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PRUDENTIAL SECURITIES, INC.
One New York Plaza, New York, New York
(December 8, 1997) CURRENCIES: DOLLAR GAINS–The dollar continued to post strong gains during the past week, propelled by the ongoing turmoil in Asia and strong domestic economic data. For now the path to a higher dollar remains open due to relative economic strength and the safe haven status of U.S. Dollar denominated assets. These factors should continue to under pin the dollar into early 1998.
The dollar has recovered more than half of its third-quarter decline against the major currencies. The financial crisis in Asia continues to be the driving force in the market, sending investors out of anything that looks risky and into U.S. Dollars. The key driving factor is the unsettled situation in Asia and the focus is now on Japan and the upcoming release of their financial plans next week. The market is looking for substantive plans to boost domestic demand and get the banking sector back on its feet so that Japan's economy can begin a sustainable recovery and pull the rest of Asia along with it. It remains to be seen whether Japan can really produce the kind of package that the markets want to see and so the risk is that the yen will slide further in the next few months. The market's view is that the pressure needs to stay on Japanese policy makers to force more than the usual policy response.
Meanwhile, the world is still counting on strong U.S. growth to stabilize the shaky global economic environment. The IMF is now forecasting a global GDP growth rate of 3.5% for 1998 compared to the previous estimate of 4.25%. The decline in projected growth is solely due to Asia's financial market crises and the expectation that growth in the Pacific Rim will slow sharply in the next year. Given the typical IMF response to emerging market problems which is to force the country into recession and boost exports as a means of fueling growth. the U.S. and dollar-bloc countries will need to grow at a healthy rate to offset the expected weakness in Asia. In this environment, the recent economic figures for the U.S. are quite encouraging. Based on our estimates, fourth-quarter growth in the U.S. should come in close to 4%, finishing off a very strong year. In contrast, the improving trend in Europe only projects to boost growth towards 2.0% to 2.5% next year. So interest rate differentials will most likely continue to be solidly in favor of the U.S. Dollar.
Going forward the issue is going to be political opposition to the U.S. financing recoveries abroad with a larger current account deficit. So far, the deficit has only widened moderately given the relative strength in the U.S. economy compared to the major trading partners. However, with the dollar/yen solidly above 130 yen and approaching 18ODM, calls from businesses competing in global markets will become louder. Once there is evidence of dollar strength adversely affecting exports, then the political pressure to curb the rally will intensity. In the short run, the stakes are still high and U.S. officials will most likely continue to simply call for Japan to boost domestic demand. However, the dollar has risen quite sharply against the Pacific Rim Newly Industrialized Countries in the past few months while gaining only modestly on the sum of western hemisphere currencies. A stronger U.S. Dollar may be in the best interest of global stability in the short run, but by the end of the first quarter of next year, political opposition is likely to build.
In the week ahead, the focus will remain squarely on Japan and the announcement of financial measures to boost the economy and address banking system problems. The announcement will set the tone for the currency markets. Expect the dollar to see profit talking early next week ahead of Japan's announcement but another sharp rise is likely later on if the package does not live up to expectations. Meanwhile, the German central bank has all but ruled out another hike in rates near term, which should keep the Deutschemark under pressure. We look for the dollar to rally into early 1998 peaking in the 135 yen and 1.83DM region.
BRITISH POUND–Sterling gave back much of its gains on indications of slowing consumer demand and more talk of Britain joining European Monetary Union. However, evidence of slower growth is not compelling and the risk is that rates continue to rise in the U.K. in the next few months, pulling sterling higher.
The key report released during the past week was the CBI distributive trades survey which indicated a slowdown in retail sales in the lead in to Christmas. After a year of strong retail activity surveys, the series appears to have peaked. However, with income and employment growth still strong, it is difficult to say for certain that the British consumer is ready to stop spending. Moreover, money supply growth and auto registrations remain very strong and tend to be reliable leading indicators of domestic demand. Figure 3 depicts the correlation of money supply, and consumer spending. Hence, the survey may represent a one-month blip in an overall strong trend. The other factor sending sterling lower was the Bank of England's decision to leave rates unchanged at the meeting last week. Although the decision was in line with expectations, it nonetheless prompted profit taking. Finally there were comments on Friday from Chancellor Brown indicating that the U.K. is going ahead with plans to enter European Monetary Union (EMU) on the second round, presumably sometime after the turn of the century. Given that the British Pound was already at the high end of its trading range, the news was enough to send the currency sharply lower.
