Then And Now
By Yiannis G. Mostrous
FALLS CHURCH, Va.–In May 2002, I wrote that the US dollar would gradually lose value but that it would remain the major currency of the world, albeit from a lower valuation plateau. At the time, you needed less than USD0.90 to buy EUR1; a little more than four years later, you need USD1.31 to purchase EUR1. Nevertheless, I stand by my 2002 assessment.
The dollar weakness that commenced last week, apart from being an important market development, has brought with it the usual arguments about the demise of the dollar. And although my long-term view is that the dollar will eventually fall victim to the fairly irresponsible US monetary policy, that time hasn’t yet come.
The US is still the most-important and most-agile economy in the world. No one–least of all its creditors–wants to see it go down hard. Such a development would benefit almost no one and would damage probably everyone.
But recent statements from central banks around the world regarding their diversification plans have a lot of people worried. Specifically, Alexei Ulyukayev, the first Deputy Chairman of the Russian Central Bank (RCB), said less than two months ago that the RCB was considering increasing its exposure to the Japanese yen (JPY). More recently, high-ranking officials in the People’s Bank of China (PBoC) also talked about diversifying away from the USD. The European Central Bank (ECB) has also revealed that it’s been increasing JPY holdings and that its current share of reserves in the JPY is 15 percent, up from 10 percent in 2003.
Many market participants have interpreted these comments as indications that these central banks were dumping US dollars in favor of other currencies. What’s really happening is that they’re increasing exposure to non-dollar currencies going forward; the USD remains the cornerstone of their forex reserves (generally at around 60 percent).
All this talk about the JPY becoming important again in the central bank diversification process has helped the Japanese currency form at least a intermediate-term bottom, thus resuming its strengthening pattern.
During the summer I wrote (see SRI, 14 June 2006, Complications):
Although the general idea is intact, the timing and targets–for the second part–have been a little off. That said, the JPY reversal is here to stay, though it will continue to be gradual (read: agonizing). If this view proves correct, the JPY will join the Chinese renminbi (RMB) as the second of two anchors for strength for Asian currencies.
It goes without saying that for the JPY to continue to strengthen, the Japanese economy must continue to improve as well. I expect this to happen, with the usual twists and turns; the JPY should break once again below 115 and finish 2007 at around JPY100 per USD1. The chart below depicts the number of yen per US dollar (a lower number means a stronger yen).
Source: Bloomberg
The US economy must avoid recession if the rest is to be able to pick up the slack and, in the process, help the US deal with its imbalances. This can happen if the US housing slowdown proves to have less impact on the rest of the world than is widely anticipated.
If the above scenario materializes, expect Asian markets and currencies to continue to perform well. More capital will be deployed to Asia, underpinning the region’s outperformance. In addition, recent data show that Asian central banks have been reluctant to intervene in the forex markets to support the USD and keep their currencies at lower levels. I’ve long expected them to take this approach and see it as another step toward stronger, more-confident Asian economies.
Keep in mind that although 2006 has been a fairly good year for Asia, the majority of foreign investors have avoided risky trades in the region since this summer’s selloff and preferred to engage risk closer to home. But if the US economy proves to be more resilient than investors currently believe it to be, expect greater inflows to the Asian markets and stronger local currencies.
Currency strength is important for emerging markets because it enhances their creditworthiness. As these currencies appreciate against the dollar, their external balance sheets improve as foreign debt falls in local currency terms.
Stronger currencies have allowed emerging markets, particularly in Asia, to establish their own monetary policies instead of following the US Federal Reserve’s lead, as was the case during every previous tightening cycle.
Asia as a whole has been resilient in this regard. Its currencies have appreciated against the dollar since 2002 but, more important, have done extremely well since the beginning of last year. The dollar strengthened against the developed currencies of the world (e.g., euro and yen) and lost value against the Asian (and other emerging market) currencies in 2005.
The chart below depicts the Asian Dollar Index, a trade- and liquidity-weighted index of 10 major Asian currencies (excluding Japan). As you can see, it’s seen strong gains during the past five years. This is a fundamental change, but Asian currencies will continue to strengthen and become more flexible versus the dollar.
Source: Bloomberg
When it comes to Asian currencies, you can’t forget the one some opinion makers would like you to believe is the enemy of the US, the RMB. Here’s what I had to say on the issue two months ago (see SRI, 20 September 2006, A Public Holiday):
I still expect the RMB to continue to gradually appreciate (it’s up 1 percent since September 20) as the following chart illustrates.
Source: Bloomberg
Finally, long-term readers know that Europe has been one of my favorite markets for some time, and I expect the European economy to finish strong this year and to have a solid 2007. The euro’s strength has come as no surprise, though I understand the fact that it usually works, as much by default as merit, as the anti-dollar. However, the euro will remain stronger for longer, helping the European consumer in the process.
