National Futures and Financial Weekly

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Copyright 1997 by Consensus, Inc.
May 09, 1997 * * 1737 McGee, Kansas City, Mo. 64108 U.S.A. * * Up Dated Daily

Overview

The total return performance of the non-dollar bond and equity markets in the first four months of 1997 clearly illustrates the importance of currency-risk management in international investing.

Global bonds for the most part posted modest positive returns in local currency terms in the first four months of 1997. Indeed, most markets outperformed the U.S. bond market over this period.

Unfortunately, because the dollar rose sharply versus the yen and continental European currencies in the early months of 1997, the total return performance of all foreign bond markets in U.S.-Dollar terms was quite weak and, in many instances, significantly negative. Indeed, in U.S.-Dollar terms the U.S. was the world's best performing bond market in the first four months of 1997.

However, if investors had the foresight to recognize that the dollar would trend higher in the early months of 1997, they could have hedged their non-dollar currency exposure and, by doing so, would have generated significant positive returns on their international bond positions, enough so to outperform the meager returns on U.S. bonds by comfortable margins.

Without a prudent currency-hedging policy, the total-return performance of non-dollar bonds can suffer greatly in an environment of a sharply rising U.S. Dollar. This is generally recognized in the international fixed income investment community, where most international bond managers engage in active hedging and currency investment strategies.

While most international fixed income investors actively manage their currency exposures, there are still a relatively large number of international equity investors who, as a rule, leave their currency exposures unhedged. We believe that this is a mistake, particularly in an environment of a strongly rising U.S. Dollar. The sharp rise in the dollar's value in the past year has helped spark a major rally in the leading equity markets in continental Europe. The rise in the value of the dollar has significantly enhanced the profitability and competitiveness of European companies and this is being reflected in a dramatic rise in share values.

In fact, the decline in the value of the European currencies has been so significant in the past six months that the persistent overvaluation of the Deutschemark and the other European currencies versus the dollar is now being rapidly corrected. Our estimate of the Deutschemark's overvaluation versus the dollar on a purchasing power parity basis is now at its lowest reading in about six years. Evidence that German companies are becoming more competitive in international markets can be found in the strong gains in German foreign orders at a time when German domestic orders continue to remain weak.

But from an investor's standpoint, the downside of all of this is that if the gains on European share prices are now heavily dependent on further gains in the dollar's value, then whatever dollar-based investors reap in terms of capital gains on their European equity holdings can be partially wiped out by losses on their European currency positions. This is pretty much what has already happened in the past year and is at risk of being repeated if the dollar continues to trend higher as we expect it will. It is for this reason that international equity investors need to consider adopting more active currency-risk management and investment strategies.

While it has been our view for some time that the dollar will strengthen against the yen and the DM and that international investors should be already hedging their non-dollar exposures, the forward exchange markets are presently pricing in substantial dollar weakness versus the yen and Deutschemark over the next six- to-twelve months. Therefore, it would be prudent not to hedge one's non-dollar exposure if the dollar was expected to fall by an even larger amount than the forward exchange rates presently anticipate. On the other hand, it would be prudent to hedge if the dollar was expected to: (1) decline modestly toward the forward rate, (2) remain stable, or (3) rise further. Given the dollar's strong sustained uptrend over the past two years, and our view that it will continue to trend higher in the future, we believe that the balance of risks and rewards tilts heavily in favor of hedging over not hedging.

Hedged foreign bonds should be appealing to U.S. domestic as well as international fixed income investors. Most foreign bonds hedged into U.S. Dollar on a three- or six-month rolling basis offer attractive standstill yield pickups over U.S. Treasuries, and in some cases--notably Canada, Belgium, Germany, Denmark, and Sweden-- the yield pickups are quite substantial.

While the ability to earn higher yields would in normal circumstances be enough of an inducement for U.S. investors to seriously consider investing in hedged foreign bonds, we believe that the overriding reason for U.S. investors to consider investing in hedged foreign bonds is that foreign bonds are likely to experience significantly less price erosion than U.S. bonds in the months ahead. The level of U.S. long-term interest rates appears to extremely low relative to the annualized pace of nominal GDP growth in the U.S., which in our view places the U.S. bond market in a vulnerable position.

U.S. 10-year bond yields have tracked closely the year-over-year pace in U.S. nominal GDP growth. The gap between 10-year yields and nominal GDP growth has averaged around 200 basis points over the past 10 years. With U.S. nominal GDP growth now running at a brisk 5.9% year-over-year pace, up sharply from the 4.0% year-over-year pace a year ago, one would have expected, based on past relationships, that 10-year U.S. bond yields would now be rising toward the 7.5% or 8.0% level.

