Global Investing

Central bankers as carry traders? Why not.

As we wrote here yesterday, FX reserves at global central banks may be starting to rise again. That’s a consequence of a pick up in portfolio investment flows in recent weeks and is likely to continue after the U.S. Fed’s announcement of its QE3 money-printing programme.

According to analysts at ING, the Fed’s decision to restart its printing presses will first of all increase liquidity (some of which will find its way into central bank coffers). Second, it also tends to depress volatility and lower volatility encourages the carry trade. Over the next 12 months these  two themes will combine as global reserve managers twin their efforts to keep their money safe and still try to make a return, ING predicts, dubbing it a positive carry story.

The first problem is that yields are abysmal on traditional reserve currencies. That means any reserve managers keen to boost returns will try to diversify from the  dollar, euro, sterling and yen that constitute 90 percent of global reserves. Back in the spring of 2009 when the Fed scaled up QE1, its move depressed the dollar and drove reserve managers towards the euro, which was the most liquid alternative at the time. ING writes:

This time, however, we are not looking for the same kind of euro pick-up that we saw in 2009. FX reserve managers typically invest in securities rated AA or higher. Even if they extend durations out to the 5-year area of sovereign curves, an average of AA/AAA Eurozone yields only pays 0.75% – exactly the same as Treasuries.5-year UK gilts are not much better at 0.9 % while Japan pays a measly 0.2% on 5-year bonds.

Instead ING analysts reckon FX reserve managers will go for currencies such as the Australian and Canadian dollars. Thanks to slightly better yields, and large, liquid bond markets,  a carry basket invested in the Australian, Canadian, Norwegian and Swedish currencies and funded out of the dollar, euro, sterling and yen will have an annualised carry pick up of 1.6%, the analysts say. That sounds pretty modest but according to ING, FX outperformance can deliver returns of over 10% on this basket. They write:

The Olympic medals have all been handed out and the athletes are on their way home.  Which countries surpassed expectations and which ones did worse than expected? And did this have anything to do with the state of their economies?

An extensive Goldman Sachs report entitled Olympics and Economics  (a regular feature before each Olympic Games) predicted before the Games kicked off that the United States would top the tally with 36 gold medals. It also said the top 10 would include five G7 countries (the United States, Great Britain, France, Germany and Italy), two BRICs (China and Russia), one of the developing countries it dubs Next-11  (South Korea), and one additional developed and emerging market. These would be Australia and Ukraine, it said.

Close enough, except that Hungary took the place of Ukraine as the emerging economy in the Top 10 and the United States actually took 46 gold medals — more than Goldman had predicted.

Lucky Australia. In a world of slowing economic growth its central bank today raised forecasts for 2012 GDP growth by a half point to 3.5 percent. That’s down to a mining boom, driven of course by China. But there’s a downside. Australia’s currency, the dollar (or affectionately, the Aussie), has steadily risen in recent years, and is up 3 percent versus the U.S. dollar this year. Unsurprisingly, the Reserve Bank of Australia tempered its good news on growth with a warning over the Aussie’s gains.

Analysts at Credit Agricole note that the Aussie’s gains this year have come in tandem with a rise in Japan’s yen. That in itself would have been highly unusual in the past: the yen is a so-called safe haven, the currency investors run to when all else is selling off, while the Aussie is a commodity currency, one that does well when world growth is looking good and risk appetite is high. CA analysts explain thus:

The role of the (Aussie) is probably changing from a traditional commodity currency to an increasingly attractive reserve currency.

Japanese mom-and-pop investors’ penchant for seeking high-yield investments overseas is well known. Mrs Watanabe (as the canny player of currency and exchange rate arbitrage has come to be known) invests billions of yen overseas every year via  so-called uridashi bonds, debt denominated in currencies with high yields.  Data shows the lira has suddenly become the red-hot favourite with uridashi investors this year.

In a note entitled Welcome Mrs Watanabe, Barclays analysts estimate $2 billion in lira-based uridashi issuance this year, ahead of old favourite, the  Australian dollar.