Source: Bloomberg
Tactical Considerations
Markets have been so strong since the summer selloff–despite entrenched bears declaring the rally dead at the end of August–that many observers are worried that a correction is long overdue. The truth is that there are a lot of profits on the table and it wouldn’t be shocking if investors decided to book some. But as things stand, my view on the market remains positive.
When it comes to Asia, you can’t casually dismiss arguments that the market could take a breather. But we’re not there yet. Despite the good performance in Asia, foreign investor presence–usually a precursor of a downturn–has been relatively small.
Estimates put the year-to-date net foreign flows at only 40 percent of 2005 levels, indicating that foreign investors haven’t really kept up with the rally. At the same time, technology stocks that usually trade at premiums of 30 percent-plus during times like this are currently trading at near premium of 6 percent. A correction, if it happens, should be a short-lived affair.
For investors who want (or need) to take profits off the table or protect their gains during a correction, keep in mind that India, Singapore, the Philippines and Indonesia are the most-expensive markets in the region. On the other hand, Thailand, South Korea and Taiwan are some of the cheapest. During the May correction, the markets that were down the most were India, the Philippines, Indonesia and China.
I’m looking to make some changes in the SRI Portfolios, but nothing will be done this week. Follow the guidelines I set out last week (see SRI, 22 November 2006, SRI, Abridged) if you’d like to deploy some new capital.
Finally, for investors interested in diversifying their cash holdings, the Singaporean dollar remains my favorite vehicle for this purpose.
FALLS CHURCH, Va.–In May 2002, I wrote that the US dollar would gradually lose value but that it would remain the major currency of the world, albeit from a lower valuation plateau. At the time, you needed less than USD0.90 to buy EUR1; a little more than four years later, you need USD1.31 to purchase EUR1. Nevertheless, I stand by my 2002 assessment.
The dollar weakness that commenced last week, apart from being an important market development, has brought with it the usual arguments about the demise of the dollar. And although my long-term view is that the dollar will eventually fall victim to the fairly irresponsible US monetary policy, that time hasn’t yet come.
The US is still the most-important and most-agile economy in the world. No one–least of all its creditors–wants to see it go down hard. Such a development would benefit almost no one and would damage probably everyone.
But recent statements from central banks around the world regarding their diversification plans have a lot of people worried. Specifically, Alexei Ulyukayev, the first Deputy Chairman of the Russian Central Bank (RCB), said less than two months ago that the RCB was considering increasing its exposure to the Japanese yen (JPY). More recently, high-ranking officials in the People’s Bank of China (PBoC) also talked about diversifying away from the USD. The European Central Bank (ECB) has also revealed that it’s been increasing JPY holdings and that its current share of reserves in the JPY is 15 percent, up from 10 percent in 2003.
Many market participants have interpreted these comments as indications that these central banks were dumping US dollars in favor of other currencies. What’s really happening is that they’re increasing exposure to non-dollar currencies going forward; the USD remains the cornerstone of their forex reserves (generally at around 60 percent).
All this talk about the JPY becoming important again in the central bank diversification process has helped the Japanese currency form at least a intermediate-term bottom, thus resuming its strengthening pattern.
During the summer I wrote (see SRI, 14 June 2006, Complications):
As noted here on numerous occasions, my expectation is that growth will continue as the Japanese economy gradually moves out of deflation while consumers return in strength, thus allowing Japanese firms more pricing power. SRI also expects 2007 to be the year that Japan’s GDP growth surpasses that of the US and the EU.
Furthermore, the yen will perform well this year and next. The currency has been fairly volatile, but . . . it’s been strengthening against the dollar. Expect this to continue at a gradual pace. It should come as no surprise if, by the end of the year, the yen trades closer to 100 yen per dollar. Expect the yen to break the 100 yen per dollar barrier in 2007.
Although the general idea is intact, the timing and targets–for the second part–have been a little off. That said, the JPY reversal is here to stay, though it will continue to be gradual (read: agonizing). If this view proves correct, the JPY will join the Chinese renminbi (RMB) as the second of two anchors for strength for Asian currencies.
It goes without saying that for the JPY to continue to strengthen, the Japanese economy must continue to improve as well. I expect this to happen, with the usual twists and turns; the JPY should break once again below 115 and finish 2007 at around JPY100 per USD1. The chart below depicts the number of yen per US dollar (a lower number means a stronger yen).
Source: Bloomberg
The US economy must avoid recession if the rest is to be able to pick up the slack and, in the process, help the US deal with its imbalances. This can happen if the US housing slowdown proves to have less impact on the rest of the world than is widely anticipated.
