Global Investing

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.

There is only anecdotal evidence central banks are actually buying the Aussie in large quantities. The German, Swiss and Russian central banks are among those that have indicated an interest. But a recent IMF report put the share of ‘other’ currencies (that includes the Aussie and the New Zealand dollar) in world FX reserves at $295 billion in the second 2012 quarter.  And that’s quite a jump from $87 billion in three years ago. The graphic below shows that the share of the “others” in central bank reserves now exceeds the sterling or the yen.

Credit Agricole adds:

Although the breakdown is unknown, such a big jump indicates at least part of diversification flows moving into Aussie.

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.

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:

One Apple chart that has been going down for 10 years is its forward P/E ratio:

Rising gasoline prices push up American’s inflation expectations for the next year:

Currency moves this year:

Currency hedging — should we bother?

Maybe not as much as you think, if we are talking purely from a equity return point of view — according to the new research that analysed 112 years of the financial assets history released by Credit Suisse and London Business School this week.

Exchange rates are volatile and can significantly impact portfolios — but one can never predict if currency moves erode or enhance returns. Moreover, hedging costs (think about FX overlay managers, transaction costs, etcetc).

For example, the average annualised return for investors in 19 countries between 1972 (post-Bretton Woods) to 2011 is 5.5%, hedged or unhedged. For a U.S. investor, the figures were 6.1% unhedged or 4.7% hedged (this may be largely because only two currencies — Swiss franc and Dutch guilder/euro — were stronger than the U.S. dollar since 1900).

Emerging market bonds denominated in local currencies enjoyed a record January last month with JP Morgan’s GBI-EM Global index returning around 8 percent in dollar terms. Year-to-date, returns are over 9.5 percent.

This is mainly down to spectacular gains on emerging currencies such as the Mexican peso and Turkish lira which have surged 7-10 percent against the dollar and euro this year.  Analysts say the currency component of this year’s returns has been around 7 percent, meaning any portfolio hedged for currency risk would have garnered returns of just 2.5 percent.

The gains come as good news to investors licking their wounds after the index ended 2011 in negative territory. A mid-year rout on emerging markets pushed up local bond yields, often by hundreds of basis points and sent many currencies to multi-year lows.

Euro breakup risks, although subsiding, are still high on investor minds.

Almost one in two fund managers surveyed by Bank of America Merrill Lynch last month said they expect a euro zone country to leave the monetary union.

Technology services company SunGard, which has modelled different euro breakup scenarios, says the departure of Greece and Portugal will lead to a 15 percent rise in the euro against the dollar, a 20 percent fall in euro zone yields, a 15 percent fall in euro zone equities and a 20 percent increase in credit spreads.

Below are other findings:

If all PIIGS left the euro, the single currency would rise 25% and regional equities would fall 20%. U.S. stocks would drop 15 percent. European banking stocks would fall by 25% and ITRAXX Financials credit spreads would increase by 100%, which would imply losses of up to 20% in high-grade corporate debt. VIX would be over 50. A total collapse scenario would see European equities down 40%, U.S. and global equities down 30%, euro yields down 75% and ITRAXX Europe and ITRAXX Financials credit spreads up 150% and 200%respectively. Oil would fall across the scenarios, ranging from 5% from a Greece departure through to a 50% decline from a complete breakup. Sterling would strengthen against the Euro by between 5-25% across the scenarios.

The results seek to model the impact of each scenario over three months, looking eight weeks before and six weeks after the shock to form a balanced picture.

Currency speculators boosted bets against the euro to a record high in the latest week of data (to end December 27) and built up the biggest long dollar position since mid-2010, according to the Commodity Futures Trading Commission. Here -- courtesy of Reuters' graphics whiz Scott Barber, is what happens to the euro when shorts build up:



It’s been a pretty miserable 2011 for India and Tuesday’s collapse of the rupee to record lows beyond 52 per dollar will probably make things worse. Foreigners, facing a fast-falling currency, have pulled out $500 million from the stock market in just the last five trading sessions.   That means net inflows this year are less than $300 million, raising concerns that India will have trouble financing its current account gap.  The weaker currency also bodes ill for the country’s stubbornly high inflation.

Why is the rupee suffering so much? First of all, it is a casualty of the general exodus from emerging markets. As a deficit economy, India is bound to suffer more than say Brazil, Korea or Malaysia.  And 18 months of interest rate rises have taken a toll on growth.

UBS analysts  proffer another explanation. They point out a steady deterioration in India’s net reserve coverage since the 2008 crisis. The reserve buffer — foreign-exchange reserves plus the annual current account balance, minus short-term external debt — stands at 9 percent of GDP, down from 14 percent in 2008.  Within emerging markets, only Egypt, Venezuela and Belarus saw bigger declines in net reserve coverage than India.