Global Investing

Central banks may be regaining some two-way control over global markets that had started to behave like a one-way bet. After flagging some unease earlier this month that frothy markets were assuming endless QE, the Fed and others look to be responding with at least some frank reality checks even if little new in the substance of their message. In truth, there may be no real change in the likely timing of QE’s end, or even the beginning of its end, but the size of the stock and bond market pullbacks on Wednesday and Thursday shows how sensitive they now are to the ebb and flow of central bank guidance on that score.  Although the 7% drop in Japan’s stock market looks alarming – Fed chief Bernanke actually played it fairly straight, signalling no imminent change and putting any possible wind down over the “next few meetings” still heavily conditional on a much lower jobless rate and higher inflation rate. The control he gains from here is an ability to nuance that message either way if either the data disappoints or markets get out of hand.

The central banks are clearly treading a fine line between getting traction in the real economy and not blowing new financial bubbles. The decider may be inflation and on that score central banks have a lot of leeway right now – global inflation is still evaporating and, as measured by JPM, fell in April to just 2.0% – its lowest in 3-1/2 years.  That said, CPI was also very well behaved in the run-up to 2007 credit crisis – it was asset prices and not consumer inflation that caused the problem. So – expect to hear plenty more cat-and-mouse on this from the central banks over the coming weeks/months.

For investors, periodic pullbacks from here are justified and likely sensible. But it’s still hard to argue against a wholesale change of behaviour – which is merely to assume central banks will prevent further growth shocks but will take some time to transform persistently sluggish growth into anything like a sustained inflation-fueling expansion . As a result, funds will likely steer clear of “safe” havens of cash, gold, Swiss franc and yen despite this bounce and continue their migration to income everywhere, with a bias to relative growth stories within that and an exchange rate tilt according to the likely sequencing of QE exit– all of which points to the U.S. dollar if not its stock markets. And for many that may just mean repariation or staying at home –the US is still the homebase for two thirds of the world’s institutional funds, or some $55 trillion of savings.

And the dollar move is just starting to play out big in emerging markets, where emerging market currencies are on the back foot everywhere from Turkey to South Africa, South Korea and others. The reaction so far as been to lift local stock markets on potential exporter relief but a big question moving ahead is to what extent persistent exchange rate weakness will start to deter or even reverse foreign investment flows.

Next week is a busy if mixed bag – a heavy G7 data slate, with Japan a focus; rate decisions in Brazil, Thailand, Hungary and Canada, US Treasury and JGB debt auctions, EU flash inflation and jobless reports, and China’s Premier visiting Germany.

Far from the rules of the dusty old investment almanac, it’s up, up and away in May after all. And judging by the latest batch of economic data, markets may well have had good reason to look beyond the global economic ‘soft patch’ – with US employment, Chinese trade and even German and British industry data all coming in with positive surprises since last Friday. Is QE gaining traction at last?

Well, it’s still hard to tell yet in the real economy that continues to disappont overall. But what’s certain is that monetary easing is contagious and not about to stop in the foreseeable future – whether there’s signs of a growth stabilisation or not. With the Fed, BoJ and BoE still on full throttle and the ECB cutting interest rates again last week, monetary easing is fanning out across the emerging markets too. South Korea was the latest to surprise with a rate cut on Thursday, in part to keep a lid on its won currency after Japan’s effective maxi devaluation over the past six months. But Poland too cut rates on Wednesday. And emerging markets, which slipped into the red for the year in February, have at last moved back into the black – even if still far behind year-to-date gains in developed market equities of about 16%!

Not only have we got new records on Wall St and fresh multi-year highs in Europe and Japan, there’s little sign that either this weekend’s meeting in London of G7 finance chiefs or next weekend’s G20 sherpas gathering in Moscow will want to signal a shift  in the monetary stance. If anything, they may codify the recent tilt toward easier austerity deadlines in Europe and elsewhere. But inevitably talk of unintended consequences of QE and bubbles will build again now as both equity and debt markets race ahead , even if the truth is that asset managers have been remarkably defensive so far this year in asset, sector and geographical choices …  one can only guess at what might happen if they did actually start to get aggressive! Perhaps the next pause will have to come from the Fed thinking aloud again about the longevity of its QE programme — so best watch those thought bubbles!

So, it’s May and time for the annual if temporary equity market selloff, right? Well, maybe – but only maybe.  A fresh weakening of the global economic pulse would certainly suggest so, but central banks have shown again they are not going to throw in the towel in the battle to reflate. The ECB’s interest rate cut today and last night’s insistence from the Fed that it’s as likely to step up money printing this year as wind it down are two cases in point. And we’re still awaiting the private investment flows from Japan following the BOJ’s latest aggressive easing there.

