Currency Wars: Winners and Losers (Merk)

Thursday, May 9th, 2013

Who is winning the “currency wars”? Our take on the greenback, yen, sterling, euro and gold:

The U.S. dollar. All the great things a couple trillion dollars in quantitative easing can buy:

• The stock market is reaching new highs. Except that investors have a rather difficult time diversifying as stock prices are highly correlated to the perception of more quantitative easing. Or shall we say Bernanke’s health?
• The average yield on US junk-rated debt falls below 5 per cent for the first time. Except that our bubble indicator is screaming: in our assessment, investors should be concerned when any asset or asset class exhibits volatility below its historic norm. Think stock prices “always” going up in the late 90s. Housing “always” going up pre-2007. Or Treasuries in recent decades until now. Or junk bonds.
• The economy is “healing” with unemployment down. Except that the “improving” employment picture is masking the fact that companies hire more workers, so that they can cut the average hours worked per employee to under 30 per week to avoid having to provide healthcare under the incoming Patient Protection and Affordable Care Act (Obamacare). Indeed, U-6 unemployment, which includes persons employed part time for economic reasons, just ticked up for the first time since July of last year.
• In our assessment, the U.S. dollar may be as vulnerable as ever, with economic growth possibly the biggest potential threat to the dollar. That’s because should growth be priced into the markets, the bond market might be at serious risk. Aside from then causing major headwinds to the consumer, what we believe is an unsustainable U.S. government deficit might come into focus. We don’t need to wait for the cost of borrowing to move higher; what’s relevant is whether the market’s perception will change. And should the Federal Reserve double down by keeping borrowing costs low, it might make the greenback all the more vulnerable. This isn’t about whether the dollar will fall; it’s about whether there’s a risk that the dollar will fall and what investors do to prepare for it.

Yen. If we think the dollar is the risky proposition, then the Japanese yen may be outright toxic. Did I say that we are short the yen (and generally put our money where our mouth is)? The one thing going for the yen is that neither Prime Minister Abe’s government, nor the Bank of Japan (BoJ) have doubled down in recent days, but that “rally” the yen had, veering away from 100 versus the dollar appears to have already broken down. For those looking for a catalyst, Japan’s upper house elections are coming up in July. While Abe already enjoys a two thirds majority in the lower house, his populist policies might get him a majority in the upper house as well, paving the way for changes to Japan’s constitution. Having said that, such changes may mostly be symbolic, as Japan has long found ways around Japan’s pacifist constitution to ramp up military spending. The only good news for the yen is that the currency’s rapid decline may temporarily halt the deterioration of its current account deficit. The current account matters, as once it is firmly in negative territory, Japan can’t rely on financing its huge debt to GDP ratio domestically anymore.

British Pound. The final straw in the glass half empty category may be the British pound. Mark Carney, outgoing head of the Bank of Canada, will lead the Bank of England (BoE) starting this summer. That may be great news for the loonie (Canadian Dollar), but not so much for the sterling. While Carney’s greatest achievement at the Bank of Canada might have been his ability to compete with former Federal Reserve Chairman Greenspan’s obfuscating talk, he has made it clear that he might engage in nominal GDP targeting or introduce a higher inflation target at the BoE. Moving the inflation target may simply be an admission of reality, as the UK has suffered from stagflation for some time.

Euro. The European Central Bank (ECB) President appears desperate of late: the euro’s persistent strength may be one of the many reasons holding back growth in the Eurozone. Whereas “everyone” is “printing” money, the ECB has been mopping up liquidity. They can’t help it, as their printing press is more demand driven than the presses of the Fed, BoJ or BoE. As banks in the Eurozone return loans from the ECB, there is little the ECB can do about it. Last week, the ECB cut interest rates. And, sure enough, for about a day, rates fell. But after a few days, short-term German Treasury Bills, as well as longer-term Bonds are roughly about the same. Similarly, spreads in the Eurozone, i.e. interest rate differentials between periphery countries and Germany, are roughly the same. A rate cut was nonsensical as one has to buy two year German Treasuries to get a zero yield; anything shorter and investors pay a negative yield, i.e. pay the German government for the honor of lending them money. There are many problems in the Eurozone, but a low benchmark interest rate isn’t one of them. We continue to believe the euro is cursed to move higher, destined to be the “rock star”, albeit it is likely to continue to be a rocky road.

Gold. Is the ultimate currency the ultimate winner in Currency Wars? So as to ensure that no good deed goes unpunished, gold had a rather volatile ride of late. And not surprisingly: as the price of gold moved up 12 years in a row, speculators decided that a good thing is even better when leverage is employed. And, as such, good things come to a screeching halt when margin calls force selling. We now have many investors sitting on paper losses. Some that bought gold because of a meltdown in the Eurozone are selling their positions. On the other hand, not everyone buying gold because of future inflation is on board. Our reason to buy gold has always been motivated by what we believe is too much debt in the developed world. While Eurozone members are trying to address their debt loads through austerity – with rather mixed results – we believe the U.S., U.K. and Japan are more likely to resort to their respective printing presses. In that environment, we believe gold should perform rather well over the coming years.

So why not hold only gold? Any investment depends on that investor’s perspective on opportunities, but most notably also on risk tolerance. Just as investing in a single stock, investing in a single currency or in gold alone can be quite volatile. What we like about investing in currencies is that currency wars can be tackled at the core, without taking on equity risk and while trying to mitigate interest and credit risk. We may or may not like our policy makers’ decisions, but more importantly, those decisions may be rather predictable. As asset prices appear to be chasing the next perceived move of policy makers, the currency market may be the right place to express such views. Gold can play an important part in such a strategy, but as the recent past has shown, one needs to have a good stomach to get through the patches when there is substantial volatility when gold is measured in U.S. dollar terms.

Please make sure you sign up for our newsletter to be the first to learn as we discuss global dynamics affecting the dollar. Please also register to join our Webinar; our next Webinar is on Thursday, May 23, expanding on the discussion herein.

Axel Merk

Axel Merk is President and Chief Investment Officer, Merk Investments, Manager of the Merk Funds.

Tags: Currency, Merk
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Yen Slips, Lifts other Currencies (Chandler)

Friday, April 19th, 2013

by Marc Chandler, Marc to Market

The weakness of the yen is the main development in the foreign exchange market. The dollar resurfaced about JPY99 for the first time this week. The ostensibly driver is the realization that, as we anticipated, Japan’s aggressive monetary stance has not sparked much of a reaction from the G20. The leaked draft statement appears to give it a pass. Importantly the yen selling took place in Asia. It helped lift the other major currencies and many of the emerging market currencies. Gold is recovering and has now the week’s low set on Tuesday.

