Global Investing

What would a benign dictator do with the euro?

Mike Dolan

Jul 16, 2012 18:32 UTC

The idea of a “benign dictator” may well be an oxymoron but as a thought exercise it goes a way to explaining why giant global fund manager Blackrock thinks the chances of a euro zone collapse remains less than 20 percent.  When push comes to shove, in other words, Europe can sort this mess out. Speaking at an event showcasing the latest investment outlook from Blackrock Investment Institute, the strategy hub of the investment firm with a staggering $3.7 trillion of assets under management,  Richard Urwin said the problem in trying to second-guess the outcome of the euro crisis was the extent to which domestic political priorities were working against a resolution of the three-year old crisis.

“The thing is if you could imagine a benign dictator, then the problems are all solvable and could be fixed in a matter of weeks,” said Urwin, who is Head of Investments at Blackrock’s Fiduciary Mandate Investment Team.  Playing with the idea, Urwin said parts of a workable plan may involve debt rescheduling or restructuring for the existing bailout countries Greece, Portugal and Ireland; a buildup of a sufficiently large liquidity fund to help the larger countries such as Spain and Italy; a euro banking union with deposit guarantees and single supervisor to ring-fence and close insolvent banks that will never function properly; the creation of a central finance ministry and the issuance of jointly-guaranteed euro bonds etc etc.

Urwin’s point of course was not to advocate a dictator for the euro zone — although he acknowledged the euro was not exactly a child of European electorates to begin with–  rather that euro members have the ability if not the willingness yet to solve the crisis and that global investors looking for signposts in the saga needed to watch closely the runes of political cooperation and leadership instead of the economics and debt dynamics alone.  Where exactly that turns is hard to guess, but but it may well be that the process that has to wait until the German elections next year, he added.

Far from thinking these plans are some fanciful wishlist, Blackrock managers stressed that a lot of what has been done in the euro bloc over the past couple of the years — in terms of cross-border bailouts and funds, fiscal integration and central bank activism — would also have been thought unthinkable as recently as 2009.  And the past month of European Union moves  — recapitalisation of the Spanish banking system,  opening up the new European Stability Mechanism to directly fund banks and not just sovereigns, and moves toward a European banking union — all marked another big, if still insufficient, step to restore system-wide confidence.

“My view is that there has been a great deal of progress in the past 60 days in Europe,” said Peter Fisher, Head of Blackrock’s Fixed Income Portfolio Management Group. “But we’ve yet to see whether the political leadership in Europe will tie themselves to the mast of reforms needed to hold the euro together. They’ve made some progress but we still don’t see them having done enough to make it credible yet for us.”

“If Hollande and Merkel started showing the sort of political leadership Kohl and Mitterand showed in committing themselves to the future of Europe, markets would sit up and take notice and it would take a lot of the uncertainty premium out,” Fisher said.

And it’s the uncertainty of political and central bank behaviour in reaction to the dead weight of western deleveraging that’s creating so much visibility problems for investors, they said — not just  in Europe but also on how a new U.S. President and Congress deal with the worrying “fiscal cliff” of pre-scheduled budget tightening there next year and how China and other emerging markets cushion their steadily slowing economies.

More EM central banks join the easing crew

Sujata Rao

Jul 16, 2012 14:25 UTC

Taiwan and Philippines have joined the easing crew. Taiwan cut interbank lending rates for the first time in 33 months on Friday while Philippines lowered the rate it pays banks on short-term special deposits. Hardly surprising. Given South Koreas’s shock rate cut on Thursday, its first in over three years, and China’s two rate cuts in quick succession, the spread of monetary easing across Asia looks inevitable. Markets are now betting the Reserve Bank of India will also cut rates in July.

And not just in Asia. Brazil last week cut rates for the eighth straight time  and Russia’s central bank, while holding rates steady,  amended its language to signal it was amenable to changing its policy stance if required.

Worries about a growth collapse are clearly gathering pace. So how much room do central banks have to cut rates? Compared with Europe or the United States, certainly a lot.  And with the exception of Indonesia and Philippines, interest rates in most countries are well above 2009 crisis lows.  But Deutsche Bank analysts, who applied a variation of the Taylor rule (a monetary policy parameter stipulating how much nominal interest rates can be changed relative to inflation or output), conclude that in Asia, only Vietnam and Thailand have much room to cut rates. Malaysia and China have less scope to do so and the others not at all (Their model did not work well for India).