If the above scenario materializes, expect Asian markets and currencies to continue to perform well. More capital will be deployed to Asia, underpinning the region’s outperformance. In addition, recent data show that Asian central banks have been reluctant to intervene in the forex markets to support the USD and keep their currencies at lower levels. I’ve long expected them to take this approach and see it as another step toward stronger, more-confident Asian economies.
Keep in mind that although 2006 has been a fairly good year for Asia, the majority of foreign investors have avoided risky trades in the region since this summer’s selloff and preferred to engage risk closer to home. But if the US economy proves to be more resilient than investors currently believe it to be, expect greater inflows to the Asian markets and stronger local currencies.
Currency strength is important for emerging markets because it enhances their creditworthiness. As these currencies appreciate against the dollar, their external balance sheets improve as foreign debt falls in local currency terms.
Stronger currencies have allowed emerging markets, particularly in Asia, to establish their own monetary policies instead of following the US Federal Reserve’s lead, as was the case during every previous tightening cycle.
Asia as a whole has been resilient in this regard. Its currencies have appreciated against the dollar since 2002 but, more important, have done extremely well since the beginning of last year. The dollar strengthened against the developed currencies of the world (e.g., euro and yen) and lost value against the Asian (and other emerging market) currencies in 2005.
The chart below depicts the Asian Dollar Index, a trade- and liquidity-weighted index of 10 major Asian currencies (excluding Japan). As you can see, it’s seen strong gains during the past five years. This is a fundamental change, but Asian currencies will continue to strengthen and become more flexible versus the dollar.
Source: Bloomberg
When it comes to Asian currencies, you can’t forget the one some opinion makers would like you to believe is the enemy of the US, the RMB. Here’s what I had to say on the issue two months ago (see SRI, 20 September 2006, A Public Holiday):
Based on a statement released in the names of the G-7 finance ministers, you can safely assume that the newly appointed US Secretary of the Treasury, former Goldman Sachs CEO Henry M. Paulson Jr, is trying to change the US–and consequently the G-7–approach toward China. The G-7 statement, while urging China to make its currency more flexible, avoided this time its usual call for outright renminbi (RMB) appreciation. The decision is in line with previous comments by Secretary Paulson that China needs time to adjust its currency in order to deal with the consequences of the move.
At the same time, the US has been calling for the IMF to assume a more prominent role as the “watchdog” of currency manipulation, thus removing pressure from the US Treasury Dept. If this can be achieved, Paulson won’t have to deal with cries from the US Senate for the Treasury Dept to “punish China” for its “unacceptable” currency regime.
China has demonstrated that it won’t respond to outright pressure, something Paulson well knows; he’s been doing business with the Chinese for a long time. He’s currently visiting China again, and I expect an understanding to be reached during his time there. China’s leadership (especially its central bank officials) knows what needs to be done, but it also knows it needs more time than the G-7 would allow.
I still expect the RMB to continue to gradually appreciate (it’s up 1 percent since September 20) as the following chart illustrates.
Source: Bloomberg
Finally, long-term readers know that Europe has been one of my favorite markets for some time, and I expect the European economy to finish strong this year and to have a solid 2007. The euro’s strength has come as no surprise, though I understand the fact that it usually works, as much by default as merit, as the anti-dollar. However, the euro will remain stronger for longer, helping the European consumer in the process.
Source: Bloomberg
Tactical Considerations
Markets have been so strong since the summer selloff–despite entrenched bears declaring the rally dead at the end of August–that many observers are worried that a correction is long overdue. The truth is that there are a lot of profits on the table and it wouldn’t be shocking if investors decided to book some. But as things stand, my view on the market remains positive.
When it comes to Asia, you can’t casually dismiss arguments that the market could take a breather. But we’re not there yet. Despite the good performance in Asia, foreign investor presence–usually a precursor of a downturn–has been relatively small.
Estimates put the year-to-date net foreign flows at only 40 percent of 2005 levels, indicating that foreign investors haven’t really kept up with the rally. At the same time, technology stocks that usually trade at premiums of 30 percent-plus during times like this are currently trading at near premium of 6 percent. A correction, if it happens, should be a short-lived affair.
For investors who want (or need) to take profits off the table or protect their gains during a correction, keep in mind that India, Singapore, the Philippines and Indonesia are the most-expensive markets in the region. On the other hand, Thailand, South Korea and Taiwan are some of the cheapest. During the May correction, the markets that were down the most were India, the Philippines, Indonesia and China.
I’m looking to make some changes in the SRI Portfolios, but nothing will be done this week. Follow the guidelines I set out last week (see SRI, 22 November 2006, SRI, Abridged) if you’d like to deploy some new capital.
Finally, for investors interested in diversifying their cash holdings, the Singaporean dollar remains my favorite vehicle for this purpose.