Category Archives: Europe

EUR/USD – Echoes of 2002

EUR/USD has bottomed out for the foreseeable future. At the beginning of the year I thought we might have another go at breaching parity on the back of further expectations of Fed tightening spurred by expectations of stimulative fiscal policy (and possibly protectionist measures) from Trump. The downside was nevertheless quite limited because the EUR was starting from very undervalued levels from a long-term perspective. Dips to parity even then looked likely to be a long-term buying opportunity. But with the break above 2015 and 2016 highs seen in July, the base looks to be confirmed technically, and the chances of a dip back below 1.05 – or even 1.10 – now looks like a long shot. The picture now looks quite similar to 2002 when the break through the 2001 and 2000 highs was the start of a 6 year rally of more than 70 figures to the highs in 2008.

Euro bears will be inclined to point out that the EUR was a lot lower then, but in reality the situations are not that different. In 2002 EUR/USD Purchasing Power Parity (according to the OECD) was around 1.17. Now it is 1.33. So, as the chart below shows, the difference from PPP at the lows in 2000 was not that much greater than it was at the lows in January this year. A little over 30 figures then, just under 30 figures this year.

eurusd and ppp

Source:OECD, FX Economics

Then, as now, the rally in EUR/USD frankly looked overdue. The case for the extreme USD strength in the early 2000s was based on a combination of the safe haven status of the USD, the uncertainty about the viability of the newly created EUR and the fallout from the 2000 crash. But by 2002 the major economies were all in the process of recovery and yield spreads, which are usually a reliable determinant for EUR/USD (and its precursor USD/DEM) were suggesting EUR/USD was substantially undervalued. Things are different now in that the yield spread doesn’t show a clear case for a higher EUR (though the US yield advantage is less clear when looked at in real terms).

eurusd and tnotebund

Source: Bloomberg, FX Economics

However, whereas the Euro area then was a region which only had a broadly balanced current account, it now has a massive current account surplus of around 4% of GDP (similar to the US current account deficit at more than $400bn). In the past couple of years this has been more than offset by portfolio and direct investment flows out of the Eurozone, and reports suggest that sovereign wealth funds have substantially reduced EUR weightings since rates turned negative. However, with monetary accommodation now looking more likely to be reduced, and European equities looking considerably cheaper than those in the US, these capital flows may well start to reverse before long.

This doesn’t mean EUR/USD is about to embark on a 70 figure rally over the next 6 years (as it did in 2002) and hit 1.75 in 2023. For the recent recovery to extend much further we are likely to need a significant narrowing in yield spreads, and this may still take some time as the ECB aren’t likely to be in a big hurry to remove accommodation. It is unlikely that the ECB are going to be too concerned about the run up in the EUR seen so far – it is quite minor on a multi-year scale, and the EUR remains quite cheap by long-term standards, but the pace of recovery may be a concern, because that will impinge on inflation in the short run. This could slow any ECB tightening, but the ECB must accept the likelihood of a long run EUR recovery. Nevertheless, EUR/USD should now be seen as a buy on the dip from a long term perspective. 1.10 looks unlikely to be breached again, so anything near 1.15 should be a buying opportunity.

A strange time to worry about the euro

An interesting survey from Central Banking shows central bank reserve managers have apparently lost faith in the euro, with the stability of the Eurozone supposedly this year’s greatest fear. Apparently concerns over political instability, weak growth, and the European Central Bank’s (ECB) negative interest rate policy have led central banks to cut euro exposure, with some eliminating it completely. This strikes me as very strange timing.

Now, there is of course uncertainty about the Eurozone. But it seems odd to me that these reserve managers have chosen this year to start worrying. Where have these guys been for the last 9 years? There has been uncertainty surrounding the Eurozone since the financial crisis (and before). Greece’s woes have hardly been a secret – they have had two debt restructurings in the last 5 years. Yields in the Eurozone periphery blew out to extreme levels when the Greek crisis was at its height, reflecting concerns about Eurozone break-up. Back then, concerns were not confined to Greece either – Spain and Portugal were also very much in the firing line. By comparison, the current bond market spreads show very little evidence of worry about Eurozone break-up. So why are the central bankers in a tizzy all of a sudden?

