wmeubank@ocp.kcmo.com
PRUDENTIAL SECURITIES, INC.
One New York Plaza, New York, New York
(November 3, 1997) CURRENCIES: ASSET MARKETS MOVE THE DOLLAR–Two weeks ago, we asked the rhetorical question whether interest rates or asset prices drove the dollar. After the events of the past few weeks, it is clear that asset markets are currently the driving force. Despite the huge fallout in the Asian markets and a visible “flight to safety” into U.S. Treasurys, the dollar actually fell last week, even against the Japanese Yen. The weakness in the dollar is linked to the U.S. dependence on foreign capital and exposure to emerging markets.
MASSIVE CURRENCY REVALUATION IN ASIA–What took place in Asia over the past few weeks was a massive currency revaluation with impact on the financial markets and real economies. The root of the currency problems really go back several years. Asia is anchored by Japan on the one hand, and China on the other, The Japanese Yen has devalued against the U.S. Dollar by some 30% over the past three years, while China's currency devalued in 1994 and is undervalued by at least 20%, by design, to boost exports. These competitive devaluations have put tremendous pressure on the Southeast Asian economies, causing current account deficits to widen. Add in poor policy decisions and the result is the need to adjust the Southeast Asian currencies downward to more competitive levels. Since those currencies had been pegged to the U.S. Dollar, there was over investment in the region because investors were lulled into complacency by the dollar pegs. One by one, from the weakest (Thailand) to the strongest (Taiwan), the countries have devalued. So, in one sense, this whole explosion in the financial markets has been the result of a massive currency revaluation which, in the long run, should make the Asian region more balanced.
As for Hong Kong, it is doubtful that they will break the peg to the U.S. Dollar in the near future. Hong Kong's economy is significantly different from the Southeast Asian economies in that they are not large exporters of manufactured goods, but more of a service sector economy, Moreover, the peg represents stability and prosperity, and the public will to maintain the peg, even at a high cost, is strong. Finally, China has made it clear that they support the policy and, with combined reserves of over $200 billion, there is plenty of money to prevent a speculative attack. So for now, Hong Kong will likely keep the peg and experience a fairly significant decline in asset prices and an economic slowdown.
Where does this leave the rest of the world? The problems in Asia suggest slower growth and lower inflation in 1998 than would have been the case otherwise. Moreover, the devaluations will leave the U.S. Dollar and European currencies less competitive. However, barring a further spread of the problems, the worst for those currencies is probably over. Japan's outlook remains the major question given their dependence on exports to Asia and large investment in the region. Yet, the yen remained strong during this turmoil. The reason is most likely that Japan is a large net exporter of capital while the U.S. is a large net importer. Hence, if Japan's financial system were pressured by these developments, they have the cushion of over $300 billion U.S. Treasurys which could be sold. That cushion means that the dollar is more at risk than Japan, in the short run, although it is counter-intuitive. In addition, the spread of the problems from Asia to Latin America was a negative for the dollar. As the market looked around for other countries with similar problems to those in Asia, Brazil and, to a lesser extent, other Latin American countries came into focus. Markets in that region were sharply lower as well. Given that the U.S. exposure to Latin America is quite large, it weighed heavily on the dollar.
Longer term, this whole storm will probably pass and the focus will return to domestic issues such as monetary policy and relative growth rates. However, for the near term, the dollar is still vulnerable to shocks to the asset markets.
BRITISH POUND–Sterling rallied sharply last week in response to Chancellor Brown's indication that Britain would not be joining European Monetary Union (EMU) in the first round, January 1999. This should not have come as a big surprise, since it is obvious that there are several key economic reasons why Britain should not join, but it did cause sterling to rally quite sharply. There was virtually no economic news released for the U.K. last week, but next week will make up for it. The calendar is full, starting with money supply figures, moving to the CIPS manufacturing survey and ending with industrial production. We look for MO money supply to rise at a 6.0% annualized rate, about unchanged from September's rate of growth but still a bit too high for the likes of the Bank of England. The CIPS survey will likely point to an ongoing slowdown in export orders and likely prove supportive to the market, but the service sector indicators should continue to show strength. Industrial production for September is expected to post a gain of 0.4% month to month and 2.6% year over year which is a healthy figure.
If the numbers are in line with expectations, then the risk of another tightening move by the Bank of England would remain but given outside market events and the sharp rise in sterling this week, we believe short rates have probably already peaked in Britain for this cycle. We would look for the British Pound to edge lower from the top end of the trading range. A decline to the 1.6200 to 1.6300 level seems likely over the near term.
DEUTSCHEMARK–The Deutschemark advanced against the dollar during the past week, as Germany appears far more insulated from the problems in Asia and Latin American than the U.S.
Turning to the economic data, the gradually improving trend in growth was apparent last week. The VDMA plant and equipment orders data were strong with an improvement seen in the level of domestic orders. The data suggest that the export-led recovery is starting to seep into the domestic sector, at least at the industrial level. In addition, the ICON consumer sentiment figures indicated a moderate uptrend in optimism.
