than the unattractive headline. It is also unlikely that the GDP deflator (-1.5%Y) turned positive year on year, despite CPI growth. The likely takeaway from this is that companies are unable to pass on hikes in import costs and are seeing their margins squeezed. The above preview forecast for GDP growth is much lower than our estimate as of June 11 (-0.7% saar), which alone shaves 0.8pp from the growth rate for F3/09. Notwithstanding the recent string of downward revisions in the government’s and BoJ’s economic forecasts for F3/09, the effects of the April-June shortfall on the annual numbers are still likely to exceed their expectations. State of the Economy from July-September and the Next Catalysts We are becoming more downbeat on the global economies in the July-September quarter. Japanese manufacturing production has dropped in two successive quarters through April-June, and the outlook is for spreading cutbacks from July-September too, as exports flag amid economic conditions worsening overseas, affecting the auto-related industry output in particular. Exports nominally were swelled by VAT exemption on diesel oil for China in May and June, but China-bound exports in June excluding mineral-based fuel turned down year on year for the first time in 76 months, and a shift in trend is evident. For overseas economies, we keep a close eye on the frequency of credit events. The past pattern suggests that defaults in the overseas bond markets may be about to increase. My personal view here is that moving past the summer, the US economy could move into a downward spiral as credit contracts further. For example, the ratio of distressed companies in the corporate bond market (those with credit spreads that exceed 1,000bp) has risen rapidly since 2H07 and now stands around 20%. A spike in this ratio has historically spelled an increase in defaults 6-12 months down the line, implying the risk of more credit events in the coming months. Conditions for fundraising via direct financing such as commercial paper are already tight, and companies are reliant on commitment lines from banks to access liquidity. US commercial banks would start reducing these lines if there is a rash of defaults, likely affecting credit in the non-financial sector, which so far has remained in relatively good shape. The household sector has also seen home equity lines of credit (HELOC) reined in since the start of the year as housing prices slump, and households are reacting by taking out more credit as a defensive measure. This increased use of credit, along with the recent tax breaks, appears to have allowed personal consumption in the US to hold up better than expected in 1H08, but as commitment lines shrink, the household sector, like the corporate sector, faces the risk of credit being choked off. In this event, both the household and corporate sectors in the US would face liquidity constraints. Our US economics team is forecasting that a recession will kick in, with annualized growth slowing to +1.0% in the July-September quarter and then giving way to negative growth of -1.5% in October-December and -0.5% in January-March 2009 (for details, see Richard Berner and David Greenlaw’s US Economics: The Perfect Storm Returns, July 7, 2008). Asia is also experiencing a fallout from rising energy costs, with manufacturing activity in India already slowing sharply and China set to step up cuts in energy subsidies after the Olympics. A number of Asian countries have relied on subsidies to withstand soaring energy prices, but fiscal situations mean that such policies are no longer sustainable, and Asian economies are likely to become more sensitive to energy prices. Japan has maintained comparatively strong growth through January-March, thanks to a high contribution from net exports, but could see a deepening recession in October-December and January-March as exports lose further steam. With the launch pad for growth in F3/10 dropping, the outlook for Japan’s economy in that year automatically moves lower. January-March 2009 Could Mark the Trough as a Bull Case Our estimate of the probability of a recession based on the coincident index (CI) has already topped 75% since last November. Adding Tankan survey and industrial production data to the mix, it looks as if the economy entered a mild downturn in January-March 2008 after peaking in October-December 2007. Post-war, it has taken an average of 16 months for the economy to hit bottom after the onset of a downturn (and 21 months on average since the oil crisis). Troughs in Japan’s cycle are concentrated in 2H of the fiscal year, and on the last two occasions have come in January. With this as a reference, we are looking for the economy this time to bottom out in January-March 2009 and then start to pick up in April-June. Our standard (or rather a bull case) scenario thus calls for a recession up until January-March 2009. We see downside risk to this view, however, even though the recent pullback in energy prices has caused pessimism to recede somewhat. First, despite the recent drop back in energy prices, it has taken 6-12 months in the past for rising prices to affect Japan’s consumer prices, so CPI inflation in 2009 will probably not ease by as much as the government and BoJ are assuming (our core CPI forecast is +1.8% for 2008 [+2.1% for F3/09] and +2.3% for 2009 [+2.2% for F3/10]). The current food inflation is also unlikely to subside quickly for the same reason. In fact, the government’s resale price