This is the third piece in Seeking Alpha's Positioning for 2013 series. This year we have taken a slightly different approach, asking experts on a range of different asset classes and investing strategies to offer their vision for the coming year and beyond.
Marc Chandler is Global Head of Currency Strategy at Brown Brothers Harriman. Marc has been covering the global capital markets in one fashion or another for 25 years, working at economic consulting firms and global investment banks. He is the author of Making Sense of the Dollar and comments regularly on markets on his blog, Marc to Market.
Marc decided that rather than the standard interview format, he would offer his assessment of global forex markets in article form.
Anticipating events a week ahead is difficult enough and here we set on the task of considering the broad forces that will impact the investment climate in the year ahead. Although fraught with the risk of seeming foolish in hindsight, we recognize the path dependent nature of such prognostications that we make, knowing full well that our information set is, of course, incomplete.
Our purpose is to describe the main contours of the investment climate and the broad forces that will impact it. As is our mandate, we are particularly attentive to the impact on and from the foreign exchange market, where the variability of currencies are a major factor in generating total returns of international portfolios, as well as a means of achieving diversification.
Continuing Unwind of the Credit Cycle
The continued unwinding of the credit cycle will be the overriding force informing policy makers and shaping the investment climate in 2013. This means growth will be weak throughout the high income countries and, this in turn, will limit the potential for export-led development in the lower income countries.
With the exception of Japan, a regime of fiscal austerity will tighten its grip on high income countries. European countries still have ambitious deficit targets for this coming year and there is another round of tax increases and spending cuts to be had. Even if the fiscal cliff in its full glory can be reduced, the fiscal thrust in the U.S. may overtake the euro area for the first time since the crisis began. The new government in Japan has promised a large public works budget and is seen open to the idea of delaying the implementation of the 2014 retail sales tax hike.
Nevertheless, more developing countries are at risk of credit downgrades. Surely, an Abe-led government in Japan is tempting the rating agencies. With interest rates well above growth rates, the U.K. debt/GDP ratio has yet to stabilize. The political inability of the United States to address its structural deficit may see the rating agencies run out of patience.
Within the euro area, a downgrade of Spain, which would put it below investment grade, may have the largest impact, but risks are to the downside for Italy as well, especially if a new government dilutes some of the reforms instituted by the technocrat government. Meanwhile, the potential burden on the core creditor nations is increasing, and a downgrade, even of Germany, cannot be ruled out.
That said, we tend to play down the significance of sovereign rating changes for the high income countries and note that officials in Europe and the U.S. are trying to gradually reduce the rating agencies’ authority. In corporate ratings, it can be appreciated that the agencies have access to private, confidential information. This is not the case with sovereign ratings. Their information set is in the public domain. It becomes one set of analysts’ opinions.
Unorthodox Monetary Policy Serving Different Masters
Given the diminished political will to use fiscal policy to stimulate aggregate demand, the onus is on monetary policy. There is scope for additional unorthodox policy measures, especially in the first half of 2013, by the Federal Reserve, European Central Bank, the Bank of England and the Bank of Japan.
Moreover, the goal of the unorthodox policies varies from country to country. In some ways, the Federal Reserve’s stance is the most radical. The roughly 2% growth average of recent quarters, the roughly 2% inflation and the sub-8% unemployment rate the U.S. is experiencing would be the envy of nearly every other high income country. However, for the Federal Reserve, especially its leadership and some regional presidents, this macro-performance is not good enough. The unemployment rate is simply not coming down fast enough.
The Bank of Japan has been pursuing quantitative easing strategies for more than a decade and yet the deflationary forces continue to grip the economy. The pressure that the DPJ has brought to bear on the BOJ to ease policy more aggressively may pale in comparison to what the LDP-led government has threatened. Changing the BOJ’s charter is the implicit and explicit threat, but must be seen as a last resort. The preferable path will be in the appointments made to the senior posts, which include the two deputies and governor. The current terms will be completed in the March-April period.
The ostensible purpose of its unorthodox policies, which could include the purchase of foreign bonds (and would likely strike Japanese trading partners as intervention) would be to end deflation by spurring inflation expectations and actual inflation, partly through the depreciation of the yen.
The key to the ECB’s unorthodox policies is the Outright Market Transactions (OMT). Under this program, the ECB will buy sovereign bonds in the secondary market, with remaining maturities up to 3 years, provided the country agrees to EU/IMF conditionality and has access to the capital markets. The purpose of this program is not to spark faster growth as the Fed seeks, nor to end deflation as the BOJ seeks, but to improve the transmission mechanism of monetary policy and reduce the premium associated with the potential collapse of the monetary union.
