PRUDENTIAL SECURITIES, INC.
One New York Plaza, New York, New York
(December 12, 1997) CURRENCIES: The dollar pulled back sharply against the major currencies late last week, largely in response to a plunge in the U.S. stock market amid worries over the Asian financial crisis. Worries that Asia's problems would reduce U.S. export growth weighed on the U.S. stock market which, in turn, pulled the dollar lower.
The dollar is caught in the Asian grip and shows no signs of pulling out soon. Strength in dollar/yen is offset by weakness in dollar/DM leaving the trend somewhere in the middle. However, on a trade-weighted basis, the dollar is slipping from recent highs. Some of this dynamic reflects the fact that the U.S. equity market is populated with multinational corporations deriving growth in earnings from expansion into foreign markets while fewer multi nationals.
This muddle can last somewhat longer because it is believed that the U.S. is more vulnerable to problems in the region than Europe. The major reason is that U.S. trade with Asia represents a higher proportion of total trade than European trade with Asia. However, that may not be the most accurate way of measuring the impact. One reason is that although 27% of U.S. trade is conducted with Asia versus 12% for Europe, the U.S. is far less dependent on trade. in general, than Europe for growth. particularly in the current environment, When measuring “openness” of an economy, then Europe looks more susceptible than the U.S. About 25% of GDP growth for continental Europe is derived from trade while it is only 12% for the U.S. Moreover, Europe's nascent recovery has been fed by exports while domestic demand has been lacking. Just the opposite is true for the U.S., where domestic demand is robust and accounts for the bulk of GDP growth.
Finally, when one considers that the U.S. economy is growing at a 3.5% to 4.0% rate while Europe is growing at 1.5% to 2.0%. it seems reasonable to assume that the U.S. economy can weather the storm from Asia somewhat better than Europe. If exports to Asia drop by 15%, which would be half again as much as exports dropped to Mexico during their currency crisis, U.S. GDP would decline by 0.5% while European GDP would drop by 0.4%, all else being equal. Considering the relative growth rates however, the impact is far greater on Europe than on the U.S. Growth in the U.S. would slow to about 3.0% while European growth would slow to 1.5%.
Despite these arguments, the dollar looks vulnerable to a further decline in the near term. A break to the 1.7500 or even 1.7300 level against the Deutschemark looks possible in the near term. Against the yen, the issue is more problematical. Simply because the yen is so weak and so oversold, there is a possibility that on the first sign of good news, the currency could rebound fairly sharply. Of the winners and losers, it is quite clear that the Australian Dollar is among the most vulnerable due to Asian problems while the UK is one of the least vulnerable.
In the week ahead, the focus is likely to be on December l6th when Japan announces measures to stimulate the economy and support the financial sector. The FOMC meeting in the U.S. is not expected to result in a policy change, so it is likely to be a non-event. Similarly, policy appears to be on hold in Europe, although the UK is problematical down the road.
BRITISH POUND–Sterling continued to trade in a range during the past week, reflecting the market's shifting expectations. The economic data continue to be favorable but concerns about weakness hi export growth and diminishing expectations for a near-term rate hike are negative.
Recent economic data indicate that the UK economy remains strong, with most of the growth derived from domestic demand. With unemployment down to 5.2%. the lowest level since 1980, income growth has fueled strong growth in consumption.
In addition, money supply growth which is a good leading indicator of domestic demand, is accelerating higher. Despite the series of rate hikes to date, the economy does not show significant signs of slowing down. The industrial sector however, is running at a sluggish pace, partly due to the strength in sterling. Industrial production fell 0.2% in October and has slowed to a 1.9% year-over- year rate. Figure 1 illustrates the trend in industrial production and manufacturing output. However, although sterling has risen about 7% on a trade-weighted basis this year, the pace of exports has not fallen nearly as much as anticipated. Moreover, the CBI survey for December indicated a positive outlook for manufacturing output growth going forward. The export order index actually posted a gain in the past month, largely due to improved demand from continental Europe.
The reports due out next week should reinforce a healthy outlook for the economy. Unemployment is expected to drop by 25,000 keeping the downward trend intact. Money supply growth will probably remain robust and keep the central bank nervous that the liquidity in the hands of consumers will eventually produce inflationary pressures. Retail sales, however, is likely to be a weak report and could be a negative for the currency. Nonetheless, the balance of the data continue to indicate that the components for strong growth are intact.
The risk in sterling is more likely to the upside than the downside. The minutes of the last monetary policy meeting indicate that the vote was unanimous to raise rates and the bias is clearly to tighter monetary policy. Although the recent RPI figures indicate that inflation is subdued, meeting the 2.5% inflation target of the central bank will probably require one more rate hike early next year. We continue to look for base rates to peak at 7.5% in the first quarter of 1998. At that level the rate differential with continental Europe will be nearly 400 basis points, a powerful supportive factor for the currency. We continue to favor the long side of the March British Pound in the 1.6300-1.6400 region in anticipation of another test of the 1.7000-1.7200 level longer term.
DEUTSCHEMARK–The Deutschemark rallied during the past week, reflecting the general sentiment that Europe is less affected by developments in Asia than most other regions. However, soft economic data limited the rally.