So far, Japan’s exposure to Turkey is negligible at just 1.2 percent of their emerging market portfolio investments (Brazil is 4 percent, Korea 3 percent and Mexico 2 percent).  But Turkey’s high yields (almost 8 percent on one-year bonds) and the lira’s resilience mean the figure could rise to $5-$6 billion a year. That is almost half of total portfolio flows to Turkey in 2011, Barclays says.

Wednesday’s market commentaries are loaded with the buzz around another technical UK recession in Q1 (the first time Britain has suffered what many see as a ‘double-dip’ since the 1970s); guessing about Wednesday’s FOMC outcome; and the European Commission letting Hungary off the hook about its controversial constitutional changes. In aggregate, and probably due to the looming FOMC,  markets are fairly stable – world equities, including euro stocks, emerging markets and even Britain’s FTSE are all higher. The US dollar, Treasuries,  volatility gauges, gold and even peripheral euro government bond yields are all down a bit.

Following is a selection of some of Wednesday’s interesting research ideas:

- Barclays’ Barry Knapp reckons US and world equities face a dilemma from the endless distortion to multiples and risk premia from monetary intervention and QE that is artifically lowering the risk-free rate akin to the “financial repression” of the 1950s — no one is sure now if equity is cheap or bonds just very expensive. He concludes that best thing for equities in the medium to long term is to avoid further QE but the problem is that stocks will almost certainly suffer in the short run if the Fed takes QE3 off the table. What’s more, Wednesday’s FOMC could be problem for markets initally if the Fed frets about the growth outlook, but a worsening of the economy might bring QE3 sooner than similar bouts in 2010 and 2011.

U.S. consumer confidence came in slightly weaker than expected but the ‘jobs-hard-to-get’ index – historically a good lead indicator of the unemployment rate - fell to 37.5 in April.

Spanish equities in price terms are near their 2009 lows but valuations are still some way above:

Australian consumer prices rose by less than expected last quarter while key measures of underlying inflation showed the smallest rise in more than a decade, paving the way for a cut next week and suggesting further cuts were possible.

An Australian local government superannuation fund has become the latest state-owned fund to invest in environmental funds.

Local Government Super (LGS), which manages around A$6 billion in assets for 100,000 local government employees in New South Wales,  has invested A$50 million ($45.96 million) into a portfolio which invests in small cap environmental technology stocks, run by London-based Impax Asset Management.

The portfolio will follow an investment strategy followed by one of Impax’s fund, which returned 47.71 percent in the last five years, versus 20.10 percent for the benchmark MSCI World Index.

Australia's Future Fund reveals that the fund's mixed asset portfolio (excluding Telstra holding) returned 5.6 percent in the third quarter.

The fund has just over 10 percent in Australian equities, 22.8 percent in global equities. Safer instruments dominate, with debt holdings at 24 percent and cash at 31 percent.

The mixed-asset fund significantly underperforms an equity-only portfolio. For example, the MSCI world equity index has risen more than 17 percent in the Q3 alone.

Africa’s emerging commercial real estate markets may look tempting from the outside, but will remain the preserve of those with the highest appetite for risk.

Even the CEO of Growthpoint, South Africa’s largest listed property firm, feels the continent (excluding South Africa) is not for the faint-hearted. Those interested in investing for the longer term, like himself, are likely to remain on the sidelines for now. “We’re less convinced about the dynamics in some of these African countries. It is higher returns for that risk, but we’re not convinced that it’s enough,” says Norbert Sasse, while in London for an investors’ conference organised by Australia’s Macquarie Bank.

“We’re sceptical with those African countries further north. Nigeria, Uganda, Kenya, Rwanda etc … you’re never sure if the law protects your property rights. The law around property title is certainly nowhere near as advanced as you would get in South Africa.”

Should emerging market investors set aside their spreadsheets and crack open a cold one?

Their markets have zoomed higher from the March lows, with MSCI’s emerging markets stock index up 81 percent. Are they heading for a fall? Will investors soon be crying in their beer? And if so what kind?

Broker Auerbach Grayson held a rooftop fete this week showcasing emerging market versus developed market beers, with nary a Yankee brew in sight.