As the Japanese economy falls deeper into a recession, along with much of the rest of the world, the JPY will likely strengthen against the EUR, GBP, AUD, EM currencies and even the strong USD. With CHF likely to remain under pressure due to Swiss banks’ large exposure to EM, JPY and USD will remain the only two safe-haven currencies in this global recession, in our view. In this note, we reiterate this thesis we have had for a while, and present some general thoughts we have on Japan. Our General View on Currencies We have not changed our view on currencies. If anything, we have become more confident that the USD will continue to rally against almost all currencies, except for the JPY. EM currencies will continue to come under significant pressure and will likely weaken substantially further, i.e., 20-30% from current spot rates. This applies to AXJ, Latam and EE currencies. Stresses and strains on EM will depress the EUR and GBP further, as they expose the structural ambiguities within the EMU through the bank lending channel. This thesis of ours may by now be familiar to investors, whom we advise to maintain a core long dollar posture, and resist temptations to short the dollar. Historically, the JPY, CHF and USD have exhibited ‘safe haven’ currency characteristics. In other words, these three currencies tend to appreciate when (i) the global economy is weak and/or (ii) the global equity markets’ buoyancy is low. While CHF has been, and will likely continue to be, undermined by concerns about Swiss banks’ exposure to EM, especially in EE (Eastern Europe), we expect JPY and USD to remain well supported for as long as the global economy is weakening. The JPY will likely be the only currency that will outperform the dollar. Regular readers of our work should be familiar with our thesis on the dollar and the JPY. At this particular juncture, there are two pressure points in the global currency markets. First, the RUB remains under intense pressure and poses a significant risk for EE currencies and, in turn, EUR, GBP, CHF and SEK (see The Ruble – Eastern Europe – EMU Nexus, November 13, 2008). Second, the growth outlook for Asian countries is being revised down rapidly. Not only has China slowed much more precipitously than many had expected, but Japan is now also technically in a recession, and we suspect that it will continue to weaken in the quarters ahead. India will likely decelerate sharply next, as tradable services, such as IT, will slow, after the deceleration in merchandise exports. Further, pressures on the EUR will also compel Japanese institutional funds to repatriate more capital back home, and the JPY could rally further. We are officially looking for an intra-year low of 85 for USD/JPY (2Q09). A Smorgasbord of Thoughts on Japan and the Yen Here are a smorgasbord of thoughts we have on Japan, the yen and other related issues: 1. JPY repatriation has further to go. The correction in EUR/JPY – from a high of 170 to 120 now – has not only hurt the profit margins of exporters but also undermined the portfolios of large institutional investors. A key question is how much JPY repatriation has taken place thus far. It may be useful to distinguish between the retail investors, who have been more active in EM, and institutional investors, such as lifers and pension funds. At a client presentation in Tokyo this Tuesday, with more than 100 funds represented, we took a poll on this question, with roughly 40% of the investors in the audience thinking that we are in the ‘third inning’ of this process, and another 40% voting for the ‘sixth inning’. What this tells us is that we are roughly halfway through the repatriation process. Of course, how much repatriation we ultimately see is also a ‘moving target’, as it is a function of the depth and duration of the global recession. Also, this survey-based result is not the only way to ask this question. Over the past decades, Japan Inc. has accumulated US$2.6 trillion worth of (net) foreign currency assets (US$6.4 trillion in gross terms). (We used an exchange rate of 95 for this calculation. Japan’s net international investment position (IIP) is ¥250 trillion (US$2.6 trillion), with an asset position of ¥610.5 trillion (US$6.4 trillion) and a liability position of ¥360.3 trillion (US$3.8 trillion). The net IIP for the US is a deficit of US$2.4 trillion (US$17.6 trillion in assets and US$20.1 trillion in liabilities.) In theory, all of these could either be repatriated or hedged. The large size of Japan’s gross foreign asset position is the main reason why the JPY tends to behave like a safe-haven currency, as a small fraction of repatriation could trigger large flows back into the JPY. (Having said the above, we should stress that JPY repatriation flows are a cyclical risk. Structurally, i.e., over the medium term, we believe that large capital flows out of Japan will be the more powerful theme. This is why we see USD/JPY recovering back to 110 by early 2010.) 