Germany's economic reports continue to show the divergence between domestic demand foreign demand. The export sector remains strong and is accelerating, as evidenced by the strength in industrial output. However, unemployment continues to rise while consumption remains weak. Unemployment rose to a new post-war high in the last month. The number of unemployed increased by 11,000 in November following a rise of 18,000 in October and 34,000 In September. The west actually saw a modest drop in unemployment but in the east, there was another sharp increase. In addition. real retail sales declined 0.5% hi the past month, continuing a long-term downtrend.
Bundesbank policy is clearly on hold for the time being. The Asian financial crisis has changed most projections for economic growth globally and given that Germany is a large trading nation, anything force which slows global growth will diminish German growth. Longer term, the Bundesbank has to be concerned with European Monetary Union and the need for short-term interest rates to converge, but those considerations are now likely pushed back until well into 1998.
We believe that the upside potential in the Deutschemark is limited in the current global environment. Hence, we continue to favor selling the Deutsche mark on rallies to the 5750-5800 level.
SWISS FRANC–The Swiss Franc also rallied during the past week, but fell back on Friday in response to comments from central bank officials who are struggling to hold down the currency. The Swiss National Bank's central concern is that the Swiss Franc will appreciate relative to the Deutschemark, thereby, rendering exports uncompetitive and snuffing out the recovery.
The Swiss economy is in the midst of a sustainable expansion. Last week's economic data indicated that consumption is rising. New car registrations rose 6.9% on a year-over-year basis, typically a signal of rising spending. Money supply growth has picked up sharply in the fourth quarter, also portending better growth down the road. Exports are rising at a 14.8% pace despite the sluggish demand in the rest of Europe. Finally, third quarter GDP rose at a 1.71/8 rate, the highest annualized growth rate in almost seven years.
Going forward, the SNB will undoubtedly continue to try to talk the currency down and to keep ample liquidity in the financial system to prevent a strong rise in the Swiss franc. However, the Swiss Franc is still seen as a safe haven currency and hence, capital inflows tend to insensitive to interest rates. Over the long run however, we continue to favor the short side of the Swiss Franc on rallies.
JAPANESE YEN–The Japanese yen edged along the lows during the past week as the market awaits the outcome of efforts to support the financial system. Meanwhile, the economic outlook remains dismal.
There is very little in the way of positive news for Japan right now. The economy is in the doldrums and may drop back into recession as consumer spending cannot seem to come back after the tax hike in April. Confidence is low, unemployment remains high and with the stock market sinking, consumers are reluctant to increase spending. The current account surplus is continuing to rise at a rapid rate, but eventually even this supportive factor is likely to give way as a result of the impact of declining exports to the rest of Asia.
The government has been working for quite some time on a combination of legislative packages designed to ball out the banking system and boost the ailing economy. At the end of the week, a final package had not yet been put in place. We expect that the LDP will approve the sale of bonds backed by collateral in government held companies on the order of U.S. $77 billion. The funds will most likely be used to put funds into the deposit insurance corporation which has been depleted by the recent bank failures. The LDP has debated using the funds to buy preferred stock of weaker financial institutions but the reform faction of the LDP objects to bailing out weak banks. The market would react much more favorably to the idea of providing funds for depositors as a means of avoiding a systemic problem like a run on the banks than to shoring tip weak banks. Allowing failed institutions to fail is a faster way to clean up the banking system than throwing good money after bad.
The other facet of the plan that the market is looking for is a tax cut. There is quite a bit of debate in the LDP about a tax cut since Hashimoto just a few weeks ago pledged no further fiscal stimulus plans to widen the already huge budget deficit. However, it is justifiably the view of the market that the biggest threat to Japan is not the budget deficit, it is the lack of domestic demand and that can be given a boost through lower taxes and de-regulation.
If the politicians come up with a relatively good plan next week, it is possible that the yen can bounce from the 130 level. It is oversold and due for at least a near-term correction. However, over the course of the next several months, the impact of Asian economic problems and the need for the Bank of Japan to provide ample liquidity to the banking system should mean that the yen will continue to move lower. Our next target is the 135-140 region.
CANADIAN DOLLAR–The Canadian Dollar rebounded on Friday from a slide to new lows on the back of a 50 basis point hike in short-term rates by the central bank. The rate hike came as a surprise both in terms of timing and magnitude but it underscores the central bank's commitment to stabilizing the currency.
The downward drift in the Canadian Dollar is something of a puzzle since the economy is growing at a robust pace with healthy domestic demand, strong exports and rising interest rates. Typically, these factors contribute to strength in a currency. But there have been two negatives for the Canadian Dollar. The first is that even after the rate hike in Friday, base rates in Canada are still 100 basis points below those in the U.S. As a result, there is still a negative incentive to hold Canadian Dollars. Figure 5 illustrates the trend in the exchange rate and short-term rate differentials.
Typically, the market demands the same or higher rates from Canada to hold the currency. Secondly, as domestic demand booms, the current account deficit is likely to widen. In the third quarter, domestic demand expanded at a huge 5.9% rate and, not surprisingly, imports exceeded exports by nearly two to one. However, it should be noted that the widening in the current account deficit is very minor and export growth is still running in double digits. Hence, we don't look for a huge rise in the current account as seen in previous cycles.
Longer term, the fundamentals for Canada remain positive but until the Bank of Canada edges rates up further, the currency is likely to remain in a sideways to lower range.
Kathy Jones
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