So where does that all leave us? A third of the way through 2013 and it’s been a good year so far for nearly all bulls – both western equity bulls and increasingly bond bulls too! Not only have developed world equities clocked up some 13 percent year-to-date (the S&P500 set yet another record high this week while Europe’s bluechips recorded a staggering 12th consecutive monthly gain in April) , but virtually all bond markets from junk bonds to Treasuries, euro peripherals to emerging markets are now back in the black for the year as a whole. For the most eyebrow-raising evidence, look no further than last week’s debut sovereign bond from Rwanda at less than 7 percent for 10 years or even newly-junked Slovenia’s ability this week to plough ahead with a syndicated bond sale reported to already be in the region of four times oversubscribed. For many people, that parallel rise in equity and bonds smells of a bubble somewhere. But before you cry “QEEEEE!” , take a look at commodities — the bulls there have been taken a bath all year as data on final global demand hits yet another ‘soft patch’ over the past couple of months.

So is this just an idiosyncratic random walk of asset markets (itself no bad thing after years of stress-riven hyper correlation) or can we explain all three asset directions together? One way to think of it is in terms of global inflation. If QE-related inflation fears have been grossly exaggerated then pressure to remove monetary stimulus or wanes again and there may even be arguments – certainly in Europe – for more. This would intuitively explain the renewed dash for bonds and fixed income in general even in the face of the still-plausible, if long term, “Great Rotation” idea. You could argue the monetary free-for-all is buoying equities regardless of demand concerns. But why wouldn’t commodities gain on that basis too?

One of the more startling moves of the week was the fresh rally in euro government debt – with 10-year Italian and Spanish borrowing rates falling to their lowest since late 2010 when the euro crisis was just erupting and 2-year Italian yields even falling to 1999 euro launch levels. The trigger? There’s been a slow build up for weeks on the prospect of new Japanese investor flows  seeking liquid overseas government bonds  – but it was signs of a sharp slowdown in Germany’s economy that seems to have had a perversely positive effect on the region’s asset markets as a whole. The logic is that German objections to another ECB rate cut will ebb, as will its refusal to ease up on front-loaded fiscal austerity across Europe. If its own economic engine is now suffering along with the rest, significantly just five months ahead of German Federal elections, then a tilt toward growth in the regional policy mix may not seem so bad for Berlin after all. And if euro economies are more in synch, albeit in recession rather than growth, then perhaps it will lead to a more effective regional policy response.

All that plays into the intensifying “growth vs austerity” debate, which had already shifted at the Washington IMF meetings last week and was sharpened this week by by EU Commission chief Barroso’s claim that the high watermark of EU’s austerity push had passed. On top of the Reinhart/Rogoff research farrago, it’s been a bad couple of weeks for the “austerians”, with only a UK Q1 GDP bounceback of any support for case of ever deeper fiscal cuts,  and investors smell a change of tack. Their reaction? Not only have euro government borrowing costs fallen  further, but euro equities too rallied for 4 straight days through Wednesday. Those arguing that investors would run screaming at the sight of a more growth-tilted policy mix in Europe may have some explaining to do.

Next week is back on monetary policy watch however. The ECB takes centre stage amid rate cut talks hopes for help for credit-starved SMEs. The FOMC meets stateside aswell just ahead of the critical US April employment report.

Figuring out what was driving pretty violent market moves this week was trickier than usual – and that says something about how much the herd has scattered this year, with ‘risk on-risk off’ correlations having weakened sharply. Just as everyone puzzled over a potential “wall of money” from Japan after the BOJ’s aggressive reflation efforts, the bottom seemed to fall out of gold, energy and broader commodity markets – dragging both equity markets and, unusually, peripheral euro zone bond yields lower in the process.  As dangerous as it may be to seek an overriding narrative these days, you could possibly tie all up these moves under the BOJ banner – something along these lines: the threat of a further yen losses pushes an already pumped-up US dollar ever higher across the board and undermines dollar-denominated  commodities, which have already been hampered by what looks like yet another lull in global demand. Developed market equities, whose Q1 surge had been reined in by several weeks of disappointing economic data and an iffy start to the Q1 earnings season, were then hit further by a lunge in heavy cap mining and energy stocks. The commodities hit may also help explain the persistent underperformance of emerging markets this year. What’s more the lift to Italian and Spanish government bonds comes partly from an assumption any Japanese money exit will seek U.S. and European government bonds and relatively higher-yielding euro government paper may be favoured by some over the paltry returns in the core ‘safe havens’ of Treasuries or bunds. The confidence to reach for yield has clearly risen over the past six months as wider systemic fears have receded – something underlined in dramatic style this week by a huge lunge in gold,  now lost almost 20 percent in the year to date.

While all that logic may be plausible, there have been dozens of other reasons floating around for the seemingly erratic twists and turns of the week.

The only truth so far is that everyone is still just guessing about the likely extent of a Japanese outflow and confidence about global growth has received another setback.

Will the yen continue to weaken?

Most people think so — analysts polled by Reuters this month predict that the Japanese currency will fall 18 percent against the dollar this year. That will bring the currency to around 102 per dollar from current levels of 98. And all sorts of trades, from emerging debt to euro zone periphery stocks, are banking on a world of weak yen.

Now here is a contrary view. David Bloom, HSBC’s head of global FX strategy, thinks one-way bets on the yen could prove dangerous. Here are some of the points he makes in his note today:

–  Bloom says the link between currencies and QE (quantitative easing) is not straightforward. Note that after three rounds of QE the dollar is flexing its muscles. The ECB’s LTRO too ultimately benefited the euro.

