Global from FX view

Global from FX view
Contribution ---- morgan stanley
http://www.morganstanley.com/views/gef/fragment/Printgef.html
June 15, 2007

By Stephen Roach | New York

Two years – 1982 and 2007 – frame the window of my experience as an economist at Morgan Stanley.  When I walked in the door a quarter century ago, my focus was on a $3 trillion high-inflation US economy that was mired in the depths of its worst recession of the post-World War II era.  Today, all eyes are on a low-inflation, increasingly integrated $52 trillion world economy.  There couldn’t be a greater difference between then and now. 

As I look back on the journey, I am struck by three macro milestones: At the top of my list is the extraordinary disinflation of the past 25 years.  When I began working at Morgan Stanley, the ravages of America’s double-digit inflation were just starting to recede.  Following nearly a 12% average annual increase in the CPI in 1980-81, the 6% increase that was unfolding in 1982 came as welcome relief.  Interestingly enough, no one at the time really believed it would stick.  The shock was that it did.  US inflation settled down to a 3.5% trajectory over the balance of the 1980s and memories of the Great Inflation finally started to fade.  This was the defining development for the greatest bull run in modern financial-market history.  On the back of sharply receding inflation, yields on 30-year US Treasuries (the bond market benchmark at the time) were literally cut in half – falling from 11% in early 1983 to around 5% at present – and the S&P 500 went up about fifteen-fold over the same 25-year period. 

During the second half of the 1970s and the early 1980s, we agonized endlessly on how to arrest the Great Inflation.  In retrospect, the cure was painfully simple – a wrenching monetary tightening.  It took the vision and courage of Paul Volcker to pull it off – at one point in 1981 pushing the federal funds rate up to 19%.  Ironically, central banks may be better equipped to fight high inflation than they are to preserve the gains of low inflation.  While the new religion of monetary discipline succeeded in keeping inflation and inflationary expectations in check, the confluence of two powerful structural forces – the IT revolution and globalization – took a secular disinflation to the brink of an unwelcome deflation.  Japan fell into that trap in the 1990s and the US came dangerously close a decade later – occurrences that in both cases were unmistakable outgrowths of the bursting of major asset bubbles.  As the multiple-bubble syndrome of the past several years suggests, the authorities still have a lot to learn in managing low-inflation economies – and in avoiding the liquidity-driven pitfalls that come from exceedingly low nominal interest rates.

America’s productivity revival stands out as a second milestone of the past 25 years.  When I started at Morgan Stanley, trend US productivity growth was around 1%.  Today the underlying trend is closer to 2 1/2%.  .  The explanation of the difference between now and then is still a subject of hot debate.  The productivity bulls wax eloquently on America’s innate attributes of flexibility, innovation, de-regulation, and risk taking.  The skeptics focus on “capital deepening” and cost-cutting – in effect, the substitution of capital for labor and the concomitant transformation from one technology platform to another that drove the IT revolution in the 1990s.  I’ve been on both sides of this debate – as one of the first productivity bulls of the early 1990s and then, unfortunately, as one of the first to abandon this view in the mid-1990s.  In retrospect, this was one of the biggest mistakes of my forecasting career.  My concern was that Corporate America had taken its penchant for cost-cutting too far – running the risk of a hollowing out that could compromise its ability to maintain market share in a rapidly expanding US and global economy.  I failed to appreciate the breadth, depth, and duration of the IT-enabled transformation of the US economy – as well as the broader leverage that ultimately would flow from the new technologies of the Information Age.

The US productivity revival of the 1990s turned the global competitive sweepstakes inside out.  At the end of the 1980s, conventional wisdom had it that America was “over” – in effect, beaten into submission by the world’s new competitive behemoths, Japan and Germany.  In retrospect, of course, nothing could have been further from the truth.  At the dawn of the 1990s, Japan and Germany were peaking out and, courtesy of a wrenching restructuring, the United States was about to emerge from its long slumber.  Fast forward to mid-2007, and the debate has come full circle.  America’s productivity growth has slowed to 1%, and the jury is out on whether this is a cyclical or structural development.  While the recent downshift in US economic growth underscores the apparent cyclicality of this development, the culmination of capital deepening – an IT share of total equipment spending that peaked at around 51% in 2000-03 – raises the distinct possibility that the IT-enabled productivity acceleration may have finally run its course.  Meanwhile, there are encouraging signs of a long overdue revival in German and Japanese productivity growth.  Recent history tells us that the pendulum of competitive prowess can change much more quickly than we might think.  That’s something to keep in mind in the years immediately ahead. 