2. The Japanese economy has significant downside risks. Our economist Sato-san was early in calling for a recession in Japan. Recent data confirm that Japan’s slowdown has, like the rest of Asia, actually accelerated. Not only is Japan technically in a recession – with two quarters of contraction in GDP, Japan’s exports are weakening dramatically – but Japan’s trade deficits in August and October are also absolutely extraordinary, particularly the October one, when oil prices had already receded. It is not clear that Japanese policymakers are prepared to deal with these risks. For example, despite the sharp decline in inflation in Japan, the BoJ has only cut the policy rate by 20bp to 0.30%. Further, a return to ZIRP, surprisingly, appears not to be expected by investors in Japan, possibly reflecting their worries that the BoJ could be troubled by the side-effects of going back to ZIRP. (At the last BoJ Policy Board meeting, the BoJ voted 1-3-4 for ‘on hold’, a 25bp cut and a 20bp cut. While the minutes – to be published later this month – will clarify the debate that took place that day, we find it remarkable that there was so much disagreement over 5bp, and that three of the board members would dissent from the governor’s preference.) At this aforementioned client event in Tokyo, we asked the audience about the prospect of the BoJ returning to ZIRP. We were very surprised to learn that some 90% of the institutional investors at our event thought that, in this cycle, we will not see ZIRP! Policymakers in Japan may be behind the curve, as they might have underestimated the sharpness of the slowdown in Asia. 3. We see MoF intervention to cap the rise in the JPY as unlikely. Part of the reason why we see further downside risks to USD/JPY is that we think it unlikely that the MoF would intervene to cap the JPY. Even if it does intervene, the repatriation flows are likely to be so sizeable in the coming months that these interventions are unlikely to reverse the upward trend in the JPY. In real trade-weighted terms, the JPY is still quite weak, from a historical perspective. Even with the sharp appreciation in recent weeks, the REER of the JPY is still around 20% weaker than it was in 2000. The weakness of the Japanese economy since 2000, despite the weak JPY, is remarkable. 4. The Japanese government may conduct a sizeable PKO (price-keeping operation) to support the Nikkei. The Diet is seriously considering a PKO operation to support Japanese equities, funded by bank loans the government may take out. A size of US$250-300 billion has been mentioned; this is equivalent to about one-tenth of the current market capitalisation of the Nikkei. An alternative way to achieve a similar end which is also being considered is to have the US$1.5 trillion GPIF (Government Pension Investment Fund) allocate a bigger share of its portfolio to Japanese equities. The March 2009 targeted portfolio has 72% allocated to JPY bonds, and only 11.1% to JPY equities. It has been suggested that the latter weight be raised. (Both operations entail the sale of JGB holdings, either by commercial banks so that they can lend to the government through bank loans or by the GPIF.) Whichever operation is undertaken, the PKO could potentially be a big deal, helping to encourage repatriation flows if indeed the Nikkei can start to outperform other equity markets because of the programmed buying by the government. (The PKO operations are also related to the SWF debate in Japan. With markets sustaining losses in recent months, political support for a SWF in Japan may have dwindled somewhat. However, if this PKO facility turns out to be profit-making, the SWF idea could be resurrected.) 5. Details of Japan’s offer to lend the IMF US$100 billion still need to be worked out. The proposal by Prime Minister Aso last Friday – prior to the G20 meeting over the weekend in Washington, DC – had been originally proposed by the MoF. It is clear that Japan would like to contribute to the global effort to resolve the financial crisis, especially in EM. Whether this US$100 billion in loans to the IMF should have been attached to some conditionality is an issue being discussed in Tokyo. Beijing, for example, has since proposed that it could also lend to the IMF out of its official reserve holdings if the issue of the IMF quotas (i.e., China’s representation on the IMF’s Executive Board) could better reflect China’s contributions. In any case, Japan’s generous offer should help to alleviate the funding pressures at the IMF. (On a practical level, Japan will not need to sell its Treasury holdings before handing the cash to the IMF. It could simply lend the IMF its Treasury holdings, which the IMF could then use as collateral to borrow in the international markets.) Greater firepower for the IMF may marginally improve the outlook for EM currencies. But we still believe that almost all EM currencies will weaken substantially; more IMF money would just marginally temper the EM currency depreciation, but should not reverse the trend. Bottom Line We maintain our thesis that, as the global economy slows, the USD and the JPY will continue to strengthen against virtually every other currency in the world. The two pressures points in the currency world – Russia and Asia – will favour the dollar and the JPY. Risky assets will likely remain under pressure, as long as the end of the global recession is not in sight. We continue to recommend that investors maintain a pro-USD pro-JPY posture, and be particularly guarded against EM currencies, EUR, GBP, CHF, SEK and commodity currencies.