for wheat is slated to go up by about 20% in October. This would dampen real income growth in 2009 as well, and means that consumption is likely to lack impetus. Second, we see some risk that the US economy could sink into a Japan-style debt deflation, as liquidity constraints and declining asset prices reduce the risk tolerance of both corporations and households. Current conditions in the US resemble those in Japan from November 1997 to 1998, and the policy response to a series of credit events is similar to that of Japan in 1997 and 1994. As many observers have pointed out, the policy response in the US has been 3-5 times faster than in Japan, which is certainly impressive, but the true effect of falling asset prices feeding back into the real economy still lies ahead. The European economy is blowing hot and cold in different regions, and could trace the same path. Third, despite the softening of energy prices, in Asia of late, the economy there is slowing as subsidies are cut and as prices soar, which creates a tightening bias for monetary policy that could trigger further deceleration in a vicious circle. Subsidies have given Asia a low sensitivity to energy prices even when these are high, and ultimately highlighted the region’s low energy efficiency. Past policies could come home to roost even at times of lower prices because they have allowed efficiency gains to be neglected. Japan, by contrast, has provided virtually no energy subsidies and benefits from high energy efficiency. Corporate Earnings: Risk of Widening Declines In previous phases of output cuts, Japanese manufacturing has, on average, come down 5-6% from the peak in about a year. This would imply that sales are bound to drop in a recession, and that the companies’ bottom-up forecast is too optimistic. In a simplified case, the typical decline in industrial output (about 6%) in a recession would mean that annual output drops on average by about 3%Y. If sales prices hold constant, manufacturing sales would have to decline 3%. In contrast to the above simplified case, the current consensus (e.g., in the BoJ’s June Tankan) was, among large manufacturers, for F3/09 sales growth of 3.5%Y. Comparison with the average pattern of correction during past recessions may also be misleading. Yet if sales volume is indeed set to fall by about 3% on average, we wonder whether it is expecting too much for revenue to rise by more than 3%. Moreover, even the BoJ Tankan targets are looking for recurring profit to fall about 10% on 3.5% growth in sales revenue, and we wonder if this is also too hopeful at a time when sales seem to us more likely to fall. Rather, without any noticeable changes in cost structures, the profit outlook gears downwards when sales are likely to fall, and profit drops of even 20-30% would not be all that surprising. Admittedly, non-manufacturing sales fluctuate less sharply than manufacturing, and some industries – such as trading, mining and electric power and gas – have a relatively high probability of securing revenue on the back of selling price hikes, leading us to expect sales to rise only marginally by 0.5% at most for large companies in total. Meanwhile, we forecast that recurring profits for all large companies in F3/09 will drop sharply by 20%, about 15pp lower than our previous forecast (MoF Corporate Statistics basis, firms with at least JPY1 billion in capital, excluding financials). This, however, is far below the bottom-up consensus. Our conclusion for the stock market is that we cannot say definitively that valuations are cheap, considering the aforementioned recessionary scenario. We estimate also that forex rates affect profits either way by some 3pp per JPY5 shift, and that a 10% change in crude oil price affects profits by about 3pp inversely. Incidentally, our assumptions for the FX rate and energy price for F3/09 is JPY101/US$ and US$127/bbl, respectively. (Note that the energy price is just the assumption based on the current futures quotes, instead of our outlook.) Given the recent modest yen depreciation, there could be modest upside in our extremely cautious profit outlook. For F3/10, we retain our corporate earnings forecast to show modest growth of 3%, partly due to an easy comparison. When the economic rebound gains vigor, however, in the latter half of F3/10, we would expect changes in corporate behavior aimed at margin expansion. Namely, once companies become more assertive on pricing, there should be macro pressure for rising prices, which could be expected to result in the surge of top-line growth. Policy Implications Monetary policy has no tools for dealing with commodity inflation or with income outflows. If a US recession stifles Japan’s growth, a rate cut could not be ruled out in Japan. Growth in gross national income (GNI) is actually underperforming GDP as trading gains diminish, and even if headline GDP grows a bit, increases in the purchasing power of the national economy would be unlikely to match that, as personal consumption in particular flags with feeble wage growth. A rate hike under this cost-push inflation could not be justified, therefore. Energy and primary goods prices are not within the control of central banks to start with, and any moves to tighten would be overkill for the economy. On the political front, general election fever is swelling, and our hope is that expectations for reforms to be resumed after the political map has been redrawn will forestall new lows for the stock market. For