Globalization is certainly on a par with the other two milestones of the past 25 years.  In this case, the comparison between 1982 and 2007 is like day and night.  I walked into this job when global trade stood at just 18% of world GDP; this year, that ratio is likely to hit a record 32%.  The problem with globalization is that we have done a lousy job in understanding and explaining it.  And by “we” I mean my fellow economists, policy makers, politicians, business leaders, and other pundits.  Far from the nirvana promised by the imagery of a “flat world” and the ecstasy of the “win-win” mantra, the road to globalization has led to saving and current-account imbalances, income disparities, and trade tensions – all having the potential to spark a very destabilizing backlash.  The threat of just such a backlash remains a clear risk in today’s environment.

Notwithstanding those concerns, globalization has been a huge success – at least on one level.  Despite persistent and devastating poverty in many poor countries, there has been a doubling of per capita GDP growth in the developing world over the past decade.  What is still missing in this newfound prosperity is a key element of sustainability – the emergence of consumer-driven growth models in these still largely export- and investment-led economies.  At the same time, in the rich countries of the developed world, the benefits of globalization have accrued far more to the owners of capital than to the providers of labor; labor shares of national income in the major developed economies are at record lows, whereas the shares going to capital are at record highs.  Moreover, the distribution of gains within the labor share of the developed economies has become increasingly skewed toward the very few at the upper end of the income distribution – at the expense of those in the middle and at the lower end.  Therein lie the seeds for a potentially powerful backlash:  As the pendulum of economic power has swung from labor to capital, the pendulum of political power is now in the process of swinging back from a pro-capital stance to that which provides support for labor.  The case for trade protectionism – especially in the United States – is alarmingly high as a result.  Sadly, this is antithetical to the global stewardship that is so desperately needed in today’s world. 

In one sense, these past 25 years have been an era of powerful transitions – transitions from high to low inflation, from stagnant to rapid productivity growth, and from closed to open economies.  Transitions, by definition, have a finite duration.  A key challenge for the global economy and world financial markets is what happens after these transitions have run their course – when disinflation comes to an end, when the productivity revival has crested, and when globalization hits its structural limits in terms of import penetration in the developed world and investment-led growth in the developing world.  Don’t get me wrong – a post-transition climate need not be characterized as a return to rapid inflation, stagnant productivity growth, or trade protectionism.  The endgame could be considerably more benign – modest inflation, “adequate” productivity growth, and a leveling out of the global trade share of world GDP.  While these outcomes offer less dynamism to the global economy than we have seen in recent years, they do not represent relapses to more problematic macro climates.  At the same time, such post-transition scenarios may well deny world financial markets the high-octane fuel that has produced such spectacular results over the past 25 years.

The jury is obviously out on these important questions – as well as on the inevitable transitions to come.  My favorite candidates in that regard: productivity catch-ups in the developed world, consumer-led growth in the developing world, a world coming to grips with climate change, and financial solutions to the demographics of aging.  There can be no mistaking the world’s increasingly robust coping mechanisms in dealing with recent and prospective challenges.  In fact, as I look back on the past quarter century, what astonishes me the most is speed – how quickly the world has come to grips with structural issues like productivity and globalization and how equally quickly the Great Inflation was brought to an end.  All this underscores the one lesson from economic history that rings truer than ever – the axiom of an ever-accelerating pace of change.  Just like Moore’s Law, it’s always hard to envision the next wave of time compression – even though it never fails to occur.

The world today is obviously a very different place than it was 25 years ago.  But let me assure you that back in 1982 there was no inkling of what was to come.  I have been privileged to bear witness to an utterly astonishing period in the transformation of the global economy.  I have relished the financial-market debate that has arisen out of this transformation.  I wouldn’t trade that experience for anything.  And now it’s off to Asia – the epicenter of the Next Wave.  My role will change, but I can assure you the lens won’t.  Stay tuned.

