PRUDENTIAL SECURITIES, INC.
One New York, New York, New York
(November 21, 1997) CURRENCIES: ASIAN TURMOIL CONTINUES TO DRIVE THE G7 CURRENCIES–The foreign exchange markets continued to focus on the problems in Asia during the past week. The dollar continues to be caught in the middle between safe- haven buying of European currencies and seesawing expectations about Japanese policies.
Domestically, the dollar was under some pressure during the week due to the deterioration in the trade balance. The trade deficit continues to steadily widen. Robust domestic growth continues to boost imports while exports, although still strong, edged a bit lower during September. It is not unusual for the third quarter to witness the widest trade gap for the U.S. Despite seasonal adjustment, the deficit tends to widen as imports of consumer goods for the holiday season reach their peak levels in the third quarter. Hence, we doubt that the deterioration in the trade balance in the past month is a reflection of Asia's problems already since the situation did not unfold until well into October. Nonetheless, the economic trend in the U.S. suggests that the trade balance is likely to widen going forward.
Other economic data however are strong with housing starts, industrial production and money growth all pointing to a healthy U.S. economy. Yet, the Fed appears reluctant to raise interest rates because of the implications of the problems in Asia. Hence, the dollar has been left relatively directionless. Over the next few months, we anticipate that the dollar will pull back somewhat. Nominal yield spreads have narrowed versus Germany and other major countries, particularly at the long end of the yield curve. The interest rate appeal to holding dollars has diminished. Meanwhile, emerging markets problems have weighed more heavily on the dollar than on the European currencies. Moreover, if Japan begins to address the underlying problems in the financial sector, then the yen has room to recover.
The dollar is likely to continue to edge lower over the intermediate term. A deteriorating trade balance and low interest rates suggest further downward pressure on the dollar.
BRITISH POUND–Sterling ended the week on a strong note, driven by ongoing strength in the economic data and the prospects for higher interest rates. Although the Bank of England is clearly becoming concerned about sterling's strength cutting into export growth, the firm policy stance is likely to continue.
The recent economic data have done little to suggest a slowdown in the economy. Last week's figures were generally a bit weaker than expectations but don't indicate a change in the overall strong growth rate. Retail sales rebounded 2.3% in the past month and the overall trend remains strong. GDP was revised lower for the third quarter, but is still growing at a 3.8% year-over-year rate. Even money supply growth, which slowed a bit, is still rising at a nearly 11% annualized rate.
Next week's data calendar is relatively light. Trade figures are due and are likely to indicate some deterioration in the trade balance. However, the J-curve has prevented a serious decline to date. Moreover, the volume of exports remains very strong and has even accelerated recently suggesting that the impact of the rising currency has riot interfered with competitiveness yet. Exports volumes have risen more than 10% on a year-over-year basis. Although we, do anticipate some worsening in the trade balance, it may riot be as severe as anticipated.
Meanwhile, the highlight next week will be the release of the preliminary budget. The budget should indicate that the Chancellor has committed to running a tight fiscal policy. We would anticipate a downward revision to the Public Sector Borrowing Requirement to about 8 billion which means a reduction in the amount of borrowing the remainder of the fiscal year. Given the strong tax revenues being generated from rapid economic growth, the overall budget should be favorable. From a longer-term perspective, the U.K. is the one G7 country with a favorable long-term budget outlook. The British population is far younger on average than the other G7 countries and the present value of unfunded pension liabilities is by far the smallest in the industrialized world.
For the near term, the outlook for the British pound is positive. The base rate is likely to move up one more time to 7.5% due to strong cyclical activity and rising money supply growth. However, as the currency moves higher, the risk of some sort of “verbal intervention” will increase. We would buy setbacks but keep stops close and take profits at the 1.7200 to 1.7300 level.
DEUTSCHEMARK–The Deutschemark traded in a range during the past week, reflecting the market's uncertainty about monetary policy going forward. The rhetoric on interest rate policy has become softer for the market over the past few weeks, perhaps reflecting the central bank's uncertainty about the impact of Asia's problems on growth. This has encouraged the expectation that rates will be on hold into early next year.
The economic data for Germany, however, continue to point to steady gains in the industrial sector. New car registrations posted a 7.9% in October, marking the sharp gain since 1991. New car registrations are a good leading indicator of consumer demand in Germany and may be the first hint that the long slump in domestic consumption is finally turning the corner. Meanwhile, the industrial sector continues to expand at a healthy pace. Exports grew a sharp 23% on a year-over- year basis in September. The IFO survey also indicated a healthy jump in business expectations over the past six months.
Bundesbank policy is likely to remain on hold for the time being despite evidence of stronger growth. M3 money supply growth has slowed to a 5.1% rate which is close enough to the midpoint of the target range to indicate steady policy. In addition, the Deutschemark has recovered from its lows, indicating less import price inflation going forward. In fact, wholesale prices fell back in October. After surging in the prior few months. Next week's release of cost of living and PPI data will probably confirm a low inflation outlook, as well. Nonetheless, moving into next year, as the economic expansion unfolds and convergence approaches, the Bundesbank is likely to continue pushing short-term rates higher. Hence, we see scope for higher rates across the curve. From current levels, we favor long positions in the
December contract.