The Bank of England’s version of quantitative easing seemed in some ways the more orthodox in the sense that with interest rates base rates well below the inflation rate, gilts were bought as another way to ease financial conditions. Alongside the U.K. Treasury, the BOE also moved to directly link lower financing costs with new lending. The funding-for-lending scheme has continued even though the BOE has ended, at least for the time being, its gilt purchases.
Changing of the Guard
Given the significance of monetary policy, investors will be sensitive to the changing of the guard. As we noted, the terms of the current leadership of the BOJ end in 2013 and this will allow the new government to appoint the personnel that will support its more aggressive agenda.
There will be a new governor of the Bank of England around mid-year. As is its habit, the U.K. surprised the market by naming Bank of Canada Governor Carney to replace Mervyn King, whose term is ending. What caught the market off-guard was that Carney had reportedly taken himself out of the running over the summer. The Bank of England’s gain, however, is the Bank of Canada’s loss. A replacement for Carney will have to be found.
It is tempting to project likely policy based on the personality or history of a particular candidate. While such extrapolation may be helpful in terms of processes, it may be less valid in terms within the context of policy. Policymakers respond to changing circumstances, constrained by the institutional framework. If Carney was seen as a hawk in the Canadian context, it does not mean that he would be a hawk in the U.K.
Moreover, in many ways central bankers have to write their own playbook now. No one really expected Mario Draghi, for example, to cut the ECB’s refinance rate at his first two meetings at the end of 2011, completely unwinding Jean-Claude Trichet’s ill-advised hikes. Nor was there anything in the background of who at least one German publication heralded as the Prussian Roman, to suggest Draghi would offer two long-term repo operations and OMT. Both of which, incidentally, are credited with stepping into the breach to reduce extreme tail risks while politicians seemed to dither.
The last central banker to be trumpeted as Carney was Alan Greenspan, who prior to the crisis was regarded as the tamer of the business cycle and the Maestro. The ability of Canada to avoid most of the pitfalls of the financial crisis has more to do with Canada’s institutional arrangements and regulatory decisions that were predated and were beyond immediate control of the central bank.
Federal Reserve Chairman Benjamin Bernanke’s terms ends at the beginning of 2014. One of the criticisms of the pre-crisis Fed is that Greenspan may have served too long, having been first appointed by Ronald Reagan in 1987. We suspect that there is an informal term limit for the Federal Reserve chairman of two terms going forward. There have also been some reports suggesting Bernanke may not be interested in another term.
Typically, to minimize disruption of the markets, a new chairman is likely to be named in late Q3 2013 or early Q4. Vice Chairman Janet Yellen and New York Fed President William Dudley are thought to be among the most likely candidates to succeed Bernanke and, at the same time, offer investors a sense of continuity.
Lastly, we note that all indications point to the retirement of Zhou Xiachuan, the Governor of the People’s Bank of China. It is not clear who will succeed him, but local contacts suggest Shang Fulin, the chief bank regulator, is a likely candidate. It may reflect the shifting emphasis of the new leadership. Institutionally, the PBOC has tended to support greater capital market liberalization, including currency appreciation, against other ministries who advocate slower change.
Two European countries have scheduled elections in 2013. Italy’s election will likely take place in late Q1, while Germany’s election will be in late Q3.
It is not clear what the rules are yet for the Italian election. While there might not be a lot of agreement in Italian politics, there is a general recognition that it needs to reform the current system, under which party officials can assign MPs. Currently, polls warn that the election could result in a hung parliament.
Owing to the idiosyncrasies of Italian politics, the president of Italy’s seven-year mandate ends shortly after the election, which must be held by the end of April. Under one scenario being discussed in Rome, a victory for the center-left PD could see Monti become the next President rather than Prime Minister. At the same time, Silvio Berlusconi has been keeping his allies and enemies off-balanced by suggesting he may run for Prime Minister again.
Other scenarios focus on the possibility of a hung parliament and that Monti could be called upon to again serve as Prime Minister. Although he has been cagey about it, Monti appears to be warming to the possibility. It may not be possible to know ex ante if Monti would claim an electoral mandate or serve again as a technocrat leader. Investors would seem to prefer if Monti had a longer tenure to expand and secure a reform agenda. An electoral mandate would of course give the policies of his government greater democratic legitimacy, but at the cost of potentially greater instability. The electoral mandate could place the government at the mercy of a small party or volatile personality.