Important Disclosure Information at the end of this Forum
Revising Our Near-Term Outlook
November 24, 2008
By Mohamed Jaber | London
While we continue to believe that the UAE’s economic fundamentals remain structurally sound, we are revising our macroeconomic forecasts in line with recent changes to our global economic outlook. We now expect real GDP to grow at a slower pace in 2009, with inflation decreasing further than we had previously estimated. We now project that real GDP will grow by about 3.8% in 2009 and 4.7% in 2010, about 2pp lower than our most recent estimates (see United Arab Emirates: Weathering the Crunch, October 8, 2008). A number of factors have affected our decision, including: (i) recent weakness in oil markets; (ii) a sharper-than-expected slowdown in global growth next year; (iii) continued weakness in real estate markets; and (iv) our expectation of generally slower growth in domestic spending over the next 12 months. In line with the lower growth estimates, we expect CPI inflation to further decline to about 8.6% in 2009 and 7.1% in 2010. This is based on our projection that the overall slowdown in domestic demand and the phasing of investments over time will further reduce the pressure on domestic consumer prices over the near term. In view of recent oil market developments, we expect the UAE’s oil sector to grow at a slower pace in 2009. According to a recent report by the International Energy Agency, the growth in global demand for oil is expected to slow in 2009. On the supply side, the UAE’s share of the October 2008 OPEC production cut was 134,000 barrels of oil per day, or about 5% of its current production level. Moreover, recent official statements seem to point to a possible slowdown in the pace of investments in the oil sector, which could in turn have a negative impact on the UAE’s future production capacity. Previous plans to expand this production capacity to about 3.5 million barrels per day by 2015 seem to have been revised, with Mr. Abdullah Nasser Al-Suweidi, the deputy CEO of the Abu Dhabi National Oil Company, recently announcing that “it will take about 10 years to get to 3.5 million barrels a day”. In light of this, we have lowered our 2009 oil-GDP growth projections from 4.5% to 1.5%. However, we expect that this temporary slowdown will be largely mitigated by a projected strengthening in oil prices starting in 2010, which is likely to re-energize investments in the hydrocarbons sector and boost oil production rates over the medium term. The weaker global economic outlook, combined with a further softening in domestic demand, will likely lead to slower-than-expected non-oil GDP growth. We now expect the non-oil economy to grow at an inflation-adjusted rate of 4.6% in 2009 and 5.5% in 2010, about 2pp lower than our most recent estimates. Our forecast change was driven by a number of inter-related factors. First, given the UAE’s open economy and its reliance on both foreign and domestic demand, we believe that the sharper slowdown in global growth that we are currently projecting for 2009 will have a negative impact on the non-oil sector. Economic sectors such as manufacturing (e.g., aluminum and petrochemical production), trade services (e.g., wholesale and retail trade) and financial services will likely grow at a lower rate next year. Second, we expect the continued weakness in real estate markets to contribute to a further slowdown in the growth of construction and real estate services. Third, we see a further reduction in the growth of domestic spending next year as: (i) investments in the oil sector are phased over time; and (ii) the feasibility of some of the large real estate investments is re-evaluated in response to tighter international credit markets and higher funding costs. It is notable that the spreads on credit default swaps (CDS) written on Abu Dhabi’s and Dubai’s sovereign debt – which may serve as a benchmark for pricing corporate risk – are currently trading at around 260bp and 725bp, respectively (almost twice their level in early October). This said, we do not expect a significant reduction in spending on infrastructure, especially in Abu Dhabi, given that the funding for such projects is based on a government budget that we expect to remain in large surplus (see below). Fourth, the significant decline in asset prices will likely result in negative wealth effects that may weigh down on domestic spending. However, estimating the magnitude of these potential wealth effects is not a straightforward