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from Breakingviews:

Global sell-off could echo summer of 2011

By Ian Campbell The author is a Reuters Breakingviews columnist. The opinions expressed are his own.Global investors have been sucking money out of risk assets. Credible reassurance that Greece will stay in the euro would see risky bets poured back on. But for now Greece looks headed for the exit door and markets’ trajectory is downwards. The global sell-off in stocks, commodities and many currencies is likely to get worse as the dollar advances.

It might seem Greece is not a big enough to warrant global concern. But a Greek default would impose losses on the rest of Europe . And Greece will be seen as the first domino. Spanish and Italian bonds will be among those selling off, exacerbating financing pressures in southern Europe’s two big economies. A huge European effort would be required to calm fears that they and Portugal will not ultimately go the way of Greece.

A further concern is growth. The euro zone has stalled, China has slowed, the United States is improving, but slowly. There are strong echoes of August 2011 - a global economic “soft patch”. But this time it is coupled with far more intense fears of a meltdown in the world’s second most important currency.

The implications are likely to continue to be felt across asset classes. As the euro and many emerging economy currencies retreat, the safe-haven U.S. dollar is appreciating. That in turn unwinds the previous dollar carry trade, on which commodities, gold and many global assets had prospered.

An important difference from last summer is that the U.S Federal Reserve is not currently embarked on a programme of fresh money printing. For many assets, gold especially, that is a big negative. Gold has thrived on dollar weakness, trading speculatively rather than as a genuine haven. It now looks very vulnerable to further falls.

Unless and until European fears are calmed, the outlook for global stocks seems poor too. The lows of August of 2011 give a guide to the potential downside. They would imply a fall in the U.S. S&P 500 to 1,150, a decline of more than 11 percent on its May 15 close.

Of course, if the Greek omens change, so too will markets. But neither Greece nor investors can keep relying on bailouts. At some point and in some way the euro zone’s fundamental solvency and competitiveness problems must be resolved. Until they are, global risks will be high and markets vulnerable.

from Breakingviews:

The pound’s climb may send the UK down

By Ian Campbell

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

British holiday-makers will welcome it. The pound is rising as the euro weakens. Sterling will rise further in the coming months if Greece exits the euro zone and exacerbates the single currency’s crisis. But the pound’s rise promises UK pain-and serious problems for policymakers.

The 4 percent rally against the euro so far this year isn’t dramatic enough to be called a problem or claimed as an excuse. The pound remains quite low. A euro now worth 80 pence is well down on its 97 pence peak but still up on the sub-70 pence that was the norm before 2008. But it won’t stay that way if the next phase of the European crisis is a euro exit - or two.

If Greece departs the zone, the resultant panic will be great. The pound would become still more of a safe haven. That 70 pence level for the euro, implying a pound appreciation of over 12 percent, could quickly be a reality. UK competitiveness in Europe would be harmed but the damage would go deeper than that.

An existential euro crisis would harm already weak European growth as investment plunges, consumers cower, banks struggle and financial markets tumble. All this euro-carnage would undoubtedly be felt across the Channel.

A half of UK exports go to the broader EU. The UK’s policymakers have been counting on rebalancing, with consumers overseas helping to pull a more competitive UK forward. Outside the EU that strategy is working. Export volumes to non-EU countries are up an annual 5.3 percent in the past three months - and by 21 percent since 2008. But in Europe a toll is already being taken by recession in weaker economies. Exports to EU countries in the three months to March are down by 3.3 percent in the past year and by 5.5 percent since 2008.

from Global Investing:

Research Radar: Greek gloom

Greek gloom dominates the start of the week as new elections there look inevitable and talk of Greek euro exit, or a Grexit" as common market parlance now has it, mounts. All risk assets and securities hinged on global growth have been hit, with China's weekend reserve ratio easing doing little to offset gloomy data from world's second biggest economy at the end of last week. World stocks are down heavily and emerging markets are underperforming; the euro has fallen to near 4-month lows below $1.29; safe haven core government debt is bid as euro peripheral debt yields in Italy and Spain push higher; and global growth bellwethers such as crude oil and the Australian dollar are down - the latter below parity against the US dollar for the first time in 5 months.

Financial research reports on Monday and over the weekend were just as gloomy, but plenty of interesting takes:

Bank of New York Mellon's Simon Derrick's view of the Greek political impasse concluded "there is at least an evens chance that the latter part of this summer will see what had officially been seen up until last November as an impossibility: a nation leaving the EUR."