Next week's data should also point to some moderate improvement in the outlook. Industrial production for September should rebound after the August decline. We look for a gain of over 2% month-to-month, which would put the year-over-year reading up to 3.5%. Manufacturing orders, which jumped over 7% in August, will probably pull back in September, but the trend remains steadily higher. Finally, unemployment is expected to rise by 25,000 for October with the overall rate unchanged. Although the increase continues a steady deterioration in employment, the pace is slowing. Since employment tends to be a lagging indicator and Germany's rigid labor laws make loosening up the labor market difficult, we would anticipate that it will be well into next year before unemployment declines.
In the week ahead, the Deutschemark should remain well supported by the economic data and the uncertainty over the Asia/Latin America problems. We continue to hold long positions.
SWISS FRANC–The Swiss Franc rallied sharply in response to flight to safety buying. Although the Swiss National Bank tried to add liquidity to the money market system in order to push the currency lower, the inflows were too strong.
The economic data would not have suggested a big move up in the Swiss Franc in the absence of a global market collapse. Swiss CPI came in at an eleven-year low of 0.3% and show no signs of a significant rebound. These figures put any potential for a rate hike to match the rest of Europe's on hold for quite some time. Although there is a measurable pick up in economic activity, the Swiss National Bank continues to try to push the Swiss Franc lower against the Deutschemark to encourage exports and investment. Next week's employment figures should point to a gradual improvement in the rate from 4.9% to 4.8% with a moderate rise in new jobs.
For the near term, the Swiss Franc should continue to benefit from capital inflows due to uncertainty in the markets. Longer term, it will probably resume its slide against the Deutschemark.
JAPANESE YEN: The Japanese Yen moved moderately higher during the past week despite the volatility in the Asian markets. Given that the Japanese economy remains in the doldrums with significant asset price deflation already having taken place, this latest round of problems suggests that the outlook is even more bleak. However, Japan's holdings of U.S. Treasurys continue to be a buffer against a sharp yen decline.
Last week's report by the Economic Planning Agency (EPA) underscored the pessimistic outlook of the government. All signals are still pointing to a deterioration in domestic economic conditions and now the one engine of growth exports, are likely to slow. Unemployment is holding at near-record levels of 3-4%, consumption is still falling and investment in residential property is declining sharply. With as much as 40% of Japan's exports going to Asia, the recent currency devaluations and expected decline in activity will probably slow the export sector. Meanwhile, Japan's banks are the leading lenders to the region. The only good news on that front is that Japanese bank loans to Asia, represent only 4% of the total outstanding loans and many of the loans are to Japanese subsidiaries which pose little risk. The problem is that Japan's banks were already holding onto huge amounts of bad loans to begin with, so this just hampers them more.
Longer term, the only solution to Japan's problems would be an aggressive restructuring of the economy to open up to imports, allow uncompetitive firms to fail and to loosen up the regulatory juggernaut. A tax cut would help despite the large fiscal deficit, In other words, a supply side remedy seems like the most sensible right now. However Japan's policy makers continue to be slow to embrace structural changes and with Hashimoto in office, even the reform wing of the LDP is having trouble getting minimal changes put into place. Hence, we look for rates to continue to edge down in Japan.
The question is whether the currency can hold up in this environment just on the threat of repatriation of capital and concerns over the rise in trade surplus? Longer term, the yen is likely to work lower, but for the near term, a further rise is likely.
CANADIAN DOLLAR–The Canadian Dollar fell to a new low for the move last week. Although Canada's exposure to problems in Asia is very small, the low level of interest rates continues to make the Canadian Dollar unattractive to hold.
The economic data for Canada continue to point to a robust recovery, GDP data for the first two months of the third quarter point to a 4.1% annualized growth rate, slightly stronger weaker than the. 4.9% rate in the second quarter, but still quite robust. The composition of growth is shifting slightly, with the service sector contributing more strongly whereas earlier in the year, the recovery was largely driven by the manufacturing sector via exports, As to the question of the day, Canada's exposure to Asia is limited although it has been growing. About 4% of Canada's exports go to non-Japan Asia while about 3.5% of the imports come from the region. Canada is far more exposed to developments in the U.S. and Europe than in Asia.
Once the markets settle down, the focus will probably shift back to the likelihood of a rate hike by the Bank of Canada, sooner rather than later. With the Canadian Dollar having fallen sharply in the past two weeks, the Monetary Conditions Index now suggests the need for “rebalancing.” The index looks to be about —5.75 when the target appears to be —5.25. However, given the wide spread between U.S. and Canadian interest rates, the Canadian Dollar will probably not appreciate much until the interest rate spread narrows another 100 basis points. We are sidelined in this market for now.
Kathy Jones
Hosted by:
One Crossroads Place
610 West Maple Ave, Suite WWW
Independence, MO 64050
(816) 252-4080
sysop@kcmo.com