Currencies
USD to Reassert; Non-G4 Currencies to Shine
June 15, 2007

By Stephen Jen | London

Summary and conclusions

We are refreshing our currency forecasts.  While keeping our view on EUR/USD and USD/JPY essentially unchanged (EUR/USD to trade below 1.30 and USD/JPY to eventually break lower in 2008, conditional on several assumptions), we are revising up our forecasts for the commodity currencies (AUD, NZD and CAD).  We believe that the global economy will continue to benefit from trade and financial globalisation.  While there may be sporadic inflation scares, we foresee an essentially ‘Goldilocks-like’ global environment.  As a result, we expect risk-taking to resume after the bond markets stabilise, and continue to believe that emerging markets (EM) should, in general, be well placed to outperform.  

Our forecast update

Our last forecast update was on March 22, 2007.  Back then, we called for another bout of generalised USD weakness in 2Q, as the US drifted deeper into a soft patch.  We warned, however, that this was a cyclical trade, and that when the US economy began to recover, so would the dollar.  We rejected the counter-argument about a US recession and the rest of the world being dragged down with a slowing US.  

The main changes to our forecasts are limited to the commodity currencies: the CAD, AUD and NZD.  I make the following points: 

• Point 1.  Very positive global outlook, both cyclical and structural.  I believe that we are re-entering a ‘Goldilocks’ environment, courtesy of trade and financial globalisation.  While there may be inflation scares, I expect disinflationary pressures from globalisation to persist, preventing these scares from turning into actual spikes in inflation.  Indeed, fast-growing economies such as Australia, Japan, Switzerland, Sweden and Norway continue to experience surprisingly low inflation rates, partly as a result of tame import prices, rapid productivity growth and immigration — all of which are related to different aspects of globalisation.   Elsewhere, in large EM economies, inflation remains well-contained.  We calculated that the 19 largest EM economies saw their weighted average inflation rate decline from 3.4% in 2006 to 2.8% in 1Q.  Circling back to the US, our US economists, Dick Berner and David Greenlaw, see the core PCE declining from 2.2% in 2006 to 2.1% in 2007 and 1.9% in 2008. 

As the global economy accelerates, it is likely that inflationary pressures will also mount.  But I believe that central banks will manage to stay ahead of the curve.  

The strength (beyond 5.00% on the US 10Y) of the sell-off in bonds has been surprising. (I wonder if we would have had such a sharp bond sell-off if US growth were 2.3% for both 1Q and 2Q, instead of 0.6% and 4.1% in these two quarters.)  While mortgage convexity hedging may have helped accelerate the move, we don’t believe that it was as powerful a factor as before.  The re-rating of the US economy, without an inflation scare, should not have had such a drastic impact on the bond markets, unless the factors that underpinned global excess savings were also beginning to change.  In any case, the weighted average G3 bond-equity yield spread remains quite supportive of equities, even if interest rates were to rise further.  In other words, I believe that there is still ample scope for the return on equities and that on bonds to converge, with both the P/E ratios and interest rates rising.  In sum, I believe that risky assets should remain supported in this ‘Goldilocks’ environment. 

• Point 2.  The dollar should gradually reassert itself against most G10 currencies.  As the US economy reasserts itself, so should the dollar.  The sell-off in the dollar in late 1Q/early 2Q was a cyclical move, not a structural one.  Further, as the dollar gains momentum, it is quite likely that some investors will pay more attention to the improving trend in the US current account deficit, and use this as another justification to buy dollars.  Both our US economists and we have argued that the prospective trend improvement in the US external imbalance is genuine, and will persist even when the US economy re-accelerates, because domestic demand in the rest of the world has accelerated in earnest, providing powerful support for US exports.  In addition, I believe that cable will be interesting, as the expected decline in inflation in the UK will likely push cable back down below 1.90.  EUR/USD should be dragged lower as a result.  We continue to see 1.28 as a likely parity for EUR/USD by year-end. 
• Point 3.  Our JPY-story remains ‘schizophrenic’.  Last summer, I abandoned the view that valuation would push down USD/JPY.  Instead, I acknowledged the importance of the ‘portfolio shift’ story, which has dominated as Japanese retail investors may indeed be going through a historical phase where they raise their exposure to riskier assets.  Since the Nikkei has underperformed other markets, it made sense for Japanese investors to continue to expatriate capital.  The breaching of the 122 mark this week is potentially important, as the market had failed on several occasions since 2005 to break this threshold.  My own view on USD/JPY is that investors should not challenge the trend, as it continues to suggests that the ‘portfolio shift’ theme is more powerful than the ‘economic fundamentals’ theme.  Specifically, as the world starts to tighten again, the JPY could be ‘left behind’.  USD/JPY, therefore, could linger in the low-120s in the coming months. 