RBS's Sanjay Mathur reckons that if there is another hung parliament after new Greek elections, implying no significant voter return to the pro-bailout parties, then euro risk soars.  "This means, on another hung parliament, that Greek government IOUs could trade as proxy currency as early as July." If that does not galvanize sufficient parties into accepting Trioka bailout demands at that point, he said that then exit looms. "Opening up the Pandora's box of exit means deposit risk across the periphery. The future of the euro would then be dictated by the subsequent policy response."

Barclays Sree Kochugovindan talks of a three phase possible deterioration of the euro crisis -- one, where solvency concerns and asset market fright are contained to Europe and mostly the fixed income markets of the periphery countries concerned; two, solvency concerns hit the core such as France and Belgium with asset market contagion widening before a series of major policy responses; and three, no major policy response or ECB SMP/LTRO, which leads to Greek default and even exit and global market shock akin to September 2008. "Given the immense cost of a crisis triggered by a Greek exit, we are not expecting the current situation to deteriorate into Phase 2. However, the risks are elevated and with the prospect of second round Greek elections in a few weeks, market jitters are likely to continue."

Deutsche Bank's global markets note also focuses on rising risks from Greece and also on the May 31 Irish referendum on the EU fiscal pact. Apart from outlining obvious risks to the Greek financing from a political vacuum, one conclusion Deutsche comes to is that a new EU growth pact may happen sooner than many had figured. "The new situation in Athens forces EU leaders to find common ground faster than we thought." Another conclusion was that Ireland may consider postponing its referendum, given the risk that a "no" vote may disastrously cut off its access to new EU funds and also given a possible delay in German parliamentary votes on the fiscal deal to June. "Ireland might do well to think about postponing the 31 May referendum." It called Spain's sweeping banking reform plan "making progress" but a 15 bln euro government recapitalisaation of the banks "too timid".

HSBC's Karen Ward and Simon Wells warn about the long-term impact of continuous quantitative easing by central banks, saying the political relationship between central banks and governments rather than inflationary consequences may be the biggest concern. "The heyday of independent central banking could be drawing to a close."

from Breakingviews:

Euro faces slide on break-up risks

By Ian Campbell

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

It’s euro strength rather than weakness that is remarkable. But a swift slide in its value is now probable. A possible Greek exit from the zone in the coming months is the big near-term risk. But there is also a broader threat. As the crisis persists France and Germany are growing further apart. More growth? Less austerity? A zone torn by discordant voices is vulnerable to a split and the euro to a slide.

Euro strength has perplexed. Even after unsettling elections the euro is still well above the $1.17 level at which it launched. The solidity may reflect Germany’s annual trade surplus of around 220 billion euros, the balanced trade position of the zone, and the European Central Bank’s 1 percent interest rate - higher than in United States, Japan and UK where outright quantitative easing have provoked currency weakness.

But the ground is shifting. While the United States seems to have finished money printing as its economy grows, the euro zone has returned to a recession which is deep in the periphery. And European political uncertainty is worsening.

Greece may end by electing a government that will not stick to the austere terms of the country’s second bail-out. Markets ought perhaps to be ready for a long-foretold Greek euro exit. But if Greece can exit the zone, why not Spain or Portugal?

Contagion risks are heightened by differences at the core. François Hollande, the new French president, is opposed to austerity in France and ill-placed to impose it in the periphery. Hollande’s preference may be for supportive fiscal spending and a far more expansive ECB. Germany won’t agree and the ECB will want its independence respected. Conflicting voices present the periphery with a temptation: why not call for monetary and fiscal rescue rather than implement tough reforms?

from Global Investing:

GUEST BLOG: A warning on global bonds

This is a guest post from Douglas J. Peebles, Head of Fixed Income at AllianceBernstein. The piece reflects his own opinion and is not endorsed by Reuters. The views expressed  do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

More and more, global bonds are being used as core portfolios for investors seeking an anchor to windward for their stock investments. While this is generally a good thing, some investors are discovering that the decision to go global can have unintended consequences: certain global bond portfolios have much higher volatility than is usually associated with core portfolios.

Bonds generally have two main sources of return: income (the return from coupon payments) and price (return from capital appreciation). Most of a bond’s return usually comes from income, which is a very stable source of returns. A smaller contribution comes from prices changes. This component is smaller, since, unlike equities, bonds have limited upside; they mature at par.

Global bonds add an additional source of potential returns: currency exposure. Currency hedging—which can be implemented simply and cheaply with currency forwards or futures—eliminates the impact of currency changes on bond returns. Nonetheless, many investors choose not to hedge, in the hope that currency exposure can boost returns. They also assume that multiple sources of return will reduce their overall risk. It turns out, though, that neither of these assumptions is correct.