One of the reasons they give is the negative interest rate policy from the ECB. It is understandable that investors aren’t happy with this, but it is hardly a new phenomenon. The deposit rate went negative in mid-2014. Furthermore, concern on this issue shows a worrying degree of money illusion. Using the OECD’s forecasts for 2018 inflation, the table below shows real interest rates across the G10.

real yieldsSource: FX Economics, OECD, national central banks

On this basis, the real policy rate and real 10 year yield for the Eurozone (using France as a proxy for the 10 year yield) aren’t really that low by international standards. In fact, the real policy rate is higher than in both the UK and US. I have ranted about money illusion many times before, so I won’t bore on, but you would have hoped that international reserve managers were a little bit more savvy than to look just at nominal rates.

So maybe they are worried about politics. I find this ironic. The UK votes for Brexit and the US votes for Trump and reserve managers are worried about politics in the Eurozone? It’s true that the Eurozone is existentially more vulnerable, and therefore you can regard political instability as more dangerous. But in reality the chance of a Le Pen victory in France is tiny, and even if she did win, the chance of France leaving the EUR given she has no parliamentary support is similarly tiny. The bigger danger is Italy, but again, despite the anti-euro lead in the polls, there is unlikely to be an election this year, and forming a coalition that would genuinely be prepared to take Italy out of the EU would be extremely difficult. Of course, Italy leaving would be disastrous (for Italy but also for the EU) so this is not a scenario that can be taken lightly. For this reason it is also extremely unlikely to happen, but that doesn’t mean there wouldn’t be major market concerns if the possibility started to look more real. Nevertheless, it is surprising that yield spreads haven’t blown out much further is this was a genuine concern.

As for weak growth, this has been an endemic problem in Europe, but it is again strange to worry about it now when Eurozone growth is picking up and looks set to record its fastest rate since 2010.

There is no doubt that the EUR has suffered from a lack of foreign capital in the last year. In 2016 there was a reduction in Eurozone portfolio liabilities of EUR66bn – foreigners sold a net EUR66bn of Eurozone assets – compared to net buying of nearly EUR400bn in 2014 and Eur300bn in 2015. As long as this continues – the net portfolio and direct investment outflow more than offsetting the current account surplus – investor concerns about the EUR are likely to be self-fulfilling. But I am not sure how long this attitude can last. The EUR is already very cheap by long term measures, and the economy appears to be picking up. If Le Pen loses – as seems very likely – I suspect it will be hard for the markets to maintain this negative attitude indefinitely. But then I don’t really understand why reserve managers have turned so negative in the first place.

What will it take for the CHF to weaken?

real-chf

Source: BIS

Equities have certainly had a good run this year so far, and there should still be more to come for European equities as long as the European economy continues its modest growth, with EuroStoxx still well below its highs and value relative to bonds looking excellent. But despite the strength of equities and good Eurozone data, EUR/CHF continues to test the lows, even on a day when the Swiss GDP data reports a disappointing 0.1% q/q and 0.6% y/y rise, underpinning the expectation of continued easy Swiss monetary policy. Why is the CHF so strong?

Well one reason is likely to be concern about European politics. The markets seem to have got themselves in a state worrying about the possibility of a Le Pen victory in France and even about Wilders in the Netherlands. People explain their concern by pointing to the victories for Brexit and Trump as illustrations of the populist movement sweeping the world and the unreliability of polls. But Brexit and Trump were not huge outside bets according to the polls. They were marginal outside bets. Sure, the markets seem to have treated Leave and Clinton as foregone conclusions, but that was never justified by the polls, which always suggested the votes would be close. But the polls don’t suggest Le Pen will be close to winning the French presidency. They suggests she needs to turn around 8 million French people Fascist in the next 2 months to win. That isn’t just unlikely, it’s wildly improbable in a way that the UK “Leave” vote and the US vote for Trump never were (at least not once he was the Republican candidate). Similarly, Wilders Freedom Party could just about be the largest party in the Dutch elections, but has effectively no chance of forming a coalition as no other party is prepared to join with them. Even with their most optimistic poll results, they will need double the seats they would achieve to form a government. So worries about European politics seem overblown, and European equities seem to get this, but the Swiss franc nevertheless remains near its highs.