exercise. In the case of the real estate market, for example, the negative impact of a possible decrease in home prices on the aggregate net worth of consumers, and ultimately on their domestic spending, would need to be weighed against the considerable wealth accumulation that took place over the past two years, during which time real estate prices appreciated at a phenomenal rate. We expect fiscal and external balances to remain in surplus, albeit at lower levels. Our forecast revision was mainly based on two factors, namely: (i) lower projected oil prices in 2009; and (ii) a weaker-than-expected global economy. Next year’s oil prices – as reflected in oil futures contracts – are now expected to be significantly lower than previously estimated. Currently, WTI crude futures contracts expiring in December 2009 are pricing at about US$65 per barrel, down from about US$100 in early October. We therefore believe that lower oil prices next year will have a negative impact on the UAE’s current account and fiscal balances, which we now expect to stand at around 15% of GDP in 2009 and 24% in 2010 (about 10pp lower than our previous estimates). However, we maintain our view that the UAE’s current account balance would remain positive at oil prices above US$40 per barrel and that the breakeven oil price for its consolidated fiscal accounts is around US$25 per barrel (a recent IMF report estimated this breakeven price at US$23 per barrel). It is interesting to note that the UAE has not run a current account deficit since 1990 (the earliest date for which such data are available) and that this has even held true in 1998 when WTI oil prices averaged around US$14 per barrel. Moreover, the lower breakeven price for the fiscal balance is mainly due to the positive effect of the investment income generated on the country’s massive stock of official foreign assets. Despite possible capital losses incurred over the past year, the size of these assets – recently estimated by the IMF to be in the range of US$500-900 billion – continues to be substantial, especially in relation to the size of the UAE economy and its fiscal budget. In addition to the projected decline in next year’s oil prices, our new estimate of the 2009 current account balance also takes into account a sharper-than-expected slowdown in global economic growth. We expect the UAE’s exports of non-oil goods and services to be negatively affected by the softening of demand from the country’s main trading partners. For instance, lower disposable income in countries that have been an important source of tourism for the UAE – such as the UK and Russia – is likely to negatively affect this sector. That said, the real economic effect of lower foreign demand may be partly mitigated by the high degree of price flexibility in the UAE. A significant government presence in the service industry – including within the hospitality and transportation sectors – combined with high labor market flexibility are likely to facilitate downward price adjustments, thereby somewhat easing the real impact of weaker global demand on the non-oil sector. Despite our projection of slower growth in 2009, we remain generally positive about the UAE’s economic outlook over the medium term. Next year is shaping up to be one of consolidation and adjustment, with asset prices moving closer to their fundamental economic values and global demand adapting to the massive credit shock of 2008. Given the UAE’s open economy and its significant reliance on foreign borrowing, especially the emirate of Dubai, it will certainly not be immune to these mostly downward adjustments. The extent of price adjustment in the real estate market will also need to be closely monitored over the next few months. However, we need to stress again our view that the government has more than enough resources to deal with the repercussions of this external shock. Moreover, our projected rebound in global growth starting in 2010, together with a potential pick-up in oil prices over the next 12 months – as implied by futures contracts – would reflect positively on the UAE’s growth, especially given its growing role as a business gateway to an oil-rich region. That said, the speed and magnitude of this projected economic recovery will very much depend on the government’s policies at this sensitive juncture. One of the government’s most important challenges will be to tackle the significant drop in investor and consumer confidence. Unfortunately, consumer and business sentiment data