These corrective gains are coming amid a generalized “risk-on” mode ahead of the weekend. Global stocks have rallied. The MSCI Asia-Pacific Index is up about 0.5%. Chinese markets led the way. With a 2.1% gain, the Shanghai Composite reversed this week;s loss amid reports suggesting China is lobbying to have its A-shares included into the MSCI Emerging Market Index, which of course, would likely force some more buying by foreign funds.

European bourses are higher as well and today’s gains are paring this week’s losses.  Spain and Italian markets are leading the way up over 1%, while the Dow Jones Stoxx 600 is up a little more than 0.5% near midday in London, led by financials, telecoms and basic materials.  Technology is under-performing and may be linked to the some disappointing earnings in the US (e.g. IBM).  The same general “risk-on” is seen in the bond markets with Italian and Spanish bonds firm, while core bonds are a bit lower.

Outside of the growing realization that the BOJ Q-squared (qualitative and quantitative easing) is not objectionable in principle. new from Japan has been light.  Abe is pressing for companies to hike wages, but the employers association is reluctant to get behind it.  Some companies, especially in the auto sector, have raised bonuses, but one-off payments may not be sufficient to boost inflation expectations.

Japanese life insurers are beginning to announce their investment plans for the new fiscal .  The head of the industry association indicated that its members are indeed likely to shift more funds into foreign bonds.  However, he warned that when JGB yields begin rising, repatriation may ensue.  Remember, typically Japanese life insurers and pension funds run relatively high hedge ratios, so the demand for foreign bonds is not the same as demand for foreign currency.  60-80% of the foreign currency risk is hedged.   Along side the new incremental buying of foreign bonds, some may adjust their hedge ratios.

The Chinese yuan is posting its biggest weekly gain in six months.  The deputy governor of PBOC indicated  near mid-week in the run-up to the G20/IMF meetings in Washington that the 1% dollar-yuan band may be increased shortly.  The last widening of the band took place April 16 last year and so some pundits are focusing on the anniversary as a key date.  At least one investment house says that the move could take place as early as this weekend.

We are a bit skeptical.  We do not put much emphasis in the anniversary, as it does not appear to be part of China’s modus operandi.  Nor do we put much credence into ideas China would move during or just after  G20/IMF meeting.  It is also not part of its modus operandi, perhaps because it looks like bowing to international pressure.  In addition, we note that Chinese policy makers are far from a homogeneous group.  The PBOC has typically pushed for faster liberalization than the central committee has often supported.

The news stream from Europe is light.  The Italian presidential election is being watched closely.  Recall that the 3rd ballot today still requires a 2/3 majority to win.  After this a simple majority will do.   The center-left’s Bersani has sought to delay a fourth ballot today to re-group and strategize, but the center-right seems opposed.

The center-left has a majority, but there are two mitigating factors.  First, the split between Bersani and Renzi may weaken its position.  Second, if the center-left pushes through its own candidate, without compromising, it may be more difficult to resolve the larger issue of putting together a new government.  Ironically then, it is possible that a center-left victory for president could force the early election scenario (as early as June).

The only data in North America today comes in the form of Canada’s CPI.  The headline year-over-year rate may slip to 1.1% while the core remains steady at 1.4%.  Earlier this week, the Bank of Canada downgraded its growth forecast and continued to push out when the economy will be at full capacity into 2015 from 2014.  The Canadian dollar is off about 1% this week and is trading within yesterday’s range.  The US dollar may find initial support in the CAD1.0200-20 ahead of the week.

Copyright © Marc to Market

Tags: Cad, Currencies, Currency, Dollar, Euro, marc chandler, Yen
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China’s Uncertainties Won’t Stop Renminbi’s Rise

Tuesday, April 9th, 2013

by Hayden Briscoe, AllianceBernstein

Recent data releases and the transition to new political leadership have created some uncertainty about China’s short-term economic outlook. While positive growth surprises are unlikely in 2013, we still think nothing can stop the long-term appreciation of China’s currency, the renminbi (RMB).

The reason we expect the RMB to continue to appreciate lies in the strength of the structural, as distinct from cyclical, factors which should continue to support it in the medium to long term. The currency’s prestige, tradability and valuation bolster our expectations that the RMB will:

• Appreciate by 2%?3% a year on average, just to keep pace with the country’s persistent trade surpluses, and by up to 5% a year once economic rebalancing is factored in
• Become fully convertible by the time the current five-year economic plan expires in 2015—much faster than widely expected
• Emerge as a core reserve currency, especially in the Asia-Pacific region and other emerging markets

China is the second-largest economy in the world. It’s also one of the most dynamic, with the gap between the Chinese and US economies in purchasing power parity terms expected to close in just a few years (Display). Global trade flows don’t yet reflect this reality and continue to be settled mostly in US dollars.

But there are signs of change. In July 2010, the Chinese government began a move to internationalize the currency by opening an offshore currency (CNH) market based in Hong Kong. Taiwan followed recently, and Singapore and London are next on the list. This will help facilitate RMB trade settlements in time zones around the world.

The proportion of China’s global trade settled in RMB has grown to 11% and continues to rise. China’s banks are supporting the trend through the provision of trade finance: letters of credit denominated in the onshore currency (CNY) now account for the third-largest share of the global total, behind US dollars and euros and ahead of yen. By 2015 one-third of China’s exports are likely to be denominated in RMB, with annual trade-settlement volume expected to hit nearly US$2 trillion, according to HSBC.

RMB-denominated trade flows are increasing in strategically important markets, in Africa and Latin America in particular. They’re also rapidly becoming institutionalized. To date, 20 central banks have agreed on CNY swap lines with the People’s Bank of China (PBOC) totaling RMB2 trillion or US$320 billion.

Portfolio flows are another potential driver of the RMB’s internationalization, as China’s capital markets open up. For example, the Chinese government bond market is capitalized at around US$2.5 trillion. It’s the third largest in the world, equivalent to the German and French bond markets combined. If included in a traditional bond index, investors would be forced to commit 10%?12% of their fixed-income allocation to Chinese government bonds. This, together with the continuing strength of overseas direct investment into China, further facilitates the RMB’s internationalization.

We expect China will do what it can to make full internationalization of the currency a reality. This will include maintaining the RMB’s credibility as a steadily appreciating currency. Given that the RMB’s appreciation sharply lags the US$2.5 trillion growth in China’s foreign exchange reserves since 2005 (Display), we think this is a realistic goal.