From a longer-term perspective, however, the British Pound still has very strong fundamentals. The economy is growing at a healthy rate, with falling unemployment. In fact, GDP is at its highest level in almost three years. In addition, both nominal and real interest rates are high and the yield curve is inverted. Moreover, the U.K. seems relatively isolated from the problems of Asia compared to other countries which rely more heavily on trade outside Europe for growth. Only about 4.5% of British exports go to Asia. Finally, we anticipate at least one more rate hike early next year, which should propel the British Pound higher.
In the week ahead, there are several major reports due out for Britain. The inflation data should be benign and could contribute to early week selling in the currency. We look for PPI to come in near last month's 1.2% reading while the RPI is likely to hold near the 2.8% level in the core rate. However, manufacturing data should indicate ongoing moderate growth as reflected in the recent purchasing managers' survey. A moderate rise in output of 0.2% and industrial production for December is anticipated while the CBI survey due out on December 11th will probably indicate that the export sector is still alive.
In the near term, sterling appears likely to retrace some of its recent gains and test the lower end of the broad trading range near the 1.6400 level. However, given the prospects for higher rates and ongoing strength in domestic demand, we anticipate another rebound early next year.
DEUTSCHEMARK–The Deutschemark retreated against the dollar on signs of slowing growth and reduced inflation in Germany contrasted with strong data in the U.S. More of the same sorts of data are anticipated in the week ahead, keeping the Deutschemark under pressure.
Last week's data painted a somewhat mixed picture for Germany. Industrial production rose more strongly than anticipated, but manufacturing orders declined rather sharply suggesting that the pace of growth in the sector may be slowing. In addition, third-quarter GDP fell short of expectations posting an increase of only 0.8% when expectations had been for a stronger 1.1% gain. Moreover nearly all of the growth was a function of strong export demand and investment, trends which are now called into question due to the problems in Asia. Finally, there is the expectation that the Bundesbank will leave interest rates on hold well into next year on the assumption that the pace of expansion is still fragile and inflation is not a risk.
Next week's economic data are likely to suggest ongoing moderate growth with little inflation. The employment figures will probably point to ongoing high levels of joblessness in Germany. A rise of only about 10,000 in jobs for all of Germany is anticipated with the rate holding near 11.2%. In addition, wholesale prices are expected to fall 0.3% due to the drop in energy prices and raw materials in general. Finally retail sales will most likely post a moderate decline on a year-over-year basis with a modest rise month to month. Although last month's gain was well above expectations, some correction is anticipated in the October figures.
Longer term, Germany's expansion actually appears to be widening out a bit. The gains seen in the industrial sector as a result of strong export demand are beginning to have modest secondary effects. However, it takes quite a long time for an export led recovery to spread out and with very rigid labor markets and heavy tax burdens on business, the expansion is still expected to be slow. The worst is probably over for Germany but robust growth is still not on the horizon.
In the near term, we look for the Deutschemark to continue to decline, testing the 1.300 level against the dollar between now and year end and reaching the 1.8300 to 1.8500 level in the first quarter of next year. However, above 1.8000, the political pressure to intervene or boost rates to support the currency will rise particularly given the approach of EMU parity setting in the spring. For now. we would sell rallies in the Deutschemark.
SWISS FRANC–The Swiss Franc also retreated against the dollar and for the first time in several weeks, posted a decline against the Deutschemark. There is some evidence that the Swiss National Bank is succeeding is pressuring the currency lower through the provision of ample liquidity to the money markets.