Between 1996 and 2011, a US dollar-hedged global bond portfolio, represented by the Barclays Capital Global Aggregate Bond Index, would have generated nearly identical returns to an unhedged portfolio— 5.9% versus 5.8% annualized. This may come as a surprise to many investors, given the decline we’ve seen in the US dollar.

Furthermore, although currency exposure represented the additional source of potential return, it didn’t reduce volatility, as you might expect. As the display below shows, currency-hedged global bonds have been consistently much less volatile than unhedged global bonds, and even less volatile than US bonds, due to the benefits of economic cycle diversification.

from Breakingviews:

Freer yuan sends the right message

By Wei Gu

The author is a Reuters Breakingviews columnist. The opinions expressed are her own.

China’s moves to free up the way its currency trades might seem like throwing a bone to the United States, ahead of the two countries’ strategic summit in May. But it is China itself that gains most from this kind of reform, however gradual. The benefits are likely to include less foreign hot money, happier trade partners and the prospect of more capital account opening in the future.

Letting the yuan rise or fall 1 percent a day, versus 0.5 percent previously, is a step towards a more market-driven exchange rate. That’s what Washington and the International Monetary Fund want, and both agree China has made steps in the right direction. The United States is particularly keen to see China get more hands off with its currency. The trade gap with the United States increased by 28 percent to $17 billion in March compared with a year earlier.

A more free yuan might not mean a stronger one, though. Last time Beijing widened the trading band in 2007, investors saw it as a sign of future appreciation. After China posted a trade deficit in the first two months of 2012, the mood has become more subdued. Moreover, the central bank still controls the pace of the yuan by setting its trading midpoint every morning. After it guided the yuan lower on April 16, spot yuan touched its weakest point in three weeks in the first hour of trading.

More flexibility will make the central bank’s job easier. The People’s Bank of China will have had to step in numerous times in 2011 as the yuan hit the bottom end of its trading range. A larger trading band should make that kind of intervention less necessary. More, increased volatility should deter investors who previously saw the yuan as a one-way bet.

For China, this is a step in the right direction. A flexible exchange rate is a necessary condition for opening up China’s capital account. A currency that moves more with the market will also have a far better chance of being taken seriously as an internationally accepted currency, as is Beijing’s ambition. More importantly, this small but decisive step shows deeper reform is still on the agenda.

from Breakingviews:

Against the euro, the pound looks sound

By Ian Campbell

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

The pound has upside against the euro. The UK economy probably grew in the first quarter while euro land keeps heading down. And UK inflation looks firmer too - and that may deter more British money printing.

After a contraction in GDP of 0.3 percent in the fourth quarter, Markit says its surveys point to a rise in UK services GDP of about 0.7 percent in the first three months of this year and growth of 0.5 percent for the UK overall. The same firm’s survey for March pointed to overall contraction in euro zone service industries, with deep recession in Spain and Italy.

UK growth is positive for the pound in part because of what it means for monetary policy. The Bank of England has shown great love for the printing press. And readily printed pounds tend to be cheaper pounds. But the second round of QE is due to be completed and signs of growth will reinforce those on the BoE’s Monetary Policy Committee who are wary of more - notably Spencer Dale, its chief economist, and Martin Weale.

Dale has pointed to a good reason to hold back: inflation might not come down quite as fast as the BoE hopes. There are signs of this in recent data. UK manufacturers reported significant rises in input prices in March. High global oil and commodity prices are the chief cause. Global inflation pressures are raised by the floods of cash issued by the U.S. Fed, the Bank of Japan, the European Central Bank - and the BoE.

For its part the euro faces many risks. Given recession and austerity, the European Central Bank may seek to find ways to loosen monetary policy further, even if German hawks have other ideas. And the queue of periphery countries which could spur further euro alarms is long. Spanish and Italian sovereign bond yields are rising again.

from Global Investing:

Hard times for EM in QE-less world of higher US yields

Now that the Fed appears to have dashed any lingering hopes for an imminent QE3, what's next for emerging markets? Most observers put this year's stellar performance of emerging bonds, currencies and equities largely down to the various money-printing or cheap money operations in the developed world. That's kept core government bond yields bumping along near record lows and benefited higher-yielding emerging assets.

Many would add that in any case a solid economic recovery in the United States should be fairly good news for the rest of the world too. Not so, says HSBC. It argues that a better U.S. outlook is not necessarily good news for emerging markets simply because the side effect of economic improvement is a stronger dollar and higher Treasury yields and that's an environement in which EM assets tend to underperform.