This is puzzling because the Swiss franc is normally seen as a safe haven. Valuation wise it is always expensive relative to purchasing power parity (PPP) because it is seen as so safe. But safe havens will normally weaken in risk positive, strong equity environments, because safety is in less demand. The Swiss franc is a little weaker than it was at its peak, but it is lagging well behind the recovery in the European economy and European equities, even though yield spreads remain very unattractive with Swiss yields significantly negative out to 10 years.

 

So what will it take for the CHF to fall to more normal levels? The underlying problem is that money has stopped flowing out of Switzerland. Normally, surplus countries like Switzerland see heavy portfolio outflows looking for better returns elsewhere in the world, but the Swiss balance of payments data shows that portfolio outflows have effectively dried up since the crash. The SNB’s intervention has dealt with speculative and hedging  flows – captured in the “other investment” category of the balance of payments – but until portfolio outflows recover properly they will not be enough to cover the current account surplus – which remains substantial. This will be required if the CHF is to reverse its uptrend. Of course, it would also at some stage make sense if the speculative flows that have gone into Swiss francs – making a tidy profit – were to go out as risks decline and appetite for foreign assets returns. This other investment category has totalled more than CHF410bn since the beginning of 2008, and has been offset by an increase in reserves of more than CHF600bn. If confidence returns, this cash should flow back out and push the Swiss franc back to fair value, which is around 10-15% below current levels.

When will this happen? Well there are obviously a lot of uncertainties. But if Le Pen doesn’t win, and Trump/the House Republicans produce a detailed infrastructure/tax reform proposal by the Spring the Swiss franc could be under pressure from May for the rest of the year.

swiss-bop

swiss-bop2

Source: SNB

ECB promises are worthless

draghi

There has been much discussion about whether the ECB has tapered or not. They have reduced the size of their monthly purchases but extended them until the end of the 2017 rather than the expected 6 months from March, so that the promised total of asset purchases is actually greater than had been expected (the market was looking for a promised 6 months of EUR80bn = 480bn but they have 9 months of 60bn = 540bn). But this is still a tapering. Why? Because promises are worthless.

The ECB’s “guarantee” that purchases will be at least 60bn a month for at least 9 months is no such thing. Of course, they are very likely to stick to the letter of this promise, but if circumstances changed so that a tightening of monetary policy was necessary, would they really choose not to enact one? How irresponsible would that be? If they did fail to respond to the need to tighten the markets would react anyway. Anticipation of higher inflation would lead to substantially higher bond yields regardless of whether the ECB chose to continue with a policy that is clearly misguided.

There is a clear logical problem with the ECB (or any other central bank) making promises about future policy while at the same time pledging to stick to its remit of hitting its inflation (or any other) target. While in practice it is unlikely to have a problem sticking to its promises, that is because the promises are well within the range of policy options that they would design to hit their targets under normal circumstances. Had the ECB chosen to go with 80bn a month for 6 months, the odds are they would have extended this again beyond 6 months, probably with smaller volume, since even Draghi has admitted that they are unlikely to stop their asset purchases dead, but  rather taper off. But unexpected things can happen, and if they do the ECB may be forced to renege on their promises. If a tightening in policy is necessary, they might choose a different method and thus stick to the letter of their promise, but the promise itself is still valueless if there are circumstances in which the ECB would renege, whether in spirit or in letter.

