Global Investing

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       The revved-up U.S. dollar – whose trade-weighted index is now up almost 5 percent in just six weeks – could well develop into one of the financial market stories of the year as the cyclical jump the United States has over the rest of G10 combines with growing attention being paid to the country’s potential “re-industrialisation”. As with all things FX, there’s a zillion ‘ifs’ and ‘buts’ to the argument. Chief among them is many people’s assumption the Fed will be printing greenbacks well after this expansion takes hold as it targets a much lower jobless rate. Others doubt the much-vaunted return of the US Inc. back down the value chain into metal-bashing and manufacturing, while some feel the cheaper energy from the shale revolution and the lower structural trade deficits that promises will be short-lived as others catch up. However, with the dollar already super competitive (it’s down 30-40 percent on the Fed’s inflation-adjusted index over the past 10 years) the first set of arguments are more tempting. Even if you see the merits in both sides, the bull case clearly has not yet been discounted and may have further to go just to match the balance of risks.  With Fed printing presses still on full throttle, this has been a slow burner to date and it may be a while yet before it gets up a head of steam — many feel it’s still more of a 2nd half of 2013 story and the dollar index needs to get above last year’s highs to get people excited. But if it does keep motoring, it has a potentially dramatic impact on the investment landscape and not necessarily a benign one, even if shifting correlations and the broader macro landscape show this is not the ‘stress trade’ of the short-lived dollar bounces of the past five years.

Commodities priced in dollars could well feel the heat from a steady dollar uptrend. And if gold’s spiral higher over the past six years has been in part due to the “dollar debasement” trade, then its recent sharp retreat may be less puzzling . Emerging market currencies pegged to the dollar will also feel the pressure as well as countries and companies who’ve borrowed heavily in greenbacks. The prospect of a higher dollar also has a major impact on domestic US investors willingness to go overseas, casting questions on countries with big current account gaps. As the dominant world reserve currency, a rising dollar effectively tightens financial conditions for everyone else and we’ve been used to a weakening one for a very long time.

Back to moment, stock markets around the world have continued to nudge new highs over the past week, with the upbeat US employment data underlining a still broadly positive global growth tilt even if Chinese data was more equivocal and Europe still looks dour. That said, at least the euro FX rate is going in the right direction for a change to help address the regional funk.

To keep a tally, global stocks are up almost 6 percent as the first quarter enters its final fortnight.

(corrects name of hedge fund in para 3 to Symphony Financial Partners)

Any doubt about the importance of a weaker yen in thawing the frozen Japanese economy will have been dispelled by the Nikkei’s surge to 32-month highs this week. Since early December, when it became clear an incoming Shinzo Abe administration would do its best to weaken the yen, the equity index has surged as the yen has fallen.

Those moves are giving sleepless nights to Japan’s neighbours who are watching their own currencies appreciate versus the yen. South Korean companies, in particular, from auto to electronics manufacturers, must be especially worried. They had a fine time in recent years  as the yen’s strength since 2008 allowed them to gain market share overseas. But since mid-2012, the won has appreciated 22 percent versus the yen.  In this period, MSCI Korea has lagged the performance of MSCI Japan by 20 percent. Check out the following graphic from my colleague Vincent Flasseur (@ReutersFlasseur)

David Baran, co-founder of Tokyo-based Symphony Financial Partners, notes the relative performance of Hyundai and Toyota (Hyundai shares have fallen 2.5 percent this year adding to 13.5 percent loss in the last quarter of 2012. Toyota on the other hand is up 5 percent so far in 2013 after gaining 31 percent in Oct-Dec last year). Baran says he has gone long the Nikkei and short the Seoul index (the Kospi) and (Hong Kong’s) Hang Seng, while taking a short position on the yen. He says:

Global Investing has written several times about Japanese mom-and-pop investors’  adventures in emerging markets. Most recently, we discussed how the new government’s plan to prod the Bank of Japan into unlimited monetary easing could turn more Japanese into intrepid yield hunters.  Here’s an update.

JP Morgan analysts calculate that EM-dedicated Japanese investment trusts, known as toshin, have seen inflows of $7 billion ever since the U.S. Fed announced its plan to embark on open-ended $40-billion-a-month money printing.  That’s taken their assets under management to $67 billion. And in the week ended Jan 2, Japanese flows to emerging markets amounted to $234 million, they reckon. This should pick up once the yen debasement really gets going — many are expecting a 100 yen per dollar exchange rate by end-2013  (it’s currently at 88).

At present, the lion’s share of Japanese toshin holdings — over $40 billion of it — are in hard currency emerging debt, JP Morgan says (see graphic).

With Shinzo Abe’s new government intent on prodding the Bank of Japan into unlimited monetary easing, it is hardly surprising that the yen has slumped to two-year lows against the dollar. This could lead to even more flows into overseas markets from Japanese investors seeking higher-yield homes for their money.