SWISS FRANC–The Swiss franc was also caught in a range during the past week, but ended on a firm note. The currency continues to be caught between safe-haven buying and efforts by the Swiss National Bank to push it lower.
The Swiss economy continues to show signs of improvement in growth. New car registrations rose 12.7% in the past month compared to year-ago levels signaling a rebound in consumer demand. The trade sector is performing strongly with the surplus rising sharply over the past year. The current account surplus stands at more than 6% of GDP. It appears likely that GDP growth next year could exceed 2%, marking the strongest year for growth in the 1990's. However, inflation remains quite low at 0.3% which leaves the central bank room to continue to pump liquidity into the economy. Moreover, they have repeatedly stated that they do not want to see the Swiss Franc gain against the Deutschemark due to safe-haven buying because it would imperil the recovery. Hence, rates are likely to remain quite low for the foreseeable future.
Barring a major financial market crisis developing, we continue to believe that the Deutschemark/Swiss Franc trade is attractive at current levels near .8100. As long as the central bank wants the currency lower against the major trading partners, the upside potential will likely be limited.
JAPANESE YEN–The Japanese Yen rebounded from a six- month low in the past week as the market began to discount the likelihood of a bank bailout package. There is still political opposition to such a plan, but there are few acceptable alternatives.
Japan's economy remains sharply divided by a strong export sector and weak domestic sector. Last week's current account figures indicated another huge rise in the surplus, led by robust exports to Europe and the U.S. against sluggish domestic demand for imports. Industrial production rose 2.4% in the latest month and stands 4.2% above year-ago levels. Shipments were also up strongly, rising 2.9% in the month and 5.1% year-over-year. There has been an inventory overhang in Japan which will probably prove to be a drag on growth over the next six months. However, inventories did edge down 0.3% in September, which may signal that the draw down has begun. From a longer-term perspective, the rally in the Nikkei from its recent low suggests that by the second half of 1998, the Japanese economy will begin a solid recovery. Historically there is a six- to twelve-month lag between an upturn in the Nikkei and a rebound in the economy. Domestic demand however, remains weak. Retail sales have slumped since the increase in the consumption tax April 1 and show few signs of rebounding despite an uptrend in income growth. Such lopsided growth implies a sluggish overall economy going forward.
The key issue for Japan however, is the banking situation. Japanese banks are going to be required to meet capitalization ratios set by the Bank for International Settlements (BIS) by next April. Because the banks still hold huge amounts of bad loans and equity shares which are under water, they are unable to meet these requirements. The Deposit Insurance Corporation has the authority to take over bad loans from banks. The LDP has proposed that the DIC use the postal savings system fund to buy the banks' preferred stock to inject fresh capital and then securitize the bad loans and sell them off. There is tremendous political opposition to using these funds however, and that is where the market uncertainty has emerged.
The alternative is to let more banks fail and promote mergers and acquisitions. However, this process will undoubtedly be lengthy and put further downward pressure on the economy. Moreover, it could spark real concerns among depositors and make even the more solid banks lose assets. We think there is a good chance that there will be some sort of public bailout for the banks. If that is the case, then the yen would most likely rally in response to the improved long-term outlook for the economy. We are, holding long positions in the December contract with close stops.
CANADIAN DOLLAR–The Canadian Dollar sank to new lows for the move before rebounding on Friday. The economic news continues to be positive, but low interest rates and worries about falling commodity prices weighed on the currency.
Canada's economic data continue to point to a robust economy. Wholesale trade jumped 1.8% in September and stands nearly 13% above year-ago levels. This series is a good leading indicator of manufacturing activity and suggests that growth will continue at a strong pace. Inventories also rose but there has been less accumulation in the third quarter than earlier in the year. The inventory/sales ratio is very close to its record low. In addition, the leading indicator rose 0.6% in October marking the 26th monthly increase. The leading index does correlate well with GDP growth longer term, suggesting strong economic growth ahead.
Perhaps most importantly the Bank of Canada's semi-annual budget statement clearly indicated that monetary policy would be tightening ahead. The Bank indicated the expectation that GDP growth would reach 4% in 1998 and that the output gap had already declined to 1.75% from 2.5% early in the year. These forecasts would suggest that the central bank has some tightening to do to prevent inflation in the year ahead. With the economy running at close to full capacity, and monetary conditions having eased with the decline in the currency, the Bank of Canada is running the risk of falling behind on monetary policy. Nonetheless, the market took the report rather calmly and did not react much to the threat of higher rates.
Longer term, we continue to anticipate moderate rate, increases over the course of the next year but until the rate spread with the U.S. narrows, the Canadian Dollar will likely continue to languish.
Kathy Jones
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