The RMB already fulfills two of the three criteria necessary to become a reserve currency—the size of the underlying economy and the credibility of the currency itself. It is progressing steadily towards fulfilling the third criteria, which is openness and financial-market depth. Internationalizing the currency is one of the goals under the country’s five-year plan and, in early September 2012, Dai Xianglong, a former PBOC governor, said that China could liberalize its capital account as early as 2015. While the precise timing will depend somewhat on global economic and financial-market conditions, we think the RMB is likely to be internationalized much faster than widely expected.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Hayden Briscoe is Director—Asia-Pacific Fixed Income at AllianceBernstein

Copyright © AllianceBernstein

Tags: China, Currency, Yuan
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Ten Things for Your Radar Screen (Chandler)

Monday, February 25th, 2013

by Marc Chandler, MarcToMarket.com

The week has begun off with a bang.  Follow through selling of sterling in early Asia saw its losses extended to almost $1.5070 before recovering almost a cent by early Europe to about $1.5165, filling the gap created by the lower opening in Asia.

The dollar gapped higher against the yen on reports that Asia Development Bank Kuroda may become the next governor of the BOJ.  The dollar reached a new 2-year high near JPY94.75 before coming off a big figure to JPY93.75 in the Europe. Japanese stocks liked the yen’s weakness.  The Nikkei jumped 2.4%.   The gap extends to last Friday’s high near JPY93.52.

Cross rate buying has lifted the euro against the dollar, and has taken out  initial resistance near $1.3250.  Intra-day technical readings warn that it is getting stretch.  European shares are higher with the Dow Jones Stoxx 600 up 0.8%, with all sectors advancing; led by technology and building materials.

The debt market is less clear cut.  Japanese 10-year government bonds and Italian and Spanish 10-year bonds are bucking the heavier tone seen in core bond markets.  On the other hand, 2-year notes are generally firmer in core Europe and Japan, but softer in Italy and Spain.

Here are 10 items that investors will be watching this week.

1. Just before the weekend, and after two weeks of persistent rumors, the UK lost its AAA rating. Moody’s cut its rating one notch to Aa1 and adopted a stable outlook. There was little market reaction to previous rating downgrades of high income countries, like the US, Japan, France and Austria. We do not expect the UK to be an exception. At the same time, our analysis suggests that the macro-economic conditions and debt dynamics are more consistent with Aa3 (of AA-). Investors should not be surprised if the other major rating agencies make good on their negative outlooks for the UK and if deeper cuts are eventually forthcoming.

2. The passive tightening of the euro area monetary conditions does not appear to be as aggressive as it had appeared and this reduces the likelihood of offsetting ECB action. The early repayment of the second LTRO was considerably less than anticipated at not even half the pace in which the first LTRO was repaid. Some 356 banks will repay 61.1 bln euros this week from the second LTRO. The large number of banks and relative small average (0.17 bln) may point to small German bank participation. On the other hand, Italian banks may have refrained given the election uncertainty.

3. Federal Reserve Chairman Bernanke provides semi-annual testimony on Tuesday and Wednesday. We expect him to help “correct” the reading of the recent FOMC minutes that some observers seemed to understand somewhat hawkishly, expecting an early end to QE3+. It was only in December that Bernanke led the FOMC to more than doubling its outright long-term asset purchases. With economy growth slowing below the pace needed to lower the unemployment rate, we see little reason to expect a change of heart. A few regional presidents disagree, but they are a minority at the Federal Reserve and especially among the voting members of the FOMC.

4. The US Congress has a few days to avert the sequester—the deep spending cuts—set to be enacted on March 1. It calls for $1.2 trillion cuts in spending over the next decade, with $85 bln to be delivered in the current fiscal year. This is on top of the $1.4 trillion of spending cuts to discretionary programs announced over the past two years. While there may be a last minute deal, as there was with the fiscal cliff, it seems a bit less likely. Assuming a 1:1 fiscal multiplier, the sequester is expected to shave US growth around 0.5%. It is possible that Congress later authorizes additional, which may mitigate the fiscal drag.

5. Results from the Italian election will likely begin around 9:00 am EST.  A tight race is expected. A center-left victory in the lower chamber is expected, but the Italian polls have a habit of projecting greater support to the center-left than actually materializes and Berlusconi appeared to be enjoying some momentum in the days leading up to the last official polls. The Senate is a different story. The center-right can block an outright PD majority, forcing a coalition, depending on how Monti does. The most dramatic market reaction may be if the center-right receives the most votes in the lower house. Grillo’s 5-Star movement, which seems largely a protest vote, is also a known unknown, to borrow a phrase. High levels of undecided voters warn of the potential for surprises.

6. The usual battery of month end data will be released. In terms of important, potentially market moving data, the week begins off slowly. We would highlight the mid-week euro area money supply and the private sector credit-creation. The continued trend toward less accommodative financial conditions will likely be evident. US January durable goods orders are expected to show a weak start to capex in Q1. The UK Q4 GDP is unlikely to be revised, but revisions of Q4 US GDP, based on the combination of trade, inventory, consumption, and construction spending will likely replace a small contraction with a small expansion. Friday is the big day with PMIs, flash euro area February inflation, US auto sales and January personal consumption and income figures.

7. On Thursday, February 28, Bankia will report its full year earnings and is expected to admit to a loss in excess over 19 bln euros, making it the largest corporate loss in Spain’s history. Its restructuring will include the divestment of substantial holdings in several large Spanish companies, including IAG Group (12% stake), Iberdola (5.3%) and Mapfre (15%)—an airlines, utility and insurer respectively. In this way, the financial crisis in Spain will lead to industrial and governance changes. At the same time, the fact that Bankia failed within eleven months of it being listed , when it raised 24 bln euros, has generated persistent protests as the Rajoy government as hundreds of thousands of small investors who bought at the IPO as looking at a 97% loss.

8. The Abe government is expected to announce a new management team for the central bank. It will include the governor and two deputies. The latest reports suggest Asian Development Bank head and former MOF official Kuroda may get the nod as governor. He is moderately dovish and has advocated buying of long-term securities. He has a strong international reputation. If Kuroda does in fact become the next BOJ governor, reports suggest it will nominate Fin Min’s Nakao as his replacement at the ADB.  Back channels suggest China will not compete for the completion of Kuroda’s term.

9. A combination of minutes from the recent meeting and comments by the governor of the Reserve Bank of Australia suggests that a March or even April rate cut by the RBA is less likely than it appeared a couple of weeks ago. While the evolution of the economy in the coming weeks is important, it now seems that, barring a significant deterioration in economic conditions, the Q1 CPI due on April 23 may be the key to a May cut.

10. In the emerging markets we note the following: HSBC flash China PMI for February was reported overnight, and came in at 50.4 vs. 52.2 consensus and vs. 52.3 final in January, which was a two-year high. This is the first reading for February, and we note that some January data was not reported due to the Lunar New Year holiday, including retail sales and industrial production.. These two series report January and February combined as one reading. On Friday, official February PMI will be reported, with market consensus at 50.5 vs. 50.4 in January. We will also get the final HSBC PMI report on Friday. We continue to believe that everything is lined up for modestly improved China data in H1 2013. Both HSBC and official PMI readings have been above 50 for three straight months now, and that has been largely reflected in improved trade and IP data recently.