But that has not been the case. Instead, U.S. 10-year bond yields have drifted lower in recent weeks and are now settling at levels closer to 6.65%. That places the gap between the current level of 10-year bond yields and the year-over-year pace in nominal GDP growth at a mere 75 basis points, which is close to the narrowest that this gap has been in the past 10 years. This suggests that either U.S. bond yields are presently too low or that the marketplace is expecting nominal GDP growth to slow in the months ahead. However, given that the OECD's leading indicator of U.S. economic activity continues to point to robust growth ahead, the risks lean heavily toward the view that U.S. bond yields are presently too low, and are thus in danger of moving significantly higher.

While bond yields are also likely to rise in Europe and Japan in the months ahead, they should lag considerably behind the rising trend in U.S. bond yields. Record high unemployment in Germany and Japan should act as a moderating influence on any rising trend in German and Japanese bond yields, while the extraordinarily low level of U.S. unemployment--the current unemployment rate of 4.9% is the lowest in 24 years--will reinforce the rising trend in U.S. bond yields.

As U.S. bond yields continue to rise relative to bond yields in Germany and Japan, this should work to reinforce the dollar's long- term uptrends versus the Deutschemark and the yen. This suggests that foreign bonds hedged into U.S. Dollars should substantially outperform U.S. Treasuries.

G-7 policymakers would clearly like to temper the dollar's rise, but even they probably recognize that there are limits to what can be done to stop the dollar from rising further. In their latest communique, G-7 finance ministers warned that they would <169>cooperate as appropriate on exchange rates,<170> strongly hinting that concerted intervention would be undertaken if exchange rates were viewed as <169>significantly deviating from fundamentals.<170> The G-7 identified the <169>re-emergence of large external imbalances<170> as a trigger for possible intervention. But in the same breath that the G-7 warned about the possibility of intervention, the communique expressed concern about the strength of the U.S. economy and the possible buildup of inflationary pressures, suggesting the likely need for a further tightening of U.S. monetary policy.

The G-7 communique also expressed concern about Europe's present high and rising unemployment rate and the pressure on Japan to achieve strong domestic demand. In both cases this suggested the likely need for Europe and Japan to continue pursuing easy monetary policies. Since such policies would clearly not be consistent with the G-7's desire for greater exchange-rate stability, the marketplace has come around to the view that the hands of G-7 policymakers are effectively tied, and that therefore, the G-7's warnings about possible concerted intervention are not credible. Hence, the resiliency in the dollar's longer-term uptrend. With the dollar likely to remain firm in the months ahead, investors will continue to be attracted to the dollar and dollar- bloc markets. Recent weekly surveys of investor positioning suggests that investors are already heavily overweight the U.S. Dollar--the latest Market Vane report indicates that 88% of investors are bullish on the dollar's prospects--but those same surveys indicate that investors are presently underweight the Canadian Dollar. The latest Market Vane report indicates that only 7% of investors are presently bullish on the C$'s prospects, the lowest such reading in the past year. Investors were right to be bearish on the Canadian Dollar as the C$ weakened to its lowest level in the past two years versus the U.S.$ last month. But the C$ is now beginning to recover some of that lost ground and we believe that Canada's positive longer-run fundamentals argue for further gains in the months ahead.

Michael R. Rosenberg

U.S.: Economic And Interest-Rate Outlook

The April Employment report suggested a downshifting in economic growth to a pace that still appears to be quite brisk. Nonfarm payrolls rose by 142,000 in April, and the March increase was sliced by 36,000 to 139,000. Bad weather and strikes dampened the April job gain, but even so, job growth has averaged a respectable 198,000 during the past three months. Other fundamentals for the economy still appear to be quite good. Consumer income outpaced spending in March, and confidence levels, while varying slightly according to different surveys, remain high.

The jobs report, as well as the employment cost index, present a more subdued picture of wage pressures than what we were expecting. Wages fell by 0.1% in April, trimming the year-to-year gain to 3.6%. The employment cost index suggested a dampening, rather than an acceleration in benefit cost growth. Nevertheless, it is hard to see how wage restraint can continue with the job market so tight. The unemployment rate slipped to 4.9% in April, its lowest level since 1973.
As with the jobs report, much of the remaining economic data for April is likely to be on the soft side of recent experience. However, we should see activity improve again in May, thanks to the return of normal weather, and the possible end of the major strikes. GDP growth for the second quarter is likely to fall well below the first quarters 5.6% pace, but is still likely to be at or above potential.
Martin Mauro

(Reprinted by permission. Copyright <189> 1997 Merrill Lynch,
Pierce, Fenner & Smith Incorporated.)

May 8, 1997
Merrill Lynch & Co.
International Fixed Income Research
North Tower, 21st Floor
World Financial Center,
New York, New York

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