By Marc Chandler, Global Head of Currency Strategy, Brown Brothers Harriman
The underlying trends seen this year have continued, but after strong follow through in Asia, a more subdued tone has been seen in Europe. The US dollar is generally softer, except against the yen and sterling. Japanese markets were closed for holiday, but the MSCI Asia-Pacific Index rose almost 0.3%, lifted by more than a 3% rally in China on speculation that there may be a sharp increase in the cap on foreign investors’ ability to invest in Chinese equities.
In Europe, the Dow Jones Stoxx 600 is up about 0.4%, led by a rise in financials. Spanish stock market is at its highest level in almost a year (Feb 2012) and Italy’s market is at its best August 2011, though their bond markets are seeing some profit-taking today. With a light economic calendar in North America today, Bernanke’s speech in Michigan after the markets close may be the highlight.
We identify six key factors shaping the investment climate.
First, and perhaps most importantly, there has been a perception that the global economy is in better shape than many had feared. ECB began pushing down the tail risks in Europe. The EU helped by signaling it is prepared to give several countries including Spain, Italy and France more time to reach their deficit targets. The Basel Accord’s more liberal definition of liquid instruments and a longer period for the adjustment also encourages risk taking. China’s economy appears to have found a base after seven quarters of slowing growth. US politicians averted the worst of the fiscal cliff, which means the recession the CBO warned, is significantly less likely.
Second, reports of the demise of Keynesian economics has been grossly exaggerated. Japan, the world’s third largest economy, is pursuing Keynesian policies as aggressively. Before the weekend, the government unveiled a JPY10.3 trillion (~$116 bn) stimulus program. It forecast that the new spending (which will require new borrowing), will boost growth by 2% and create 600k new jobs.
Complementing the stimulative fiscal thrust, the government seeks more monetary accommodation. The BOJ meets on Jan 21-22 and local reports suggest that the BOJ will likely recognize 1) that the LDP have a strong popular mandate and 2) that in a battle of wills, the government wins as it can re-write the BOJ Act.
Third, ECB’s Draghi appeared to signal last week that the bar to further monetary easing is high. The bar is sufficiently high that a rate cut in Q1, even if contraction from H2 12 carries over into early 2013, is unlikely. There has been significant improvement in the euro area’s financial condition and the ECB expects that this improvement will remove a headwind on the real economy.
Among these improvements is new that the ECB’s balance sheet fell to 2.96 trillion euros in the week ending January 4, which is the smallest it has been since the end of last February. In addition, there are expectations that some banks will return some of the funds borrowed under the LTRO facility. We recognize that there are many factors outside of monetary policy and relative size of central bank balance sheets that impact currency movement. Yet the contrast between the shrinking ECB balance sheet and the expansion of the Fed’s is notable and will encourage euro bulls.
In addition, emergency lending assistance, provided by the national central banks, has also fallen in the most recent week to its lowest level in almost six months, though this may soon be adversely impacted by Cyprus as it awaits its aid package. The latest Target2 report, which covers the month of November, also shows a reduction in Germany’s claims and a corresponding decline in Spain, and Italy’s liabilities. Key measures of retail deposits in both Italy and Spain rose in November.
Over the weekend the French employers and 3 of the five national unions appear to have struck a deal that could produce greater flexibility in the labor market (euphemism for making it easing to using short-term contracts, downsize work forces and reduce wages), while employers may have to pay a bit more in payroll tax. Hollande’s neo-liberalism may also help ease investors’ anxieties of the Socialist President.
Fourth, the Obama Administration has rejected a constitutional fight over the debt ceiling and has rejected exploiting the platinum coin loophole farce. This makes a new showdown between the Administration and the Republican-controlled House of Representatives over the debt ceiling, spending authorization and the spending cuts that have been delayed until March 1.
The latest economic data suggests the slowdown in Q4 was more dramatic than previously expected after a 3.1% Q3 GDP print. Nor should a better Q1 be expected. The end of the payroll savings tax holiday is expected to hit consumption, which remains a key driver of the economy.
Fifth, the technical condition of the market is more mixed now. There is little technical evidence of an immediate trend reversal and some of the strong advances of the major foreign currencies at the end of last week appeared to be the re-establishment of positions cut at the end of last year and the “resolution” of the US fiscal cliff. However, we encourage investors to be particularly sensitive to a deterioration in the technical condition of the foreign currencies, which could be signified by a daily reversal pattern (such as outside down days, or shooting stars).
There have been some large moves in the foreign exchange market in recent days. Last week, the euro posted its largest rally since September. The yen’s depreciating streak extended to nine weeks, the longest in almost 24 years. The Canadian and Australian dollars rose to multi-month highs. The market is vulnerable to a near-term correction.
There were some other interesting price developments to note. The VIX fell to its lowest level since the financial crisis began the middle of 2007. Gold recorded its first advancing week since November. MSCI Emerging Market Index snapped an 8-week advancing streak to close lower last week. At the start of the year, foreign inflows into the equity markets in Indonesia, South Korea and Taiwan are weaker than the start of 2012. International equity managers may be concern about the impact of the weakness on sectors and companies, especially in South Korea and Taiwan.
Sixth, is the week’s economic data. Given our understanding of the ECB’s stance, we do not expect much of a market response to data from the euro area the covers Q4. On the other hand, Q4 data from the US and UK may still be seen as new information for investors. In the UK, inflation figures on Tuesday, which are expected to show some increase in pressures, and the retail sales report on Friday, which will likely be soft, are the main events.
The US reports inflation, retail sales, housing starts, industrial production figures and business inventories in terms of hard data. Only the inventory data (which may be helpful in estimating Q4 GDP) and the January Empire and Philly Fed surveys will be of the most interest, as the earning season gathers steam. Japan will release several monthly economic reports, but the focus will remain strictly on the government’s stimulus efforts and next week’s BOJ meeting.