Elsewhere in EM, the Israeli central bank meets today and is expected to keep rates steady at 1.75%. Hungary’s central bank meets Tuesday and is expected to cut rates 25 bp to 5.25%. Brazil reports Q4 GDP as well as February trade and PMI data on Friday. These readings will be important coming ahead of the next COPOM meeting March 5/6, where many analysts are looking for the central bank to signal a more hawkish stance in its policy statement.

Copyright © MarcToMarket.com

Tags: Credit, Currency, marc chandler
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Emerging Markets Radar (February 4, 2013)

Sunday, February 3rd, 2013

Emerging Markets Radar (February 4, 2013)

Strengths

• The HSBC China January Final Manufacturing PMI was 52.3 versus 51.5 in December. The final reading was higher than HSBC’s preliminary January PMI of 51.9, announced January 24. The new orders sub-index climbed to a two-year high of 53.7.
• Truck demand has been rising since October 2012 and dealers are fully de-stocked with inventory sometimes less than one month’s sales in January, Chinatruck.org reported.
• There is an 80 percent chance that A-shares will rally around Chinese New Year according to historical data, CICC reported.
• The Philippines GDP grew 6.8 percent in the fourth quarter, and was up 6.6 percent for 2012, boosted by private consumption and investment. CLSA has raised the Philippines GDP growth to 5.5 percent from previous 4.8 percent for 2013.
• Taiwan’s GDP growth was 3.4 percent for the fourth quarter, exceeding market expectation and improving from 1 percent in the third quarter. For 2012, Taiwan’s GDP growth was 1.3 percent, which is highly dependent on trade since domestic demand is soft.
• Hong Kong’s December retail sales value growth beat expectation and was up 8.8 percent. Jewelry, watches and clocks sales were up 9.3 percent due to money inflows from China.
• Korea’s January exports grew by 11.8 percent versus market expectation of 8.9 percent, after a 5.7 percent decline in December. Imports rose by 3.9 percent in January after falling 5.2 percent in December. Headline inflation in January was steady at 1.5 percent.
• Thailand inflation came in at 3.39 percent in January, versus market consensus of 3.5 percent.
• Unemployment has fallen to new or near-record lows in Brazil (4.6 per cent), Chile (6 per cent) and Colombia (10 per cent). No wonder domestic consumption is soaring: Got a job, will spend.
• Eastern Europe follows Germany’s green shoots: manufacturing PMI improved in January, particularly in Hungary where it surged to 55.9, a 10-month high.
• The internet has shown a flurry of attention to the ad campaign below from the Eastern Poland Economic Promotion Program. The kid could be right as Poland was named one of the best emerging markets in the world, according to Bloomberg Markets Magazine, with 21 percent GDP growth projected from 2013 to 2017.

Weaknesses

• The China official January PMI was 50.4, indicating the industrial activities are expanding. The reading was lower than 50.6 in December and market expectation of 5.09, due to slowing activities approaching and during the Chinese New Year holiday season. In spite of lower January PMI, the new orders sub-index in the official PMI inched up to a nine-month high of 51.6, which might be the driver behind the Shanghai A shares index’s’ overnight gain of 1.41 percent. The National Bureau of Statistics of China (NBS) said on Friday that it had expanded the sample size for the official PMI survey to 3,000 firms from the previous 820 across 31 industries in January, which makes month-over-month comparison difficult.
• Indonesia headline inflation edged up to 4.6 percent in January from 4.3 percent in December. This was largely due to heavy rains, which caused disruption of food distribution and crop failures.
• Turkey’s hopes for a second upgrade to an investment grade rating were dashed after Moody’s issued a statement leaving the sovereign rating unchanged.
• Colombia’s peace talks are resuming in Cuba amid acrimony over the rebels’ insistence on their right to take police officers prisoner, in a clear reference to last week’s capture of two police officers. For years investors have been unable to exploit Colombia’s large-installed capacity due to the uncertainty surrounding the FARC.

Opportunities

• The chart above shows key leading indicators are moving in the same direction that points to restocking in China. CEBM, an economic research firm in China, also recently conducted an inventory survey among industrial sectors, and discovered inventories were low in general, which supports improving CPI numbers.
• With the right mix of policy measures, Indonesia could repeat Turkey’s hat trick–control currency appreciation, curb loan growth, and improve competitiveness of the export sectors. And, Indonesia’s macro challenges do not even look as stretched as Turkey’s were back in 2010-2011.
• The two-day summit of Latin American Community of States (CELAC) and the European Union last weekend ended with a final declaration that calls for guaranteeing legal certainty for investors and avoiding protectionism. “We have a good final declaration that spoke about the need to avoid protectionism and guarantee legal certainty for investment,” said European Commission President Jose Manuel Barroso.

Threats

• Latin American policymakers are manning their defenses ahead of what could be a new battle in the “currency wars” as flows of hot money put unwelcome upward pressure on their currencies.
• Property prices rose 1 percent month-over-month in January due to developers’ optimism that the government didn’t further tighten the housing market in the last year, according to a Soufun.com report. This faster price increase can eventually invite tougher government policies in tightening the market.
• Continued decline of unemployment in Russia belies weakness in real wage growth. It is increasingly driven by shrinking labor force due to persistent demographic contraction of the working age population, rather than strong labor demand. This keeps unemployment down even despite labor demand and the broader economy being close to stagnation.

Tags: Currency, Economy, US Economy
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Why is China Holding All That Debt? (Aziz)

Friday, February 1st, 2013

Via John Aziz of Azizonomics blog,

What does it mean that China is making a lot of noise about the Federal Reserve’s loose monetary policy?

Via Reuters:

A senior Chinese official said on Friday that the United States should cut back on printing money to stimulate its economy if the world is to have confidence in the dollar.

 

Asked whether he was worried about the dollar, the chairman of China’s sovereign wealth fund, the China Investment Corporation, Jin Liqun, told the World Economic Forum in Davos: “I am a little bit worried.”

 

“There will be no winners in currency wars. But it is important for a central bank that the money goes to the right place,” Li said.

At first glance, this seems like pretty absurd stuff. Are we really expected to believe that China didn’t know that the Federal Reserve could just print up a shit-tonne of money for whatever reason it likes? Are we really expected to believe that China didn’t know that given a severe economic recession that Ben Bernanke would throw trillions and trillions of dollars new money at the problem? On the surface, it would seem like the Chinese government has shot itself in the foot by holding trillions and trillions of dollars and debt instruments denominated in a currency that can be easily depreciated. If they wanted hard assets, they should have bought hard assets.

As John Maynard Keynes famously said:

The old saying holds. Owe your banker £1000 and you are at his mercy; owe him £1 million and the position is reversed.