Elections in Germany could be a game changer. The Social Democrats (SPD) are the main opposition party and have a stance that appears closer to France, Italy and Spain, even though much of Angela Merkel’s European agenda has often relied on support from the SPD to ensure parliamentary approval. The Social Democrats (and Greens) are more sympathetic, for example, of joint bonds than Merkel’s CDU/CSU/ FDP coalition.
Yet, even with a competent and articulate leader in the person of Peer Steinbrueck, the SPD is unlikely to wrestle the chancellery from Merkel. Even the SPD and Greens together do not appear to have sufficient public support to unseat her. With the implosion of the FDP, many observers see a grand coalition, as was the case 2005-2009, as a likely scenario. Merkel and Steinbrueck, who was the finance minister in that grand coalition government, share equal antipathy for another grand coalition, however. Politics can make for strange bedfellows and a coalition with the Greens (some, albeit limited, precedent in state governments) and the new Pirate Party may be preferable to a grand coalition.
Three Critical Issues
The investment climate remains vulnerable to shocks emanating from the U.S. fiscal consolidation, the European debt crisis, and the pace of growth in China.
Unlike the debt crisis in European periphery, the U.S. variation is not a creation of the bond vigilantes or investors more generally. U.S. yields are near record lows. Auctions continue to meet good demand. The Federal Reserve’s real trade-weighted dollar index against a broad array of trading partners, as well as just the major partners, is little changed this year.
Rather the fiscal crisis in the U.S. has been brought upon it as a consequence of domestic political forces. We see a substantial risk that the U.S. goes over the fiscal cliff, with tax cuts expiring and mandated spending cuts kicking in, before clawing its way back. The net result will be a fiscal drag on the economy in the first part of the year but not sending it into a recession as the Congressional Budget Office projects if the U.S. were hit with the full cliff effect.
We acknowledge that under such a scenario, the Federal Reserve, given the leadership and the shifting composition due to the rotation of regional presidents, may opt to extend its long-term asset purchase program (QE3+) in Q2 2013.
We are more optimistic about the U.S. economic outlook as the year progresses. Within the larger downtrend, there may be new business investment that had been sidelined due to the uncertainty surrounding the fiscal cliff. The housing market and residential investment are improving. There also will be diminished headwinds from state and local governments. In addition, the dramatic increase in oil and gas production will over time boost the competitiveness of the U.S. as a point of production, which has far reaching implications including the likely reduction in the current account deficit.
After the first quarter, tail risks in Europe may again emerge as sovereigns and banks compete for record amount of funds. The focus will remain on Spain and Italy. Spain will need to raise around EUR10 bln a month. Without the benefit of another long-term repo operation by the ECB, bank and investor appetites for more paper may diminish. The government’s forecast that the economy will only contract 0.5% in 2013 will likely prove too optimistic, warning of further deterioration of its debt/GDP ratio. In turn, this keeps Spain’s credit rating vulnerable. Currently all three major agencies give Spain the lowest in the investment grade space with a negative outlook.
Pressure on Spanish Prime Minister Mariano Rajoy to ask for assistance will likely intensify. The risk is that he will hold out long enough that a serious economic shock could be inflicted. The idea that the Rajoy government floated in early December was that it would agree to request aid if the ECB would guarantee that Spain would pay no more than 200 bp more than Germany for 10-year money.
At the time, Spain’s premium was about 410 bp, which itself represents a third decline from the year’s peak. It is not clear where the 200 bp threshold came from. Spain has been paying more than that since April 2011. No central bank can make such a guarantee. Moreover, under the Outright Market Transaction (OMT) program, the ECB would be buying bonds with three years and less duration. Its ability to influence, let alone dictate, long-term rates is surely questionable. Nevertheless, suggesting this as a condition is another way to signal lack of intent to ask for a full assistance program.
Italy is also another potential flashpoint. Unlike Spain, which in part is coping with the end of a construction boom, Italy is plagued by rot. Italy experienced slow growth even in the best of times and now faces a renewed contraction. It does not appear to be regaining competitiveness as fast as other peripheral countries. Added to this combustible situation is a political climate in flux. Much of Monti’s reforms were implemented by decree. There are clearly risks that not only won’t the reform agenda be extended with a new government, but that some of the reforms will be diluted if not reversed.