The reason why we still have a downward trajectory for USD/JPY over the medium term is to reflect our view that, first, the Japanese economy is doing just fine (1Q GDP growth of 3.3% ranks it number two among the G10 economies, after Canada).  If the global economy is indeed re-accelerating, then the chances of Japan being the next major country to be re-rated by investors are quite high.  Second, the Nikkei’s relative performance is key.  For the past year, and especially during and after the risk-reduction in February and March, the Nikkei underperformed the other major markets.  But with Japan being the only country in the world not susceptible to outright inflation or an inflation scare, it is likely to remain in a ‘Goldilocks’ state for longer than other countries.  As a result, the Nikkei should have a good chance of outperforming from this point forward.  Japanese retail investors so far have taken more risk through overseas assets.  If and when the Nikkei starts to outperform, the JPY can rally, supported by local flows.  This is our central case.  But if the Nikkei continues to lag, we would not recommend that investors put on long-JPY positions.    

• Point 4.  China and the ‘CNY-bloc’ currencies.  The biggest change in our view is that we now recognise, belatedly, how powerfully the emergence of China has affected the three commodity currencies, the CAD, AUD and NZD.  Although these were previously known as ‘dollar-bloc’ currencies, we would consider calling them, from now on, ‘CNY-bloc’ currencies.  Not only have the positive terms of trade shock and the positive export effects China have had on these economies been significant, but going forward, they are also likely to be the targets of M&A flows and private capital flows.  These three currencies have been performing well since 2002, and I expect them to continue to reflect strength from China and the global economy.  Among the three, however, I believe that the AUD should outperform.  

Bottom line 
We believe that the dollar should reassert itself as the US economy accelerates.  EUR/USD and cable should fall.  We are patient on the JPY call, and anticipate that an outperforming Nikkei will support the JPY by this autumn.  We now believe that the AUD, NZD and CAD can continue to do well, as a derivative of a buoyant Chinese and global economy. 

Currencies
Misalignments, Manipulation and Intervention
June 15, 2007

By Stephen Jen | London

Summary and conclusions

We believe that the core cause of currency misalignments may be financial globalisation.  Specifically, the extraordinarily rapid pace of financial globalisation, which, in turn, was fueled by buoyant financial markets and low implied volatility, may have pushed most G10 exchange rates far away from the fair values (FVs) implied by traditional valuation models that are centred on real economic fundamentals. 

This idea we have has several policy implications.  First, exchange rates are likely to remain misaligned as long as financial markets remain buoyant.  Only if we experience a violent bout of risk-reduction would the G10 exchange rates move back to their FVs.  Second, a ‘Plaza-like’ intervention effort to wrestle the exchange rates back toward their FVs may not be successful, since central banks would need to counter the structural forces, rather than fickle speculative flows, of global capital.  This means that the shift in focus in US legislation on exchange rates from currency manipulation to misalignment will likely encounter significant obstacles in practice. 

Exchange rate fair valuation

We have updated our quarterly FV calculations; there were no major changes to these estimates from the previous set.  Specifically, EUR/USD, GBP/USD and USD/JPY remain grossly overvalued.  EUR/JPY is still the most misaligned cross in the G10 space.  The three commodity currencies, the AUD, NZD and CAD, also remain meaningfully mis-priced.  Like the JPY, the CHF is also undervalued. 

Currency misalignments are here to stay?

The G10 exchange rates have been misaligned for so long that we are starting to wonder if we are missing a part of the story, i.e., there may be important qualifications we need to acknowledge when interpreting the traditional approach to currency valuation. 

We have the following thoughts: 

·   Thought 1.  Financial versus trade globalisation.  Most valuation frameworks, including ours, are centred on different aspects of the real economy.  For example, productivity growth, the terms of trade and fiscal positions are all concepts that are more closely related to the real economy than to the financial markets.  While equity and bond prices should indirectly reflect these fundamental features of an economy in question, large cross-border capital flows, which could be driven by factors other than the real fundamentals, could have substantive effects on exchange rates. 

