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Currencies
Heightened Alert on Many AXJ Currencies October 13, 2008 By Stephen Jen | London & Stewart Newnham | Hong Kong Summary and Conclusions In response to the de-rating of global growth announced on October 6 by our Global Economics Team, we are revising down, further, our outlook for most AXJ currencies. Global financial conditions have deteriorated so substantially in recent weeks that material damage has been inflicted on the global economy. We were already on alert regarding the downside risks facing AXJ currencies in May (see DEFCON-3 on Some Emerging Market Currencies, May 15, 2008). Now the alert level is higher: AXJ currencies remain very vulnerable in the coming months, as Themes that Matter for the AXJ Currencies We first turned bearish on the AXJ currencies on May 1, 2008, and since then been consistently highlighting the risk of a U-turn in the appreciating trends in the AXJ currencies. There are several global and region-wide themes to keep in mind when thinking about the AXJ currencies. 1. Global demand growth will slow dramatically in 2009. This point is obvious. The de-coupling versus coupling debate in 1H was only interesting when the 2. A temporary recovery in risk-taking and global recession. While there is clearly the risk in the short-term that bigger and continued policy stimulus (i.e., more coordinated interest rate cuts) may trigger a recovery in risk-taking and risky asset prices, we believe, ultimately, the global economy will drive most risky assets. For our call on USD/AXJ, we believe that the right investment strategy is to buy USD/AXJ on dips, as these prospective surges in EM risky assets are likely to be short-lived, as long as the global economy is decelerating. 3. Fiscal fortitude. To counter the global headwinds, these economies may eventually need to rely on fiscal measures rather than monetary easing. Thus, one variable to consider in thinking about the likely relative performance between the AXJ currencies is their ‘fiscal fortitude’, i.e., both their ability and willingness to deploy counter-cyclical fiscal measures. Interest rate cuts, such as the one implemented by the BOK this morning, may not be consistent with a stronger currency. 4. There are two trades in this cycle. We believe that many AXJ currencies (e.g., KRW, INR, IDR, PHP) will likely experience extreme pressures in the coming months, as the world slows and risk taking in the world is curtailed. However, as soon as the global economy regains traction, we expect the AXJ currencies to lead the world in a rally. Thus, there are two trades in this cycle: sell AXJ currencies as we enter the global recession, but buy AXJ currencies back as the global economy bottoms. CNY: We continue to look for further modest CNY appreciation in spite of the risk of a hard landing for the Chinese economy. This is chiefly because KRW: The USD/KRW price action has become increasingly hyperbolic (+51% YTD). We factor in the risk that the upward price momentum could continue even though the valuations are starting to become stretched. This risk of overshoot is premised on our concern that the macro-dynamic, inflation and (most importantly) banking concerns have yet to be fully resolved (see KRW: The Fourth Shock, May 6, 2008 and “KRW: The Unstable Won”, FX Pulse, September 4, 2008). We note that banking concerns extend the price move, as they have done for other currencies around the world. INR: The USD/INR’s price action is starting to accelerate, in our view. Indeed, we believe the risk is that the INR could trace out a similar price path to that of USD/KRW: both currencies share similar negative fundamentals, namely a negative macro-dynamic and rising banking concerns. On top of this, IDR: We believe that PHP: The BSP appears to have returned to a more dovish policy response in fighting inflation – the central bank left rates on hold at 6% in September when CPI was still running at 11.9%. As a consequence, we believe that the PHP is losing monetary policy support. At the same time, the TWD+SGD+MYR+THB: These currencies, which are part of the ‘Cyclicals’ group of AXJ currencies, are all undermined by the same two factors: the global slowdown and falling interest rate support. Each of these currencies’ underlying economies is open (in terms of high exports-to-GDP ratios) and hence is naturally sensitive to global economic activity. Therefore, the oncoming slowdown in the world economy is likely to impact these Cyclicals disproportionately. At the same time, most of these currencies are also losing interest rate support. Disinflationary pressures are starting to take hold, which is likely to lead to policy easing in these countries (see AXJ: The AXJ Cyclicals Are Trending Down, August 20, 2008). Indeed, Bottom Line We turned bearish on AXJ currencies on May 1, 2008, and have become even more bearish, now that the world is falling into a synchronized recession.