The market has chosen to accept Draghi’s protests and not see the taper as a taper. But it is a taper. Future policy promises are worth nothing because central banks will do what they perceive is right at the time, and will effectively override any policies they have committed to if circumstances demand. It is time the markets stopped taking notice of this nonsensical approach of promises. Forward guidance is one thing – providing an idea of what they expect to do – though events have shown even this is wrong often enough to have very limited value. Promises are a step too far, and imply either omniscience  – so that there can never be a need to renege on a promise – or irresponsibility – with central banks prepared to sacrifice correct policy to stick to a promise they made under different circumstances. Central banks are not omniscient, and should not be irresponsible – so promises of this short are worthless and worse, potentially damaging.

A crisis for UK democracy?

power-of-the-press-5-638

A bit on the markets in a minute, but first a bit of a rant.

If the Daily Mail call High Court judges “enemies of the people” simply for saying that parliament has to sanction the triggering of Article 50, what will it do if some MPs choose to vote against the wishes of their constituents?

This is a difficult issue for some MPs. After all, some are in constituencies that voted to Remain but themselves support Brexit. Others are in Leave constituencies but were in favour of Remaining. The Daily Mail would argue that the people have spoken with the referendum, but the result was close, and had more young people voted might have gone the other way. It might go the other way if it was done again today. So in my view MPs should vote in line with their own views. But they won’t. Even if they are in “Remain” constituencies, and are pro-Remain themselves, very few MPs will vote down a bill to trigger Article 50. Partly because they will be put on the front page of the Daily Mail if they do. And they remember what happened to Jo Cox. This is not a good way to govern a country, and reminiscent of some unpleasant regimes.

Unless MPs are prepared to act as responsible human beings and stand up to their party, the press and the noisy section of their constituents, they are becoming an irrelevance. They are mere ciphers. They are not being allowed to make their own decisions about anything important. It is important to have a role for personal conscience.

The further irony is that Brexit was (according to the Leave camp anyway) supposed to be about taking back control of our government from the EU. But if MPs are effectively just servants of the government, we are effectively being governed by royal prerogative. Come back Oliver Cromwell.

Anyway, rant over. The markets.

Sterling has managed a little rally in response to the High Court decision that parliament has to trigger Article 50, but this doesn’t look like it will be enough to sustain a strong rally in GBP for at least two reasons.

1) Although GBP is now a lot cheaper than it was, it is not dramatically cheap against the USD or the EUR given the big UK current account deficit and the lack of (real) yield attraction available in GBP.

2) Even if the High Court decision is upheld by the Supreme Court, it doesn’t mean no Brexit. Brexit is still extremely likely to happen. There might be some impact on the shape of the Brexit, but even this isn’t clear. If the government sticks to its guns on rejecting free movement and the EU sticks to its guns on making free movement a condition for single market access, it seems doubtful that parliament will really be able to have much real effect. What does seem likely (though not certain) is that there will be a significant delay in triggering Article 50 because of the time it is likely to take to put a bill through the Commons and Lords (average time one year). There could be a simple resolution to speed things along, but this would mean parliament would have to have its say at a later date.

So the vote has created extra uncertainty around Brexit, and has perhaps increased the chances of a softer version and a longer delay. This is mildly supportive for GBP, but some argue that the delay and uncertainty only makes things worse as firms are unable to plan for the future. I’d say this is outweighed by the increased chance of a softer Brexit, but not so much as to justify a dramatic GBP rally. EUR/GBP may manage to get back to the 0.86 area, but unless there is a lot more promise of a soft Brexit or some evidence on Eurozone weakness and/or UK strength gains beyond this are hard to justify. Still, it looks like it might be enough to stabilise GBP in the 0.86-0.91 range.