Japanese mom-and-pop investors — known collectively as Mrs Watanabe -  have for years been canny players of currency and interest rate arbitrage. In recent years they have stepped away from old favourites, New Zealand and Australia, in favour of emerging markets such as Brazil, South Africa and Turkey. (See here  to read Global Investing’s take on Mrs Watanabe’s foray into Turkey). Flows from Japan stalled somewhat in the wake of the 2010 earthquake but EM-dedicated Japanese investment trusts, known as toshin, remain a mighty force, with estimated assets of over $64 billion.  Analysts at JP Morgan noted back in October that with the U.S. Fed’s QE3 in full swing, more Japanese cash had started to flow out.

That trickle shows signs of  becoming a flood. Nikko Asset Management, the country’s third  biggest money manager, said this week that retail investors had poured $2.3 billion into a mutual fund that invests in overseas shares — the biggest  subscription since October 2006. This fund’s model portfolio has a 64 percent weighting to U.S. shares, 14 percent to Mexico and 10 percent to Canada while the rest is split between Latin American countries.

Emerging market currencies have been a source of frustration for investors this year. With central banks overwhelmingly in rate-cutting mode and export growth slowing, most currencies have performed poorly. That has been a bit of a dampener for local currency debt –  while returns in dollar terms have been robust at 13 percent, currency appreciation has contributed just 1.5 percent of that, according to JP Morgan.

The picture could be changing though.  Fund managers at the Reuters 2013 investment outlook summit this week have been unanimously bullish on emerging debt, with many stating a preference for domestic debt. So far this year, dollar debt has taken in three-quarters of all inflows to emerging fixed income.

Andreas Uterman, CIO of Allianz Global Investors told the summit in London that many emerging currencies looked significantly undervalued, and that this anomaly would gradually resolve itself:

Israel’s financial markets had a torrid time on Monday as swirling rumours of an imminent air strike on Iran caused investors to flee. The shekel lost 1.4 percent, the Tel Aviv stock exchange fell 1.5 percent and credit default swaps, reflecting the cost of insuring exposure to a credit, surged almost 10 percent.

There has been a modest recovery today as the rumour mills wind down. But analysts reckon more weakness lies ahead for the shekel which is not far off three-year lows.  Political risks aside, the central bank has been cutting interest rates and is widely expected to take interest rates, currently at 2.25 percent, down to 1.75 percent by year-end. Societe Generale analysts are among the many recommending short shekel positions against the dollar. They say:

Expect the dovish stance of the Bank of Israel to remain well entrenched for now.

Time was when investing in emerging markets meant buying dollar bonds issued by developing countries’ governments.

How old fashioned. These days it’s more about emerging corporate bonds, if the emerging market gurus at JP Morgan are to be believed. According to them, the stock of debt from emerging market companies now exceeds that of dollar bonds issued by emerging governments for the first time ever.

JP Morgan, which runs the most widely used emerging debt indices, says its main EM corporate bond benchmark, the CEMBI Broad, now lists $469 billion in corporate bonds.  That compares to $463 billion benchmarked to its main sovereign dollar bond index, the EMBI Global. In fact, the entire corporate debt market (if one also considers debt that is not eligible for the CEMBI) is now worth $974 billion, very close to the magic $1 trillion mark. Back in 2006, the figure was at$340 billion.  JPM says:

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.

Investors with exposure to Argentina will have been dismayed in recent weeks by the surging cost of insuring that investment — Argentine 5-year credit default swaps have risen more than 300 basis points since mid-May to the highest levels since 2009. That means one must stump up close to $1.5 million to insure $10 million worth of Argentine debt against default for a five year period, data from Markit shows.

The rise coincides with growing fears that President Cristina Fernandez Kirchner is getting ready to crack down on people’s dollar holdings. Fears of forcible de-dollarisation have sent Argentine savers scurrying to the banks to withdraw their hard currency and stash it under mattresses. That has widened the gap between the official and the “black market” exchange rate. (see the graphic below from Capital Economics)

While government officials have denied there is such a move afoot, Fernandez has not helped matters by exhorting people to “think in pesos”.  That will be hard for Argentines, most of whom have vivid memories of hyperinflation, default and devaluation. Unsurprisingly, most prefer to save in dollars. 

The Indian rupee’s plunge this week to record lows will have surprised no one. After all, the currency has been inching towards this for weeks, propelled by the government’s paralysis on vital reforms and tax wrangles with big foreign investors. These are leading to a drying up of FDI and accelerating the exodus from stock markets. Industrial production and exports have been falling.  High oil prices have added a nasty twist to that cocktail. If the euro zone noise gets louder, a balance of payments crisis may loom. The rupee could fall further to 56 per dollar, most analysts predict.

True, the rupee is not the only emerging currency that is taking a hit. But the Reserve Bank of India looks especially powerless to stem the decline. (See here for an article by my colleagues in Mumbai) .  One reason  the RBI’s hands are  effectively tied is that  India is one of the few emerging economies that has failed to build up its hard currency reserves since the 2008 crisis and so is unable to spend in the currency’s defence. Usable FX reserves stand now around $260 bilion, down from $300 billion just before the 2008 crisis.  See the following graphic from UBS which shows that relative to GDP, India’s reserve loss has been the greatest in emerging markets.

But there is worse. The relative decline in reserves since 2008 coincides with a ballooning in India’s external debt, both private and public. Comprising mostly of corporate borrowing and trade credit, the debt stands at $350  billion, up from $225 billion four years back.