in the UAE are not reliable. Most of the information on this subject is based on anecdotal evidence that tends to be overly bullish during boom times and excessively bearish during down periods. Nevertheless, we do believe that, at the very least, investor confidence seems to have dropped considerably since this summer, as demonstrated by: (i) the excessive risk-aversion to most asset classes; (ii) the weak performance of financial markets; and (iii) possible softening in the real estate market. To be sure, the authorities have already taken concrete steps to shore up public confidence in financial institutions, including through guaranteeing all bank deposits and interbank lending, as well as injecting significant liquidity into the banking system. However, additional steps may still be needed. These include fostering a greater degree of corporate transparency and clearly communicating to the market the level of support that the federal government is willing to provide to large quasi-public entities that are deemed ‘too big to fail’. A large federal guarantee would necessarily require the backing of the government of Abu Dhabi, which has historically been the largest provider of funds for federal services (about US$8.5 billion annually during 2004-07, according to the IMF). Such a guarantee would also go a long way towards reducing market speculation about the willingness of the emirate of Abu Dhabi to provide support to the mostly Dubai-based, quasi-public entities which may be running into funding constraints and whose failure may arguably have significant systemic consequences. In view of the substantial political, financial and economic commitments that the emirate of Abu Dhabi has historically demonstrated toward the preservation of the federation, and given the symbiotic relationship that exists between the emirates of Abu Dhabi and Dubai, we have little doubt that an implicit guarantee is already in place. However, market participants do not seem to share our conviction, given that they are currently attaching a massive premium to the default risk of some of Dubai’s quasi-public entities. For example, the CDS spread on Nakheel’s 5-year debt has currently reached 1,900bp, which has effectively shut the company out of international debt markets. We think that resolving this unsustainable situation requires a prompt, concerted and transparent strategy by the federal government and by the governments of the individual emirates. This would send a clear signal to the market that the authorities stand firmly behind their flagship companies and help to reduce the destabilizing effects of the current market uncertainty.
Important Disclosure Information at the end of this Forum
Disclosure Statement
The information and opinions in Morgan Stanley research were prepared or are disseminated by Morgan Stanley & Co. Incorporated and/or Morgan Stanley C.T.V.M. S.A. and/or Morgan Stanley & Co. International plc and/or Morgan Stanley Japan Securities Co., Ltd. and/or Morgan Stanley Asia Limited and/or Morgan Stanley Asia (Singapore) Pte. (Registration number 199206298Z) and/or Morgan Stanley Asia (Singapore) Securities Pte Ltd (Registration number 200008434H) and/or Morgan Stanley Taiwan Limited and/or Morgan Stanley & Co International plc, Seoul Branch, and/or Morgan Stanley Australia Limited (A.B.N. 67 003 734 576, holder of Australian financial services licence No. 233742, which accepts responsibility for its contents), and/or Morgan Stanley India Company Private Limited and their affiliates (collectively, "Morgan Stanley"). As used in this disclosure section, Morgan Stanley includes RMB Morgan Stanley (Proprietary) Limited, Morgan Stanley & Co International plc and its affiliates.
Global Research
Conflict Management Policy
Morgan Stanley Research observes our conflict management policy, available at www.morganstanley.com/institutional/research/conflictpolicies.
Important Disclosures
Morgan Stanley Research does not provide individually tailored investment advice. It has been prepared without regard to the circumstances and objectives of those who receive it. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages them to seek a financial adviser's advice. The appropriateness of an investment or strategy will depend on an investor's circumstances and objectives. Morgan Stanley Research is not an offer to buy or sell any security or to participate in any trading strategy. The value of and income from your investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized.