Currencies
We Are in the Second Inning of the EM Currency Sell-off October 13, 2008 By Stephen Jen & Spyros Andreopoulos | London Summary and Conclusions Most EM currencies are in jeopardy. Despite the sharp sell-off we have seen so far in some crosses, our view is that we are only in the second inning of this powerful process that will likely last well into 2009. So far, capital outflows by local investors may have been the key driving force behind the EM currency weakness. But as the global economy slows in the coming quarters, capital inflows from non-EM economies will likely decline sharply, depressing EM currencies even further. While differentiation between EM economies based on their economic fundamentals will obviously be a part of the thought process for investors, we believe, in this cycle, contagion will be much more powerful and will overwhelm much of the differences in the economic fundamentals between countries. In other words, countries with seemingly positive economic fundamentals could very well see their currencies plummet as sharply as those without good fundamentals. We remain very worried about the EM currencies and expect there to be adverse implications from this EM currency sell-off for their economic fundamentals. Sharply Slower Global Growth in 2009 On our current forecasts, the world is heading into a synchronous recession in 2009. Our own guess is that risks to growth are biased to the downside for the EM economies, relative to our forecasts. As the global economic slowdown materializes in earnest, the EM currency sell-off we envisage will likely go through several phases. • Step 1. The dollar experiences a broad-based risk-aversion induced rally. This process began in May this year, and will likely continue. According to our Dollar Smile Framework, whenever the • Step 2. Exchange rate expectations in EM economies are grudgingly altered, and hedging strategies revised. The move higher in the dollar will, and in some cases has already, set off a chain reaction. After an initial phase of denial, domestic agents (exporters, importers, and investors) will need to realign their hedging strategies with the new expected path of the exchange rate. In our view, the adjustment of hedging strategies by local economic agents has been the single-most powerful driver behind the recent weakness in KRW, INR, BRL, and MXN. For countries that have experienced persistent currency strength in recent years, it is likely that the exporters are over-hedged (i.e., bought the local currency at the earliest opportunity for both the carry and the expectation that it will strengthen over time) and importers are under-hedged (i.e., sold the local currency at the latest opportunity). My colleagues covering We illustrate our simple calculation of how serious this problem might be in various countries. Assuming that the general expectation of how the currency will perform in the coming year is a function of its performance in recent years, with the most recent year’s performance having the highest weight, we calculated that, in There are several implications of this domestic hedging story. First, the impact of the unwind of these positions could be rather violent, as suggested by the recent performance of INR, KRW, BRL and MXN. Second, the strength of the pushback from the local investors to the idea that the dollar could strengthen further is, to us, an informal proxy for how big this problem is. For example, in the past weeks, our call on USD/BRL has been met with the fiercest pushback, which we actually found alarming. Third, this process of positioning unwind has nothing to do with the economic fundamentals of the country in question. Thus, investors should not be fixated on the ‘need to differentiate’ between countries’ fundamentals in thinking about currency risks. • Step 3. Carry trades to be unwound. The altered path of expected currency movements will eventually undermine the confidence of foreign institutional funds that have carry positions, which we suspect to still be extremely large. The EM currencies that carry high yields and with good market liquidity could be very vulnerable to a simultaneous sell-off as overseas institutional funds unwind their carry positions. Here are some of the high-yield EM currencies (their 3M interest rates in parentheses): IDR (33%); TRY (18%), ISK (16%), INR (16%), PHP (14%), BRL (13%) and ZAR (12%). Again, the relative economic fundamentals matter less in this process of positioning unwind. We are, in fact, very bearish on all of the above-mentioned currencies. • Step 4. Other types of capital inflows to abate sharply in 2009. What we have discussed so far are dynamics that will likely take place in the near future, originating mainly from the local investors’ behaviours and what some foreign investors might do with their legacy investment positions. However, what is at least as worrying for these EM currencies is that, in 2009, new capital inflows will likely dwindle. In some recent notes (On the Vulnerability of EM Currencies (October 2, 2008), Capital Flows and the BRIC Currencies (September 26, 2008) and Risks of a Sharp Reduction in Capital Flows to EM (September 26, 2008)), we warned that gross capital flows into EM, which surged from an average of around US$550 billion a year during 2005-06 to US$750 billion a year in 2007-08, could fall to US$550 billion in 2009. In light of the sharp deterioration in global financial conditions and our new global growth forecasts published on October 6, it now looks likely that 2009 may only see US$400-450 billion of flows into EM. This dramatic slowdown will likely expose the structural problems that many EM economies have, and will stress-test the thesis that EM performance in recent years has not benefitted from the credit bubble. Need for Differentiation, and Contagion Factor We believe the need for differentiation is important, but often exaggerated, particularly in times of intense market pressures. The EM economies with relatively good economic fundamentals (such as Interventions Will Not be Trend-Reversing The global forces triggering the sell-off in EM currencies are immensely powerful. We do not believe that currency interventions will be successful at reversing trends, though they may contain the pace of the currency sell-off. A Global EM Currency ‘Moment’, in Contrast to History All of the currency crises in modern history have been regional. However, we believe many EM currencies in different parts of the world could experience intense pressures in the months ahead, in contrast to the historical norm, i.e., the EM currency ‘moment’ will be global, not regional. Bottom Line We remain very worried about most EM currencies and believe that the violent sell-offs in some EM currencies in recent weeks mark only the beginning of what is likely to be a multi-month process. |