Two good examples are the JPY and CHF.  It is remarkable that the currencies of two of the largest net savers in the world are also the weakest in the world, despite the fact that Japan’s 1Q growth was 3.3% — faster than any of the G7 countries except for Canada — and Switzerland’s 1Q growth was 3.2%.  Further, both of these economies are growing above potential. 

EUR/JPY is another example.  Most valuation models suggest that this cross rate is extremely overvalued.  However, the trend from 2001 has been powerful and definitive.  Our ‘Global Funnelling Hypothesis’ is a capital flows framework, divorced from the relative economic fundamentals of Japan and Euroland. 

The fundamental variables that used to dictate currency trends — and are key input variables to our valuation framework — for the time being no longer seem to have the same impact on exchange rates that they used to.  Instead, capital flows and nominal variables (such as cash interest rates) seem to dominate.   Importantly, during the sharp risk-reduction in February/March, all of the G10 exchange rates we track moved toward their fair values!  This suggests to us that capital flows, not economic fundamentals, somehow dominate the currency markets, and have played a critical role in pushing exchange rates into territories that are considered ‘misaligned’ relative to the real economies. 

·   Thought 2.  The US Senate Finance Committee’s proposed bill is not bad.  In the bill put forward on Wednesday by Senators Baucus, Grassley, Schumer and Graham, it was proposed that, if currency misalignments resulting from distorted policies (the ‘malign’ type of currency misalignments) are not resolved after 360 days, the US Treasury, in consultation with the Fed, could consider outright currency intervention.  We have these thoughts: 

First, this bill is not nearly as protectionist as it could have been, as it does not contain automatic triggers for countervailing duties.   

Second, it does not mandate but only allows the Treasury to decide on outright currency intervention.  Assuming that the US Treasury tries to do things in the best economic, not political, interest of the US, it would not hastily conduct interventions.  

Third, one way we judge to see if a policy is ‘good’ is to ask what the economic impact would be if other countries were to adopt the same policy.  We believe that this particular bill is sensible enough that if Euroland and Asia were also to adopt this bill, the net impact on the global economy would not necessarily be negative. 

Fourth, in practice, however, there would be operational issues, particularly regarding emerging market currencies such as the CNY.  If the US Treasury were to decide to intervene to sell dollars and buy CNY, it would be difficult for it to implement this trade without the consent of Beijing. 

Fifth, this bill presumes that the JPY misalignment is considered ‘benign’, while the CNY misalignment is considered ‘malign’.  Under this bill, no action can be taken regarding the JPY. 

·    Thought 3.  Measures of misalignments are subjective.  Currency misalignments are essentially the differences between the spot exchange rates and what one may consider is the ‘correct’ price for the currency, based on some economic fundamental variables or other considerations.  While this may sound straightforward in theory, in practice, there is no one ‘correct’ equilibrium price because different practitioners consider different variables in coming to that view.  For example, for USD/CNY, there are estimates of misalignments ranging from 5% to 50%.  In fact, in a recent paper issued by the US Treasury, the subjective nature of currency valuation was highlighted as a source of major policy complication. 

The subjective nature of currency valuation will make it difficult for the US and other countries to agree on whether and by how much a certain exchange rate is misaligned. 

·   Thought 4.  Currency interventions in the G10 space may not be effective.  On Monday, June 11, 2007, the RBNZ conducted its first intervention since the float of the NZD in 1985.  We are not convinced that its intervention will be effective in capping NZD/USD, though it could be an effective way for the RBNZ to accumulate some foreign reserves.  Like many other countries, the RBNZ faces the ‘impossible trinity’ or the policy ‘trilemma’ of trying to target both interest rates and the exchange rate with an open capital account.  If we are right that global capital flows have fundamentally distorted exchange rates and pushed them away from their FVs, the RBNZ would be ‘taking on’ these private sector flows.  In the end, 8.00% of ‘risk-free’ government bond will likely remain attractive to many investors in the world. 

Bottom line

We have become introspective about the concept of fair valuation of exchange rates, and have come to the view that FV calculations may be fundamentally ‘biased’ in that they are usually based on real economic fundamentals.  But with financial globalisation and the sharp surge in cross-border asset holdings, persistent exchange rate misalignments could simply reflect differences between capital markets and the real economies.  This hypothesis of ours suggests that exchange rates will likely stay mis-aligned, as long as financial globalisation continues, and that policy makers should exercise care when contemplating intervening in the currency markets.

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