monetary policy, the chance of a pre-emptive rate cut is remote, but some reactive adjustment, for example in consideration of systemic financial risk, is conceivable. The timing could be the April-June quarter of 2009, when the BoJ might essay a 25bp reactive cut to stimulate a reviving economy, as before then we assume that a US recession from October-December to January-March will have coincided closely with a downturn in Japan’s economy. Yet, there is very little room to play with when cutting rates, and little risk that debt deflation in the economy will reverse, given the balance sheet adjustment progress made at financial institutions and companies, so we would not expect the policy rate to be left at 0.25% for more than two quarters at the most. Risks There is risk for the global economy from October-December, once tax breaks have worn off in the US. There is an overhang from the issue of undercapitalization of financial institutions, exacerbated by balance sheet adjustment which would put a negative financial accelerator into play, and the US could be saddled with sub-par growth even in 2H09. A sharp and decent pullback of energy prices could prevent such a scenario. Domestically, if a general election is delayed, the market would struggle all the more to break out. A leading paper’s poll indicates that the approval rating for the Fukuda cabinet perked up a little after the G8 summit, but this is still down in the 20% range which imperils the administration’s grip on power. There is little incentive for the ruling parties to dissolve the Diet and call a snap election when they have an absolute majority in the lower house and such low approval ratings, and this leads to a sense of stalemate among market participants. If the political situation coheres, it would be welcomed by the market as a portent of change, but there is also the risk that a general election could result not in a reform-minded alliance (a center-right coalition cabinet) but an alliance of anti-reform factions like in the mid-1990s. The outcome would depend in part on the state of the economy and markets. If society is overly preoccupied with issues such as income distribution (disparity between rich and poor areas is a well-aired topic), Japan could end up with an anti-reformist alliance – the last thing it needs, in my view.
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EUR/USD Fair Value: Views from Stuttgart and Sicily
August 01, 2008
By Stephen Jen & Luca Bindelli | London
Summary and Conclusions The fair value (FV) of the EUR is calculated based on the composite fundamentals of Euroland. However, with the divergent economic trends of economies within the Euro-zone, and their varying structural characteristics, the ‘FVs’ of the EUR based on the different economies must be quite diverse. We have computed the FVs of the EUR using the economic fundamentals of Germany and Italy. This approach, conceptually, is similar to our ‘shadow price’ argument about the JPY. In essence, due to intra-regional divergence, the EUR could become an unstable currency over time, just like the JPY, as it gravitates toward different ‘shadow prices’, reflecting the FVs of the various economies within the Euro-zone. The Concept of ‘Shadow Prices’ We first proposed the term ‘shadow prices’ back in 2002. This concept is perhaps best explained using the JPY as an example. Japan’s exporters are exceptionally competitive, but Japanese financial assets are not. The ‘equilibrium’ level of USD/JPY that would still leave Japanese exporters competitive could be much lower than that leaving foreign investors indifferent between holding JPY assets versus USD assets. Specifically, USD/JPY at 80 could still leave a major Japanese auto-maker competitive, while USD/JPY at 150 would be necessary to entice foreign investors to treat JPY assets and non-JPY assets equally. Thus, there is a USD/JPY ‘shadow price’ at 80 and one at 150. As a result, as investor focus shifts from the current account (C/A) to the financial markets, USD/JPY could drift within this wide range, with 80 or 150 taking turns as the ‘centre of gravity’. Indeed, for the past 15 years, USD/JPY has been confined within this range. When the world’s concerns centre on trade and competitiveness, 80 should be the centre of gravity for USD/JPY. However, when investor focus shifts to the financial sector, as was the case in the mid-1990s and 2000, 150 became the centre of gravity for USD/JPY, because it was the shadow price for the financial sector that dominated. This concept could be applied to the Euro-zone. But rather than looking at the ‘sectoral’ divergence, there is great geographical divergence within Euroland, and the FVs of the EUR could be computed from the perspectives of Germany, Italy, Ireland and others, and the FVs are unlikely to be similar. A Joke, as an Analogy To help illustrate this notion of multiple shadow prices, we re-tell a joke. Two hunters go into the woods to hunt for deer. Spotting a deer, the first hunter takes aim but misses it as his shot was way in front of deer. The second hunter then takes aim and shoots. He also misses, as his shot was way behind the deer. (The deer shows a lot of consideration by staying put throughout so as to help us tell this story.) The two hunters then give each other a high-five to celebrate. One says, ‘on average, we nailed it!’ In a way, modeling EUR/USD’s (and other exchange rates’) FV is analogous to this joke above. Our Calculations As regular readers of our work know, we run quarterly calculations of our FV framework that contains 13 different specifications for the top 11 G10 crosses. For EUR/USD, the median of the 13 FVs is 1.30, with a range of 1.07 to 1.44. Thus, while the various perspectives have produced a wide range of FV estimates, the FVs of all 13 different specifications are significantly below the current spot exchange rate. This is why, for a long while, we have been warning that EUR/USD (and the EUR index for that matter) has been grossly over-valued. But instead of using the Euro-zone-wide economic data as right-hand-side variables, we have re-estimated the FVs using German and Italian data, separately, to produce two sets of FV estimates. The FV of the EUR using data from Italy was indeed consistently below that using German data, and the gap between the two has actually widened gradually over time. Right now, there is a 17% gap between the FVs from the German and Italian data. However, while the FV line using German data is above that using Euro-zone-wide data, it is still below the spot EUR/USD rate. In other words, EUR/USD is over-valued even if we use only German data. We have the following thoughts. • Thought 1. Extreme undershoots and overshoots in EUR/USD. One feature to highlight in Exhibit 1 is that there were forces that propelled EUR/USD either significantly below the FV using Italian data (during 1999-2002), or significantly above even the FV using German data (now). There are several hypotheses for these extreme movements in EUR/USD since 1999, but our favourite is portfolio-based explanations. The 2005 correction, in retrospect, was remarkable, as EUR/USD corrected to almost precisely its FV, before surging again into over-valued territory. As the divergence between the US and Euro-zone business cycles decline in the quarters ahead, we expect EUR/USD to drift gradually lower. • Thought 2. Fuzzy data in the Euro-zone. Unlike the US, Euro-zone data are ‘fuzzier’ in that country data elevate both signals and noise. Since Euro-zone-wide data are not yet complete, investors have naturally been forced to augment their information set with country-specific data. However, waves of these data from the 15 member countries could bias investors’ thoughts about the EUR or the state of the Euro-zone economy. Back in 2000-01, when the EUR was weak, investors placed a disproportionate weight on Italian data, which were dismal. In recent quarters, on the other hand, when investors were by and large bullish on the Euro-zone, they placed a disproportionate emphasis on the German data. The end result was that the swing in EUR/USD has been exaggerated because there were ‘multiple shadow prices’ that fed the virtuous and vicious circles. • Thought 3. ‘One-size-fits-none’ monetary policy? This shadow price analysis also accentuates the point that the Euro-zone may not be an optimal currency area, in that the divergence of economic trajectories is still quite significant, 10 years after the launch of the euro. The deer hunter joke earlier in this note is an analogy for not only the FV of EUR/USD, but also the equilibrium interest rates for the various economies in Euroland. While the ECB may have a justified stance for the Euro-zone, with inflation being so different within Euroland, it may in fact have a ‘one-size-fits-none’ policy rate, as the member countries diverge. • Thought 4. If Italy breaks away from the EMU, the FV of EUR/USD should go up. There has been sporadic talk of Italy or Spain one day breaking away from the EMU. While we believe that the political momentum is too strong for any member country to break away from the EMU, theoretically, if Italy were to break away from the Euro-zone, the composite FV of the EUR should actually rise. Having said this, the sentiment effect on the EUR from the view that the Euro-zone may be disintegrating would be negative, countering the valuation point mentioned above. Both the sentiment effect and the valuation effect in the event of succession, therefore, should be considered by investors. • Thought 5. China and the dollar zone. As an extension of the previous thought, one could also consider the role that China has played by being a part of the dollar zone. The harder the USD peg in China was (e.g., before USD/CNY became more flexible in 2005), the more the dollar was supported. One could calculate (though we haven’t done these calculations) the FV of the USD using the US economic fundamentals, or using the composite fundamentals of the members of the USD area (e.g., China, the GCC, etc.). The latter would probably yield higher FVs for the USD. We believe that the loosening of the USD peg by China – which was, in turn, a result of persistent political pressures from the US and Euroland – has had a meaningfully negative effect on the USD, i.e., China’s ‘breaking away from the USD zone’ has not been positive for the USD. Similarly, if and when the GCC decide to break away from the USD area, the USD will most likely suffer. Bottom Line The FV of EUR/USD using German data is 17% higher than that using Italian data. There are, thus, multiple shadow prices for EUR/USD across member countries. At present, spot EUR/USD is above the FV using German data. Further EUR/USD weakness could shift investor focus to weaker economies such as Italy, and away from Germany. In other words, the shadow price of ITL could become the new centre of gravity for EUR/USD.
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