But I think Keynes is wrong. I don’t think China’s goal in the international currency game was ever to accumulate a Scrooge McDuck-style hoard of American currency. I think that that was a side-effect of their bigger Mercantilist geopolitical strategy. So China’s big pile of cash is not really the issue.

It is often said that China is a currency manipulator. But it is too often assumed that China’s sole goal in its currency operations is to create growth and employment for China’s huge population. There is a greater phenomenon — by becoming the key global manufacturing hub for a huge array of resources, components and finished goods, China has really rendered the rest of the world that dependent on the flow of goods out of China. If for any reason any nation decided to attack China, they would in effect be attacking themselves, as they would be cutting off the free flow of goods and components essential to the function of a modern economy. China as a global trade hub — now producing 20% of global manufacturing output, and having a monopoly in key resources and components — has become, in a way, too big to fail. This means that at least in the near future China has a lot of leverage.

So we must correct Keynes’ statement. Owe your banker £1000 and you are at his mercy; owe him £1 million and the position is reversed; owe him £1 trillion, and become dependent on his manufacturing output, and the position is reversed again.

The currency war, of course, started a long time ago, and the trajectory for the Asian economies and particularly China is now diversifying out of holding predominantly dollar-denominated assets. The BRICs and particularly China have gone to great length to set up the basis of a new reserve currency system.

But getting out of the old reserve currency system and setting up a new one is really a side story to China’s real goal, which appears to have always been that of becoming a global trade hub, and gaining a monopoly on critical resources and components.

Whether China can successfully consolidate its newfound power base, or whether the Chinese system will soon collapse due to overcentralisation and mismanagement remains to be seen.

Tags: Commodities, Currency, Economy, Gold, US Economy
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Elliott’s Paul Singer: The Rise and Fall of Money

Friday, February 1st, 2013

Money Tsunami

by excerpt from Paul Singer, Elliott Management

The concept of “money” used to be simple: items of recognized value, initially in the form of shells, livestock, and then precious metals. At some point, someone decided to print currency on paper, but it was widely understood that it had to be backed by something real, like gold or silver. That history is oversimplified, but it illustrates this central truth: Money that is created at will, rather than grown in the field, mined from the earth, or otherwise subject to supply limitations, can be easily degraded. Nobody would want to own something that may or may not have value and purchasing power in the future. What, then, determines the value of money? The worldview and ethics of those in charge of the printing presses are obvious answers that are often overlooked. Another is the confidence (or inertia!) of the people who hold and trade the money, or claims denominated in money.

Fast forward to the modern era, which features central banks, so-called “fractional reserve banking,” leverage, and derivatives. Central banks allowed commercial banks to create money by making loans while keeping small amounts of reserves on hand or at the central banks. As money market funds, bank CDs, and other like instruments were created and then became a sizeable portion of the global financial system, things got even more complicated. An obvious clue that the very definition of money, to say nothing of the appropriate ways to analyze and adjust monetary policy, have departed from the understanding and control of monetary authorities can be found in the proliferation over time of acronyms to describe what used to be called simply “the money supply”: M1, M2, M2A, M3, MZM, and several others.

Add modern derivatives, which entered the scene in a significant way only some 30 years ago, and the picture becomes even murkier. To demonstrate this, in slow motion, consider the creation of a credit default swap (CDS), and then a mortgage collateralized debt obligation (CDO). Assume an investor wants to be long the credit of IBM. The investor offers to sell to a dealer a CDS on IBM. The dealer purchases the CDS and either keeps it or lays off the risk by booking an offsetting transaction with someone else. Actual securities issued by IBM are not part of these transactions – the CDS is just a contract between the investor and the dealer. As IBM’s credit quality is perceived to change, the price of the CDS will fluctuate and money will change hands between the investor and the dealer (based on the “mark to market”). This position is basically a borrowing by the investor who now “owns” a security referencing the credit of IBM, and who has put up only a small deposit – a tiny fraction of the notional credit exposure that the investor is long. It also represents a highly-leveraged loan by the dealer. Although the investor/borrower does not receive the full proceeds of this “loan,” he or she bears the full risk of loss on the underlying asset. It is as if the investor borrowed money from the dealer, added a small amount of his or her own money, and purchased an IBM security with the total amount of money. Interestingly, such borrowings also have the effect of impacting the price of the actual underlying assets (in this case, IBM credit) due to arbitrage pressures. In effect, these transactions by investors and non-bank dealers represent many of the characteristics of the creation and dissipation of money, but they are outside the traditional and commonly-understood mechanics of fractional reserve banking. Most economists would not consider these transactions in the context of money supply, but we think that they are being mechanistic and not seeing the actual effects of the basically unlimited ability of private derivatives transactions to have many of the same effects as are caused by the creation and destruction of “money.”

The ecosystem of mortgage securitizations has similar characteristics. It starts with the tranching of pools of mortgages into mortgage-backed securities (MBS) and then the referencing (via derivatives) of low-rated tranches to form new securities called synthetic CDOs. Based upon fanciful assumptions about diversity that prevailed pre-2008, the bulk of synthetic CDOs that referenced low-rated mortgage-pool tranches magically turned into AAA-rated securities. These instruments, even in subprime mortgage securitizations, were consequently treated by regulators as zero-risk-rated. Until the music stopped, these high-rated securities had many of the powerful multiplier effects of money. Furthermore, the institutions that packaged and sold the MBS, and those that put together the synthetic CDOs, performed many of the functions of banks (conjuring credit out of small reserves) even if they weren’t banks. Finally, the entire process caused demand for houses to increase and prices to rise.

The purpose of this part of the discussion about money is to show that things have gotten really complex and subtle in the modern banking and derivatives era, and that the old model of money as being solely or mainly the product of bank reserves and bank loans is woefully inadequate.

Now one more element should be added to this mix: quantitative easing, or QE. The government spends money on roads, bureaucrats’ salaries, entitlements, etc. To pay for such spending, Treasury sells a security to the public, and it has an obligation to repay the purchaser when the security matures. The security might be a Treasury Bill, a 30-year bond, or anything in between. The Federal Reserve (or the Fed, as it is commonly known) has the ability to set short-term interest rates, which has incentive/disincentive effects on bank lending and consumer spending. In a nutshell, that model has prevailed as the status quo since the Fed was created in 1913, up until 2008.

Since the crash of 2008, there has been an additional dynamic at work. Namely, the Fed is purchasing massive amounts of Treasury securities, either directly or on the open market. To be clear, the cash outlays by Treasury for government spending are the same as in the preceding paragraph. The difference is that post-crash, there are far fewer securities outstanding that the Treasury must pay off at maturity, because trillions of dollars of such securities are owned by another department of the federal government. We think this process is the effective equivalent of money-printing.