The Bank of Japan unleashed its full firepower this week, pushing the yen to 3-1/2 year lows of 97 per dollar.  Year-to-date, the currency is down 11 percent to the dollar. But those hoping for a return to the carry trade boom of yesteryear may wait in vain.

The weaker yen of pre-crisis years was a strong plus for emerging assets, especially for high-yield currencies. Japanese savers chased rising overseas currencies by buying high-yield foreign bonds and as foreigners sold used cheap yen funding for interest rate carry trades. But there’s been little sign of a repeat of that behaviour as the yen has fallen sharply again recently .

Most emerging currencies are flatlining this year and some such as the Korean won and Taiwan dollar are deep in the red. The first reason is dollar strength of course, but there are other issues. Take equities — clearly some cash at the margins is rotating out to Japan, where equity mutual funds have received $14 billion over the past 16 weeks.  While the Nikkei is up 21 percent, Asian indices are broadly flat. In South Korea whose auto firms such as Hyundai and Kia compete with Japan’s Toyota and Honda, shares are bleeding foreign cash. The exodus has helped push the won down 5 percent to the dollar in 2013.

US MARCH JOBS REPORT/THREE OF G4 CENTRAL BANKS THURS/NEW QUARTER BEGINS/FINAL MARCH PMIS/KENYA SUPREME COURT RULING/SPAIN-FRANCE BOND AUCTIONS

Given the sound and fury of the past fortnight, it’s hard not to conclude that the messiness of the eventual Cyprus bailout is another inflection point in the whole euro crisis. For most observers, including Mr Dijsselbloem it seems, it ups the ante again on several fronts – 1) possible bank contagion via nervy senior creditors and depositors fearful of bail-ins at the region’s weakest institutions; 2) an unwelcome rise in the cost of borrowing for European banks who remain far more levered than US peers and are already grinding down balance sheets to the detriment of the hobbled European economy; and 3) likely heavy economic and social pressures in Cyprus going forward that, like Greece, increase euro exit risk to some degree. Add reasonable concerns about the credibility and coherence of euro policymaking during this latest episode and a side-order of German/Dutch ‘orthodoxy’ in sharp relief and it all looks a bit rum again.

Yet the reaction of world markets has been relatively calm so far. Wall St is still stalking record highs through it all for example as signs of the ongoing US recovery mount. So what gives? Today’s price action was interesting in that it started to show investors discriminating against European assets per se – most visible in the inability of European stocks to follow Wall St higher and lunge lower in euro/dollar exchange rate. European bank stocks and bonds have been knocked back relatively sharply this week post-Dijsselbloem too. If this decoupling pattern were to continue, it will remain a story of the size of the economic hit and relative underperformance. But that would change if concerns morphed into euro exit and broader systemic fears and prepare for global markets at large to feel the heat again too. We’re not back there yet with the benefit of the doubt on OMTs and pressured policy reactions still largely conceded. But many of the underlying movements that might feed system-wide stresses – what some term a “slow panic” like deposit shifts etc – will be impossible to monitor systematically by investors for many weeks yet and so nervy times are ahead as we enter Q2 after the Easter break.

Victims of the dollar’s strength are piling up.

Total returns on emerging market local currency bonds dipped into the red for the first time this year, according to data from JPMorgan which compiles the flagship GBI-EM global diversified index of domestic emerging debt. While the EMBI Global index of sovereign dollar debt has already taken a hit the rise in U.S. yields, local bonds’ problems are down to how EM currencies are performing against the dollar.

JPMorgan points out that while bond returns in local currency terms, from carry and duration, are a decent 1 percent, that has been negated by the 1.3 percent loss on the currency side. With the dollar on the rampage of late  (it’s up almost 4 percent in 2013 against a grouping of major world currencies) that’s unsurprising. But a closer look at the data reveals that much of the loss is down to three underperforming markets — South Africa, Hungary and Poland. These have dragged down overall returns even though Asian and Latin American currencies have done quite well.

The graphic below shows South African local debt bringing up the bottom of the table, with the FX component of returns at around minus 9 percent  In rand terms however the return is still in positive territory, but only just. Hungary and Poland fare only slightly better.

Sterling looks likely to be one of this year’s big G10 currency casualties (the other being  yen).  Having lost 7 percent against the dollar and 5.5 percent to the euro so far this year on fear of a British triple-dip recession, sterling probably has further to fall.  (see here for my colleague Anirban Nag’s take on sterling’s outlook).

Many see an opportunity here — as a convenient funding currency to invest in emerging markets. A funding currency requires low interest rates that can bankroll purchases of higher-yielding assets including stocks, other currencies, bonds and commodities. Sterling ticks those boxes.  A funding  currency must also not be subject to any appreciation risk for the duration of the trade. And here too, sterling appears to win, as the Bank of England’s remit widens to give it more leeway on monetary easing.

All in all, it’s a better option than the U.S. dollar, which was most used in recent years, or the pre-crisis favourite of the Swiss franc, says Bernd Berg, head of emerging FX strategy at Credit Suisse Private Bank.