With the exception of information regarding Morgan Stanley, research prepared by Morgan Stanley Research personnel is based on public information. Morgan Stanley makes every effort to use reliable, comprehensive information, but we do not represent that it is accurate or complete. We have no obligation to tell you when opinions or information in Morgan Stanley Research change apart from when we intend to discontinue research coverage of a company. Facts and views in Morgan Stanley Research have not been reviewed by, and may not reflect information known to, professionals in other Morgan Stanley business areas, including investment banking personnel.
To our readers in Taiwan: Morgan Stanley Research is distributed by Morgan Stanley Taiwan Limited; it may not be distributed to or quoted or used by the public media without the express written consent of Morgan Stanley. To our readers in Hong Kong: Information is distributed in Hong Kong by and on behalf of, and is attributable to, Morgan Stanley Asia Limited as part of its regulated activities in Hong Kong; if you have any queries concerning it, contact our Hong Kong sales representatives.
Morgan Stanley Research is disseminated in Japan by Morgan Stanley Japan Securities Co., Ltd.; in Canada by Morgan Stanley Canada Limited, which has approved of and takes responsibility for its contents in Canada; in Germany by Morgan Stanley Bank AG, Frankfurt am Main, regulated by Bundesanstalt fuer Finanzdienstleistungsaufsicht (BaFin);in Spain by Morgan Stanley, S.V., S.A., a Morgan Stanley group company, supervised by the Spanish Securities Markets Commission(CNMV), which states that it is written and distributed in accordance with rules of conduct for financial research under Spanish regulations; in the US by Morgan Stanley & Co. Incorporated, which accepts responsibility for its contents. Morgan Stanley & Co. International plc, authorized and regulated by Financial Services Authority, disseminates in the UK research it has prepared, and approves solely for purposes of section 21 of the Financial Services and Markets Act 2000, research prepared by any affiliates. Private UK investors should obtain the advice of their Morgan Stanley & Co. International plc representative about the investments concerned. In Australia, Morgan Stanley Research and any access to it is intended only for "wholesale clients" within the meaning of the Australian Corporations Act. RMB Morgan Stanley (Proprietary) Limited is a member of the JSE Limited and regulated by the Financial Services Board in South Africa. RMB Morgan Stanley (Proprietary) Limited is a joint venture owned equally by Morgan Stanley International Holdings Inc. and RMB Investment Advisory (Proprietary) Limited, which is wholly owned by FirstRand Limited.
Trademarks and service marks in Morgan Stanley Research are their owners' property. Third-party data providers make no warranties or representations of the accuracy, completeness, or timeliness of their data and shall not have liability for any damages relating to such data. The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of MSCI and S&P. Morgan Stanley bases projections, opinions, forecasts and trading strategies regarding the MSCI Country Index Series solely on public information. MSCI has not reviewed, approved or endorsed these projections, opinions, forecasts and trading strategies. Morgan Stanley has no influence on or control over MSCI's index compilation decisions. Morgan Stanley Research or portions of it may not be reprinted, sold or redistributed without the written consent of Morgan Stanley. Morgan Stanley research is disseminated and available primarily electronically, and, in some cases, in printed form. Additional information on recommended securities/instruments is available on request.
The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (DIFC Branch), regulated by the Dubai Financial Services Authority (the DFSA), and is directed at wholesale customers only, as defined by the DFSA. This research will only be made available to a wholesale customer who we are satisfied meets the regulatory criteria to be a client.
The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (QFC Branch), regulated by the Qatar Financial Centre Regulatory Authority (the QFCRA), and is directed at business customers and market counterparties only and is not intended for Retail Customers as defined by the QFCRA.
As required by the Capital Markets Board of Turkey, investment information, comments and recommendations stated here, are not within the scope of investment advisory activity. Investment advisory service is provided in accordance with a contract of engagement on investment advisory concluded between brokerage houses, portfolio management companies, non-deposit banks and clients. Comments and recommendations stated here rely on the individual opinions of the ones providing these comments and recommendations. These opinions may not fit to your financial status, risk and return preferences. For this reason, to make an investment decision by relying solely to this information stated here may not bring about outcomes that fit your expectations.
|
![](/img/clear.gif"){kind=spacer}