For those who think otherwise, we pose the following question: If QE did not have the effect of printing money, why would the Fed do it? We do not think that QE is merely a duration swap. If the government simply wanted shorter duration and cheaper borrowing costs, the easy course would be for the Fed to set interest rates at zero and for the Treasury to issue only 30-day Treasury Bills to pay for government spending. One possible outcome of such an approach would be that the price of long-term bonds would be uncontrolled, and could possibly fall precipitously, thereby driving up long-term interest rates. Instead, the government adopted a zero interest rate policy, or ZIRP, and Treasury’s borrowing rates dropped as the Fed purchased its bonds, elevating the prices of virtually all other securities. All of this contrivance is intended to be an indirect way of supporting economic activity, and perhaps it has done that to some degree. But it is causing massive distortions of risk-reward in stocks and bonds, as well as significant expansion of future risks of both inflation and severe losses in asset prices. These losses would be experienced by both the Fed and by investors.

The Fed’s explanations of these policies are delivered with equanimity and aplomb. However, in our view, the inventions of modern finance have “gotten away from them” and are not adequately understood by the money-printing overseers. A “smoking gun” is the complete failure of policymakers (and financial-institution executives) to predict or understand the circumstances surrounding the 2008 financial crisis – neither the inner workings/interconnectedness of the institutions involved nor the risks inherent in the system. Recently released minutes of Fed meetings in 2007 make it clear that they did not understand the modern financial system: its structure, the instruments that comprised it, the implications of the leverage and risk-taking afforded by untested derivative products, and the vulnerability and opacity of the major financial institutions. It does not mean that the Fed has no credibility when it acts or makes pronouncements today. But it certainly means that they should not have a great deal of presumptive credibility, especially about elements that are experimental and untested or that they got so wrong recently (like QE, and the risks of a system comprised of modern highly-leveraged financial institutions laden with derivatives positions, respectively).

It is critically important for investors to try to understand what global QE is actually doing, where it may lead, and what will happen when it slows, stops or shifts into reverse. What we urge most strongly is that the current atmosphere of calm and stability, and the lack of virulent inflation, must not be relied upon to continue forever. There are certain words and phrases in official communications that give some hint of the uncertainty that exists about key elements of central-bank policies: confidence, anchored inflationary expectations, and velocity are prime examples. Our takeaway is that when investors lose confidence in ZIRP-soaked, QE-ridden, faith-based paper money, the consequences could be abrupt and catastrophic to societal stability. We do not know exactly what to do about it, except to urge policymakers to STOP substituting QE for sound tax, regulatory, labor, environmental, and fiscal policies.

Due to the combination of the lagged nature of inflation in wages and consumer prices, the vital (if possibly more ephemeral than policymakers think) role of “confidence,” and the fact that each particular brand of paper money is competing with other currencies that are similarly mismanaged, the world is in a position today in which the major central banks see only the beneficial effects of QE and not the risks. Bonds that otherwise might be collapsing and repudiated are at sky-high prices with stingy yields. Reported consumer inflation is near historic lows. Consequently, central bankers think that what they got away with yesterday will also work today and next week. Investors either have not figured out that they are long seriously overpriced promises or think that they will all have the luck and perspicacity to reject such instruments before they plunge in price.

The reason we combined derivatives and QE in this discussion is that both are proud inventions of modern financial science, both have many of the characteristics of money-creation, and both are undertaken without any real understanding by public or private sector leaders of their nature, power, interconnectivity, and ultimate consequences. QE is exceptionally dangerous and way past its tipping point. We do not believe it can be unwound without serious consequences. Central bankers think (hope?) that it can be easily unwound at some future date, but they may not be right.

When the rejection of long-term bonds and paper money starts at some unpredictable future time, it may be fast and difficult to contain or reverse. History is replete with examples of societies whose downfalls were related to or caused by the destruction of money. The end of this phase of global financial history will likely erupt suddenly. It will take almost everyone by surprise, and then it may grind a great deal of capital and societal cohesion into dust and pain. We wish more global leaders understood the value of sound economic policy, the necessity of sound money, and the difference between governmental actions that enable growth and economic stability and those that risk abject ruin. Unfortunately, it appears that few leaders do.

About Paul Singer

Hedge fund manager’s $20 billion (assets) firm, Elliott Management, has been delivering compounding returns north of 14% since its 1977 inception but these days Singer, a Republican, may be best known for his political views. The father of a gay son who married his partner in Massachusetts in 2010, he has donated more than $11 million in support of gay and lesbian rights, and has played a major role in the passage of marriage equality in New York. He pledged $1 million to start a new Super PAC called American Unity, in support of gay rights, but also pushed to get Chris Christie to run for president. The former Wall Street lawyer known for playing hardball after scooping up sovereign debt of countries like the Republic of Congo and Argentina has also donated more than $9 million to support different military veteran organizations including Military Families United and Spirit of America.

Tags: Currency, Gold
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Bill Gross: Investment Outlook (January 31, 2013)

Thursday, January 31st, 2013

This is the way the world ends…
Not with a bang but a whimper.
T.S. Eliot

They say that time is money.* What they don’t say is that money may be running out of time.

There may be a natural evolution to our fractionally reserved credit system which characterizes modern global finance. Much like the universe, which began with a big bang nearly 14 billion years ago, but is expanding so rapidly that scientists predict it will all end in a “big freeze” trillions of years from now, our current monetary system seems to require perpetual expansion to maintain its existence. And too, the advancing entropy in the physical universe may in fact portend a similar decline of “energy” and “heat” within the credit markets. If so, then the legitimate response of creditors, debtors and investors inextricably intertwined within it, should logically be to ask about the economic and investment implications of its ongoing transition.

But before mimicking T.S. Eliot on the way our monetary system might evolve, let me first describe the “big bang” beginning of credit markets, so that you can more closely recognize its transition. The creation of credit in our modern day fractional reserve banking system began with a deposit and the profitable expansion of that deposit via leverage. Banks and other lenders don’t always keep 100% of their deposits in the “vault” at any one time – in fact they keep very little – thus the term “fractional reserves.” That first deposit then, and the explosion outward of 10x and more of levered lending, is modern day finance’s equivalent of the big bang. When it began is actually harder to determine than the birth of the physical universe but it certainly accelerated with the invention of central banking – the U.S. in 1913 – and with it the increased confidence that these newly licensed lenders of last resort would provide support to financial and real economies. Banking and central banks were and remain essential elements of a productive global economy.

But they carried within them an inherent instability that required the perpetual creation of more and more credit to stay alive. Those initial loans from that first deposit? They were made most certainly at yields close to the rate of real growth and creation of real wealth in the economy. Lenders demanded that yield because of their risk, and borrowers were speculating that the profit on their fledgling enterprises would exceed the interest expense on those loans. In many cases, they succeeded. But the economy as a whole could not logically grow faster than the real interest rates required to pay creditors, in combination with the near double-digit returns that equity holders demanded to support the initial leverage – unless – unless – it was supplied with additional credit to pay the tab. In a sense this was a “Sixteen Tons” metaphor: Another day older and deeper in debt, except few within the credit system itself understood the implications.