I have put this in terms of EUR/GBP rather than GBP/USD because coming into the US election the picture for the USD is obviously very uncertain. Most take the view that a Clinton victory will be USD positive, and market behaviour in the run up to the election suggests this is the case, but with a Clinton victory now priced as around an 80% chance, the market reaction may not be huge. The Fed is very likely to hike if markets respond positively – even neutrally – to the election, and that should be enough to sustain the USD against most currencies, though which currencies it gains most against will to some extent depend on the (uncertain) medium term equity market reaction to the combination of a Clinton win and higher US rates.

This is all pretty much the consensus view, and I’m not going to speculate too much on what happens if Trump wins, except to say that I’m not sure the impact will be that sustained. In the end, Washington will put fairly substantial limits on what he is able to do.

Merkel must spend more

 

merkel1

I seem to have left my purse at home

Yesterday’s ECB press conference was, for the most part, fairly lacklustre. No unexpected measures, Draghi sounding quite bored, forecasts very little changed. Markets had vaguely hoped for at least the promise of more action, but got nothing new. But towards the end there were some interesting comments which, together with the G20 statement last week, underline that the ECB and other central banks are telling governments  – specifically Germany – that there isn’t much more monetary policy can do and it is time for some fiscal action. Draghi’s two comments on this were to state that governments which had scope to do more on fiscal policy should, and he noted that Germany had scope to do more. He also agreed strongly with a questioner who noted the weakness of German wage growth and underlined that higher wage growth in Germany was very much desired. In other words, he told Germany they should be spending more money.

There are a few things the German government can do directly about wage growth. The can pay government employees more, and they can raise the minimum wage, but the majority of wage deals are struck without direct government involvement. As Draghi also noted in answer to another question, Europe is not a planned economy. But without stronger German wage growth, it is very hard to get inflation up in Europe, as German wage costs provide an effective ceiling in many industries to wage costs in the rest of Europe. It was precisely because wage costs elsewhere in the Eurozone rose so much faster than in Germany in the 2000s that the rest of Europe became so uncompetitive, and a lot of this was because German wages barely rose at all. Nominal wage costs in Germany rose less than 1% from 2000 to 2008. That’s in total, not per year.  Given the relative weakness of the rest of the Eurozone, unless Germany can get inflation above the 1.5-2% target, there is no chance that the European average can get up there, and to do that, wage costs have to rise a lot faster. So Draghi is putting pressure on Germany to inflate.

There is plenty the German government can do. German is running a (marginal) budget surplus. The government can borrow at negative rates. It is hard to see the downside to expanding borrowing aggressively and spending on infrastructure, especially since they need to find jobs to give all the extra refugees they are letting in (or wage growth will fall further). It would even provide the ECB with more debt for their QE program. It would not just be a good thing for the Eurozone, it would be a good thing for Germany, where I’m told the roads are in dire need of  attention.

Another way of looking at this is to note that the German current account surplus last year was 8.5% of GDP, and is forecast to be over 9% this year. 9%!!!!!! The UK is worried about it’s deficit of 6% (and rightly so) but the UK problem is at least partly the lack of demand from the Eurozone, and the rest of the Eurozone also struggles because Germany doesn’t import enough. Germany is the main guilty party. It needs to reduce it’s current account surplus by expanding demand. There is no way of doing this by monetary policy any more, as rates are as low as possible already. The government needs to take responsibility by increasing investment.

Why Germany hasn’t gone down this route already is a mystery to me. It seems to have something to do with the fiscal conservatives who believe in balancing your budget without regard to the cycle, the needs of the EU as a whole, or anything that has been written on economics since the 19th century. But it really is time to get real, and Draghi and the G20 are ramping up the pressure on Merkel, Schaeuble and co.  It used to be that Japan was the main guilty party for running massive trade surpluses, then China. Now it’s Germany, and action is overdue.

current-accounts

Source: OECD

From an FX perspective, such actions would be supportive for the EUR in the short term, and some may not like that, but amassing a massive current account surplus is far more damaging in the long term, as it will either prevent a European recovery or cause the EUR will surge higher in the next US downturn as capital outflows dry up.

 

 

 

 

GBP – History repeating.