For an example, it looks back to the days between November 2010 and Feb 2011 when signs of improvement in the U.S. economy steepened the U.S. yield curve,  pushing the spread between 2-year/10-year Treasuries almost 100 bps wider.  Flows to emerging markets dipped sharply, the following graph shows:

Money did continue to flow into emerging local bonds and equities in this period, albeit at a slower pace. But from local bonds the return was negative, HSBC notes. That could be an indication of what's to come:

The carry trade is not dead yet but the change in tone by the Fed suggests it may have passed its best days.

Headwinds for emerging markets may in fact be greater now than 18 months ago.  U.S. growth expectations haven't budged much HSBC says:  the bank expects U.S. growth under 2 percent this year and in 2013. On the other hand emerging market output gaps are much tighter than they were 18 months back and oil prices are higher. That makes the outlook for emerging local currency bonds more challenging,  especially as a  stronger dollar will give EM currencies less room to rise.

Should ongoing improvements in U.S. data result in further hawkish moves from the Fed and if such changes see U.S. yields rise further, we would expect this to be positive for the dollar vs EM . The combination of a potentially more inflationary backbone and a more challenging backdrop for EM FX might become a headwind for local rates.

from Global Investing:

Market exhaustion?

It's curious to see so many asset managers reaffirm their faith in a bullish 2012 for world markets just as a buzzing first quarter comes to a close on Friday with hefty gains in equities and risk assets.  Whether or not there is a mechanical review of portfolios at quarter end, it's certainly a reasonable time for review. The euro zone crisis has of course eased, the ECB has pumped the banks full of cash and the U.S. recovery continues.  So, no impending disaster then (unless you subscribe to the increasingly-prevalent hard-landing fears in China). But after 11+ percent gains in world equities in just three months on the back of all this information, you have to wonder where the "new news" is going to come from here. The surprise factor looks over and we're highly unlikely to get 10%+ gains in global stocks every quarter this year.  So, is it time for tired markets to sober up for a while or maybe even reconsider the risk of reversal again? Strategists at JPMorgan Asset Management, at least, reckon the economic news has just lost its oomph.

There are broad signs of exhaustion in markets, which is coinciding with a softening in the data, suggesting that in the short term the moderation in the “risk on” environment may continue.

JPMAM cite the rollover in the Citigroup economic surprises indices, shown below, and also say their own propietary Risk Measurement index -- a 39-factor model built on data from money markets, equities, economic data, commodities etc -- is flagging more caution.

Time for a pause and bit of a think then, at least until the first-quarter corporate earnings season kicks in next month. And it's here the next leg of any equities story may have to play out, rather than in the corridors of central banks and finance ministries. Gavyn Davies, Fulcrum Asset Management chairman and formerly BBC chairman and Goldman Sachs economist, reckons the valuation case for equities is pretty strong after a lousy decade -- even if government bond yields continue rising. What's less certain, he says, is whether the historically high share of nominal GDP commanded by after-tax corporate profits can persist. This requires a paradigm shift, one he reckons is bridged by globalisaton trends. One quarter won't solve that puzzle, but attention may shift in that direction over the coming weeks.

from Global Investing:

Fresh skirmishes in global currency war

Amid all the furious G7 money printing of recent years, Brazil was the first to sound the air raid siren in the "international currency war"  back in 2010 and it continues to cry foul over the past week. With its finance ministry issuing fresh warnings last night over hot-money flows being dropped by western economies on its unsuspecting exporters via currency speculation,  Brazil's central bank then set off its own defensive anti aircraft battery with a surprisingly deep interest rate cut late Wednesday. Having tried everything from taxes on hot foreign inflows to currency market intervention, they are braced for a long war and there's little sign of the flood of cheap money from the United States, Europe and Japan ending anytime soon. So, if  you can't beat them, do you simply join them?

The prospect of  a deepening of this currency conflict -- essentially beggar-thy-neighbour devaluation policies designed to keep countries' share of ebbing world growth intact -- was a hot topic this week for Societe Generale's long-standing global markets bear Albert Edwards. Edwards, who represent's SG's "Alternative View", reckons the biggest development in the currency battle this year has been the sharp retreat of Japan's yen and this could well drag China into the fray if global growth continues to wither later this year. He highlighted the Japan/China standoff with the following graphic of yen and yuan nominal trade-weighted exchange rates.

Edwards goes on to say that this could, in turn, create another explosive FX standoff between China and the United States if Beijing were to consider devaluation -- the opposite of what the protectionist U.S. lobby has been screaming for for years.

"We have long stated that if the Chinese economy looks to be hard landing, as we believe it will, the authorities there will actively consider renminbi devaluation, despite the political consequences of such action."

"Clearly, the US will not respond well if China chooses to devalue. But China might argue that as its reserves are now declining there is clear downward pressure on its currency and that, after all, the US has asked it to allow market forces to have more of an influence!"