The Swiss economic expansion appears to be moderating a bit, which is taking some of the upward pressure off the currency. Last week's unemployment report indicated an increase in joblessness for the first time in eleven months and the unemployment rate edged up to 4.9% from 4.8%. Although the increase may represent just a pause in the overall pace of improvement, it was less than anticipated. In addition leading indicators fell 0.2% in the past month interrupting a year-long upward trend. Overall, it still looks like the Swiss economy will grow at a 1.8% rate in 1997 which is the best performance since the early 1990's.
The Swiss National Bank has steadfastly held to the policy of trying to hold down the currency in an effort to boost economic growth. Safe haven flows into the currency have kept it quite buoyant, so the central bank has responded by keeping interest rates at very low levels. If international markets begin to stabilize, then the Swiss Franc is likely to continue falling against both the dollar and the Deutschemark. For the time being, we favor the DM/SF cross at current levels (8070) in anticipation of a move back towards the 8150 region longer term.
JAPANESE YEN–The Japanese Yen fell to a new five-year low against the U.S. Dollar during the past week, as the markets continue to pressure policy makers into action to spur the economy. The focus is squarely on next week's announcement of measures designed to boost the domestic economy and put the financial sector on more sound footing.
We have written at length in the past few weeks about Japan's problems, so we won't reiterate the whole story. Suffice it to say that the bursting of the asset bubble and subsequent policy paralysis combined with insubstantial regulation of the banking system have all led up to the current problems. With the dollar/yen at 130 and poised to move higher, the dismal state of the Japanese economy and its more dismal prospects are clearly discounted. The issue now is whether policy makers will take the action needed to restore some semblance of growth to the economy.
The good news is that the Bank of Japan and Ministry of Finance now appear ready to allow insolvent banks to fail. Although they risk a “run on deposits” by following this course, it is better than the previous seven years of throwing good money after bad and allowing failed institutions to remain in business. However, the underlying issue is that Japan desperately needs to boost domestic growth and the surest way to do that is to put enough liquidity into the system to boost money supply and get consumers spending. Japan's broad money supply figures have been edging lower over the past year. Since money supply growth spurs GDP growth, it is not too surprising to see the economy perform in a lackluster manner. If officials announce plans to close failed institutions and get bad loans off the books, then the banks that remain can go about the business of lending again and fuel economy growth going into 1998. That is what the market will be waiting to see.
Meanwhile, the market's job is to keep the pressure on Japanese officials to move in the right direction. Hence, we would anticipate further gains in the dollar against the yen culminating in a first-quarter top in the vicinity of 135. Longer term, Japanese officials have little choice but to make some substantive move in the direction of boost domestic demand. Although the political will is weak, the alternative is dire and so in the eleventh hour, we anticipate a change in policy. For now, the yen is quite oversold and susceptible to short covering rallies but the longer-term picture will depend on the policies announced over the course of the next few weeks.
CANADIAN DOLLAR–The Canadian Dollar continued to edge lower despite strong data and ongoing threats of higher interest rates. The same factors continue to pressure the currency: low interest rates vis-a-vis the U.S. and worries about an expansion in the current account deficit.
Canada's economic data continue to be quite strong. GDP figures for the third quarter will be available in the next few weeks and should indicate a strong growth rate of 4.8%. Much of the strength is due to a rise in consumer spending and in business investment, both of which are expected to continue the breakneck pace of the past year. Housing activity appeared to cool off in the third quarter, but on a year-over-year basis housing is still rising at a double digit pace. In addition, capacity utilization is now over 85% and rising and leading indicators point to even more strength going forward.
The Bank of Canada is not the least bit unnerved by the decline in the currency in light of strong economic growth, a declining budget deficit and rising interest rates. After the last rate hike to 4%, the rally in the currency lasted less than a day. As a result, there is still little evidence of monetary restraint on the economy and hence, the door is open to further rate hikes ahead. One worry however is the recent widening of the current account deficit as consumer spending has picked up. It is typical at this stage of the business cycle that the deficit widen a bit but that may lend to pressure on the currency near term.
Nonetheless, the Canadian Dollar is oversold and quite undervalued. We are sidelined for now in anticipation that it will take another one or two rate hikes to boost the currency.
Kathy Jones
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