It’s all just a little bit of history repeating” The Propellerheads

“We learn from history that we do not learn from history.” Hegel

“The history book on the shelf is always repeating itself” ABBA

Instinctively, I tend to assume the human race has made progress over the last 100 years and our understanding of most things has increased dramatically. Technology has advanced enormously and clearly one thing that has changed in financial markets is the ability to access liquidity in all manner of financial instruments. But has the understanding of what drives financial markets and what is the appropriate valuation for markets improved?  I would like to say yes, but my experience tells me that the answer is no. Technology has vastly increased the amount of information available to market participants, but the understanding of the importance of various different pieces of information seems no better than it was in 1929, 1974, 2000, 2008 or times in between. In fact, the huge increase in the amount of information available may only serve to obfuscate the information of real importance, as markets react to red headlines and systematic asset managers are programmed to react in the same way as in the past or to follow the crowd. An increase in the volume of information only reduces the impact of the information that is of real importance if the market assigns some importance to every piece of information. Or in other words, the more information there is the more possible reasons there are to justify any given market valuation. Thus, the 2000 dotcom bubble found a reason for a wildly out of line valuation, and there were enough greedy investors and trend followers to send equity markets to stratospherically silly levels.

So much for philosophy. What’s the relevance to today’s markets? I wrote recently about the low valuation of European equities (see “A huge opportunity”), and I stick by that view. Some have come back to me worrying about low European growth, Italian banks, Cocos, European immigration, populist movements, but this seems to me to miss the point. There are always risks and concerns, but they have to be evaluated relative to the things that matter for value – in the case of equities this means growth prospects, the initial level of  earnings and dividends, alternative investments (interest rates), and risk premia, which is a bit of a catch all and can be used to justify almost anything, but a sensible view tells me that risks now are less serious than they were at the height of the Greek crisis.

For currencies the metrics are different, and although most of the time the markets are dominated by risk on/risk off trades, it makes little sense to think of currencies moving in this way over the long run. Real currency levels are ultimately anchored to fairly static long run valuation measures, unlike equities which rise over time with nominal growth. Relative growth rates can certainly matter for currencies, not least because they affect relative interest rates, but in the developed world there is actually relatively little long term divergence in growth rates, especially when adjusted for population growth. This isn’t really that surprising, as in the developed world technology and capital is very mobile, and it is hard for one country to show a sustained superior growth performance. Most of the time, better growth is temporary, and comes with a price, usually a bigger current account deficit, as is currently clear in the UK. Changes in the terms of trade – as can be seen with the big move in the oil price – will of course have a long term impact, but I distrust debt fuelled growth (and any growth that is generating an unsustainable current account deficit is debt fuelled from a whole country perspective) as long run reason for currency strength. Sooner or later (admittedly usually later) the positive currency impact of stronger growth and higher rates is reversed either by the need to rein back on growth to control the current account or inflation or the budget, or by others catching up.

What does this have to do with history repeating for GBP? Well it’s a roundabout way of saying that the strong pound, the growing UK current account deficit (and indeed twin UK deficits) are a repeat of a long history of similar episodes in post war UK economic history. The strength of the pound won’t last and we are headed for either a slow or a fast decline in the pound, depending on whether the UK stays in the EU (staying will hold GBP up) and whether the world economy picks up (if it does the decline in GBP will be slower). But the period of UK and GBP outperformance is hitting traditional current account buffers. Sure, UK won’t have to go cap in hand to the IMF this time as in 1976, and a fading of Brexit fears may trigger a GBP rally of sorts. But whatever the politicians agree, the risk of a vote to leave will remain, and more importantly, the underlying economics doesn’t justify a stronger pound, or even as strong a pound as we have now in the longer run. With even McCafferty accepting that UK rates aren’t going up, EUR/GBP is a buy on the dip, even if the ECB cut again as is widely expected and add to QE. Look for 0.85 this year in EUR/GBP, possibly 0.95 if things go badly on Brexit.