Economist Hyman Minsky did. With credit now expanding, the sophisticated economic model provided by Minsky was working its way towards what he called Ponzi finance. First, he claimed the system would borrow in low amounts and be relatively self-sustaining – what he termed “Hedge” finance. Then the system would gain courage, lever more into a “Speculative” finance mode which required more credit to pay back previous borrowings at maturity. Finally, the end phase of “Ponzi” finance would appear when additional credit would be required just to cover increasingly burdensome interest payments, with accelerating inflation the end result.

Minsky’s concept, developed nearly a half century ago shortly after the explosive decoupling of the dollar from gold in 1971, was primarily a cyclically contained model which acknowledged recession and then rejuvenation once the system’s leverage had been reduced. That was then. He perhaps could not have imagined the hyperbolic, as opposed to linear, secular rise in U.S. credit creation that has occurred since as shown in Chart 1. (Patterns for other developed economies are similar.) While there has been cyclical delevering, it has always been mild – even during the Volcker era of 1979-81. When Minsky formulated his theory in the early 70s, credit outstanding in the U.S. totaled $3 trillion.† Today, at $56 trillion and counting, it is a monster that requires perpetually increasing amounts of fuel, a supernova star that expands and expands, yet, in the process begins to consume itself. Each additional dollar of credit seems to create less and less heat. In the 1980s, it took four dollars of new credit to generate $1 of real GDP. Over the last decade, it has taken $10, and since 2006, $20 to produce the same result. Minsky’s Ponzi finance at the 2013 stage goes more and more to creditors and market speculators and less and less to the real economy. This “Credit New Normal” is entropic much like the physical universe and the “heat” or real growth that new credit now generates becomes less and less each year: 2% real growth now instead of an historical 3.5% over the past 50 years; likely even less as the future unfolds.

Not only is more and more anemic credit created by lenders as its “sixteen tons” becomes “thirty-two,” then “sixty-four,” but in the process, today’s near zero bound interest rates cripple savers and business models previously constructed on the basis of positive real yields and wider margins for loans. Net interest margins at banks compress; liabilities at insurance companies threaten their levered equity; and underfunded pension plans require greater contributions from their corporate funders unless regulatory agencies intervene. What has followed has been a gradual erosion of real growth as layoffs, bank branch closings and business consolidations create less of a need for labor and physical plant expansion. In effect, the initial magic of credit creation turns less magical, in some cases even destructive and begins to consume credit markets at the margin as well as portions of the real economy it has created. For readers demanding a more model-driven, historical example of the negative impact of zero based interest rates, they have only to witness the modern day example of Japan. With interest rates close to zero for the last decade or more, a sharply declining rate of investment in productive plants and equipment, shown in Chart 2, is the best evidence. A Japanese credit market supernova, exploding and then contracting onto itself. Money and credit may be losing heat and running out of time in other developed economies as well, including the U.S.

Investment Strategy

If so then the legitimate question is: how much time does money/credit have left and what are the investment consequences between now and then? Well, first I will admit that my supernova metaphor is more instructive than literal. The end of the global monetary system is not nigh. But the entropic characterization is most illustrative. Credit is now funneled increasingly into market speculation as opposed to productive innovation. Asset price appreciation as opposed to simple yield or “carry” is now critical to maintain the system’s momentum and longevity. Investment banking, which only a decade ago promoted small business development and transition to public markets, now is dominated by leveraged speculation and the Ponzi finance Minsky once warned against.

So our credit-based financial markets and the economy it supports are levered, fragile and increasingly entropic – it is running out of energy and time. When does money run out of time? The countdown begins when investable assets pose too much risk for too little return; when lenders desert credit markets for other alternatives such as cash or real assets.

REPEAT: THE COUNTDOWN BEGINS WHEN INVESTABLE ASSETS POSE TOO MUCH RISK FOR TOO LITTLE RETURN.

Visible first signs for creditors would logically be 1) long-term bond yields too low relative to duration risk, 2) credit spreads too tight relative to default risk and 3) PE ratios too high relative to growth risks. Not immediately, but over time, credit is exchanged figuratively or sometimes literally for cash in a mattress or conversely for real assets (gold, diamonds) in a vault. It also may move to other credit markets denominated in alternative currencies. As it does, domestic systems delever as credit and its supernova heat is abandoned for alternative assets. Unless central banks and credit extending private banks can generate real or at second best, nominal growth with their trillions of dollars, euros, and yen, then the risk of credit market entropy will increase.

The element of time is critical because investors and speculators that support the system may not necessarily fully participate in it for perpetuity. We ask ourselves frequently at PIMCO, what else could we do, what else could we invest in to avoid the consequences of financial repression and negative real interest rates approaching minus 2%? The choices are varied: cash to help protect against an inflationary expansion or just the opposite – long Treasuries to take advantage of a deflationary bust; real assets; emerging market equities, etc. One of our Investment Committee members swears he would buy land in New Zealand and set sail. Most of us can’t do that, nor can you. The fact is that PIMCO and almost all professional investors are in many cases index constrained, and thus duration and risk constrained. We operate in a world that is primarily credit based and as credit loses energy we and our clients should acknowledge its entropy, which means accepting lower returns on bonds, stocks, real estate and derivative strategies that likely will produce less than double-digit returns.

Still, investors cannot simply surrender to their entropic destiny. Time may be running out, but time is still money as the original saying goes. How can you make some?

(1) Position for eventual inflation: the end stage of a supernova credit explosion is likely to produce more inflation than growth, and more chances of inflation as opposed to deflation. In bonds, buy inflation protection via TIPS; shorten maturities and durations; don’t fight central banks – anticipate them by buying what they buy first; look as well for offshore sovereign bonds with positive real interest rates (Mexico, Italy, Brazil, for example).

(2) Get used to slower real growth: QEs and zero-based interest rates have negative consequences. Move money to currencies and asset markets in countries with less debt and less hyperbolic credit systems. Australia, Brazil, Mexico and Canada are candidates.

(3) Invest in global equities with stable cash flows that should provide historically lower but relatively attractive returns.

(4) Transition from financial to real assets if possible at the margin: buy something you can sink your teeth into – gold, other commodities, anything that can’t be reproduced as fast as credit. Think of PIMCO in this transition. We hope to be “Your Global Investment Authority.” We have a product menu to assist.

(5) Be cognizant of property rights and confiscatory policies in all governments.

(6) Appreciate the supernova characterization of our current credit system. At some point it will transition to something else.