If Spain does receive an assistance program, it may not be very helpful for Italy. In fact, we are concerned that in such a scenario, Italy would become more vulnerable rather than less. It would be the lightning rod for euro skeptics. In this context, we remain concerned that France shares many characteristics with the Mediterranean countries and has not been compelled, as the peripheral are now, or as Germany was by the fall of the Berlin Wall, to rationalize and restructure the economy.
We had thought 2012 would be characterized by what we called “The Three No’s”: No euro area break-up. No euro bond. No ECB backstop. Defying the expectations of many, Greece remains in the monetary union and we expect it to continue to do so throughout 2013 and beyond. Demands for a euro bond as the only way forward have died an ignoble death. The ECB’s OMT is the closest thing we have to sovereign backstop, especially if the ESM buys long-term bonds in the primary market.
In a similar vein, despite the prevailing pessimism at the time, we had anticipated a soft landing in China and recognized the risk of a bumpy landing. This appears to be what is being delivered. After seven quarters of slowing, we expect Q4 2012 GDP to have improved. Owing to greater interest in sustaining stable growth and the excesses associated with rapid growth, Chinese officials appear content with GDP growth around 7.5%. We anticipate modest yuan appreciation of a few percentage points over the course of the year.
Further complicating China’s economic challenges, demographic projections suggest that its labor force will peak in 2013. This coupled with inflation and wage pressures are changing the competitive landscape. Businesses are responding in three ways: 1) moving into the interior where labor is cheaper, 2) moving out of the country to Vietnam, Malaysia, Thailand, or even the U.S. (see Apple’s decision to shift some computer production, for example), or 3) boosting capital investment and reduce workforce.
China will also continue to pursue the internationalization of the yuan. The recent agreement with South Korea to activate the bilateral swap lines to promote trade settlement in local currencies may serve as a model for additional arrangements. This, coupled with the gradual easing of limits on the capital account, is more practical and seems to be what Chinese are genuinely interested in rather than aggressively pushing for the yuan’s use as a reserve currency.
While China has become the single largest trading partner for a number of Asian countries and integrating into the global supply chains, developments on the political front are quite different. China’s territorial disputes with a number of neighbors, including Japan, India, the Philippines, and Vietnam, are a potential flashpoint of crisis next year. This is especially true of Japan, where more nationalistic political forces are moving into ascendancy.
The Middle East still seems to be a powder keg. Regime change in Syria is certain. What is significantly less certain, as the situation in Egypt begs as well, is whether the regime change will promote inclusive democratic principles and integration into the world economy, or simply replace one unresponsive harsh government with another.
The confrontation with Iran over its pursuit of nuclear power is likely to reach a head in Q2 2013. Regime change in Syria, and a reduction in the threat for retaliation by missile attack from the Gaza Strip, may improve Israel’s tactical position. Nevertheless, an Israeli attack would be a reflection of the failure of the multilateral effort.
Foreign Exchange Market
We expect the dollar to remain in broad trading ranges against the euro and sterling. The prospects of more aggressive expansion of the Fed’s balance sheet and the protracted fiscal cliff self-created crisis, even as Europe muddles along, could see the dollar start off 2013 in a softer phase. This could see the euro trade toward $1.35 and sterling toward $1.65. We look for the dollar to recover subsequently as the U.S. economy strengthens and the European debt crisis flares up once again.
We see the yen under-performing as the market adjusts to the new and more aggressive policy mix under the new Japanese government. This may see the dollar trade toward JPY85 in the first part of the year, but there will be costs, such as higher interest rates, if dramatic yen depreciation is anticipated. The higher rates will not only increase the government’s debt servicing costs, but also weaken bank balance sheets.
We recognize the demand for Australian dollars related to reserve diversification, but it is very rich to almost any valuation metric one uses. It had previously experienced a positive terms of trade shock and now it is experiencing a negative one. The OECD’s purchasing power parity model finds the Australian dollar is nearly 40% over-value, the most in its universe. The same model finds the Mexican peso the most under-valued—almost 60% under-valued. As a mean-reversion trade, there is much to consider in a long peso short Australian dollar position. A contrarian theme, it also expresses the enhanced competitiveness of the Americas' side of the Pacific. By some measures, Mexican labor is cheaper than Chinese labor and coupled with cheaper energy will further dampen relative production costs. The carry works in the trade’s favor. Medium-term technical factors also favor the peso over the Aussie, suggesting scope for a 10% move in 2013.
Disclosure: Marc Chandler has no positions in any securities mentioned in this piece and was its sole author.
To read other pieces from Seeking Alpha's Positioning for 2013 series, click here.