We may be running out of time, but time will always be money.

Speed Read for Credit Supernova

1) Why is our credit market running out of heat or fuel?

a) As it expands at a rate of trillions per year, real growth in the economy has failed to respond. More credit goes to pay interest than future investment.

b) Zero-based interest rates, which are the result of QE and credit creation, have negative as well as positive effects. Historic business models may be negatively affected and investment spending may be dampened.

c) Look to the Japanese historical example.

2) What options should an investor consider?

a) Seek inflation protection in credit market assets/ shorten durations.

b) Increase real assets/commodities/stable cash flow equities at the margin.

c) Accept lower future returns in portfolio planning.

William H. Gross
Managing Director

* The terms “money” and “credit” are used interchangeably in this IO. Purists would dispute the usage and I would agree with them, arguing for the usage for simplicity’s sake and the evolving homogeneity of the two.
† Outstanding credit includes all government debt as well as corporate, household and personal debt. Does not include “shadow” debt estimated at $20-30 trillion.

Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to certain risks, including market, interest rate, issuer, credit and inflation risk. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Sovereign securities are generally backed by the issuing government. Obligations of U.S. government agencies and authorities are supported by varying degrees, but are generally not backed by the full faith of the U.S. government; portfolios that invest in such securities are not guaranteed and will fluctuate in value. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the U.S. government. Commodities contain heightened risk including market, political, regulatory and natural conditions, and may not be suitable for all investors.
The views and strategies described herein are for illustrative purposes only and may not be suitable for all investors. The information is not based on any particularized financial situation, or need, and is not intended to be, and should not be construed as investment advice or a recommendation for any specific PIMCO or other strategy, product or service. Investors should consult their financial advisor prior to making an investment decision. There is no guarantee that these investment strategies will work under all market conditions and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.

This material contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. ©2013, PIMCO.

Tags: Bill Gross, Bonds, Commodities, Currency, Economy, energy, Gold, Outlook, PIMCO, US Economy, Us Treasuries
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The Case for Japan, with a Caveat (Koesterich)

Tuesday, January 29th, 2013

While Japan’s stock market has been disappointing investors for more than two decades, it’s currently in the midst of one of its periodic rallies. Stock prices awakened late in 2012, and are now up approximately 20% over the past twelve months.

This has a lot of momentum-oriented investors eying Japan, asking: “Is now a good time to consider taking the plunge?”

My answer is yes, but with an important caveat. While I’m optimistic that Japanese stocks can move higher in coming months, I’d advocate investing in them only if dollar-based investors have the flexibility to hedge the currency effect of a weaker yen (more on that below).

So with that caveat out of the way, here are four reasons why I think Japanese stocks can move higher in the near term:

• They’re cheap. Despite the recent rally, Japan remains one of least expensive markets in the developed world, with Japanese equities still trading at close to book value.
• New fiscal stimulus. Japan’s new Prime Minister Shinzo Abe recently announced a new 10.3 trillion yen stimulus package. While I’m skeptical that this will do much to help Japan’s long-term stagnation (which is more a function of structural rigidities in the economy and a rapidly aging population), the stimulus should boost Japanese growth in the short term.
• An improving global outlook. As Japan is an open economy dependent on exports, Japanese stocks have done best when global growth is improving. While I have modest expectations for global growth in 2013, I do expect to see some improvement in emerging markets, particularly in China. Japanese exporters should benefit from this trend.
• Upcoming monetary stimulus. The Bank of Japan (BOJ) recently announced an inflation target of 2%. In order to reach this new goal, the BOJ will convert its current asset purchase program into an “open-ended scheme”, similar to the Fed’s QE3. The BOJ will buy about 13 trillion yen of assets on a monthly basis, starting in January of 2014. This program will weaken the yen, which is a positive for local stocks, and particularly exporters. This is because a weaker yen makes Japanese companies more competitive in international markets.

It’s this last point, however, that represents the big risk of investing in Japan for dollar-based investors. For them, a weaker yen means that any gains in Japanese stocks will be offset by currency losses. In other words, a depreciating local currency lowers the total return on the investment, as I recently explained in a post on currency considerations for international investing. Without the flexibility to hedge this currency effect, dollar-based investors may wind up giving back a significant portion of their Japanese gains.

Source: Bloomberg

Russ Koesterich, CFA, is the iShares Global Chief Investment Strategist and a regular contributor to the iShares Blog. You can find more of his posts here.

International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations.

Tags: Currency, Economy, Koesterich, Outlook, US Economy
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Where to Invest in Europe Now (Koesterich)

Friday, January 25th, 2013

by Russ Koesterich, iShares

While US stocks have gotten off to an exceptionally strong start in 2013, European equities have kept pace.

This performance is likely leaving many investors wondering whether they should jump on the European bandwagon. My take: I’m less bearish on Europe now for three reasons:

• Improving fundamentals: Europe is likely to suffer through another year of sluggish growth and its political problems remain, but the overall situation on the continent has improved, with peripheral bond yields plummeting and taking much of the pressure off Spain, Italy and Portugal.
• Cheap valuations: Much of the bad news in Europe is already reflected in European stock prices. For instance, the Euro Stoxx 50 is currently trading for about 1.23x book value versus 2.2x for US large caps. Some of this discount is justified given that European companies are less profitable than American ones, but even after accounting for the profitability difference, European shares look inexpensive.
• Yield: The current dividend yield on the S&P 500 is a bit more than 2%, about half the yield for European large caps.

So where should investors go in Europe? In the past, I advocated avoiding peripheral countries such as Italy and Spain, which looked cheap for a reason. But while Spain still appears that way, I’m upgrading my view of Italian equities to neutral from underweight for two reasons:

• Current Valuations: While Italy’s growth outlook remains dire, prices of Italian shares already reflect this.
• Improving Sentiment: Despite the short-term pain inflicted on the economy by difficult reforms, the reforms have made a big difference in restoring Italy’s credibility and competitiveness. Thanks to the country’s fiscal reform and the European Central Bank’s bond buying commitment, Italy’s borrowing costs have fallen significantly over the past six months.

Elsewhere in Europe, I’m maintaining my neutral view of Germany, a market I would be looking to buy on a dip, and I continue to advocate overweighting France, a market that looks attractively valued. To access these markets, I like the iShares MSCI Italy Fund (NYSEARCA: EWI), the iShares MSCI Germany Fund (NYSEARCA: EWG) and the iShares MSCI France Fund (NYSEARCA: EWQ).

Source: Bloomberg

Russ Koesterich, CFA, is the iShares Global Chief Investment Strategist and a regular contributor to the iShares Blog. You can find more of his posts here.

In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Securities focusing on a single country may be subject to higher volatility.

Copyright © iShares

Tags: Currency, Koesterich
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