Deutsche said of Korea:

After this week’s rate cut, our model suggests rates are essentially in line with the rule as defined by the past behaviour of the Bank of Korea

But there are also doubts that the doves can deliver.

“Juice is gone” on Portuguese bonds?

Ingrid Melander

Jul 16, 2012 11:53 UTC

Portuguese bonds staged an impressive rebound on the back of the European Central Bank’s cheap loan money flood in the first half of the year. The bailed-out country has managed the rare feat of being one of the best performing sovereign bond markets of the year so far with returns of over 40 percent for 10-year government bonds.

But the rebound was illusory in some respects because Lisbon had suffered more than most at the end of last year when some feared, prematurely at least, that the logic of the Greek debt restructuring would be applied to Portugal too. And even if Lisbon has been praised for its efforts to cut its deficit, it is still considered the euro zone’s second riskiest country in terms of bond yields.

Richard Batty, investment director at Standard Life Investments, says:

“At the moment the premium suggests a big credit risk associated with holding (Portuguese) assets. Many of our clients have asked us not to invest in Portugal because sovereign bonds in places like Portugal and Greece are not risk-free anymore.”

Portugal’s 10-year debt is still priced as low as 65 cents in the euro on secondary markets compared to 93 cents for equivalent debt in fellow bailout member Ireland. For Federico Sequeira at Exotix brokers, most good opportunities found in the first half are gone.

“At one point the sovereigns started trading at a very low level and people started investing when they realised Portugal’s problems were not as bad as that of Spain. Today you probably won’t find opportunities on the bond side … the moment everybody got involved the juice was gone.”

GUEST BLOG: Is Your Global Bond Fund Riskier than You Thought?

Joel Dimmock

Jul 16, 2012 11:04 UTC

This is a guest post from Douglas J. Peebles, Head of Fixed Income at AllianceBernstein. The piece reflects his own opinion and is not endorsed by Reuters. The views expressed  do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Global bond funds continue to attract strong inflows as near-zero interest rates lead many investors to look abroad for assets with attractive yields. As we’ve argued before, global bonds provide many important benefits, but it’s crucial that investors select the right type of fund.

Not all global bond funds are cut from the same cloth. One key consideration that investors often overlook is the extent to which the fund elects to hedge its currency exposure. When a domestic currency depreciates – as it did for US-dollar–based investors during most of the period between 2002 and 2008 – foreign currency exposure can help boost returns from holding global bonds.

This is fine while the good times last. But it’s important to understand that currencies are extremely volatile – much more so than bonds – and adverse movements in currencies can quickly swamp the income and price gains generated from holding global bonds. As such, for investors looking at their global bond allocations as a hedge for their equity risk, choosing not to hedge against currency swings could have disastrous results.

Take 2008, for example.  That year, bonds rallied strongly across the developed world, providing valuable diversification for investors smarting from heavy losses in their equity portfolios…if investors were hedging the currency exposure in their global bond allocations. Those who didn’t got a lot more volatility than they had bargained for, and—depending on their base currency—may have been faced with significant losses in their bond portfolios as well as in their stock portfolios.

Food prices may feed monetary angst

Be it too much sun in the American Midwest, or too much water in the Russian Caucasus, food supply lines are being threatened, and food prices are surging again just as the world economy slips into the doldrums.

This week, Chicago corn prices rose for a second straight day, bringing its rise over the month to 45%, and floods on Russia’s Black Sea coast disrupted their grain exports.  Having trended lower for about nine-months to June, the surge in July means corn prices are now up about 14% year-on-year. And all of this after too little rain over the spring and winterkill meant Russia, Ukraine and Kazakhstan’s combined wheat crop would fall 22 percent to 78.9 million tonnes this year from 2011.

But as damaging as these disasters have been for local populations, their effects could be much more widely felt.

The problem is that not only do rising food prices raise the cost of living, squeezing incomes further during a downturn, but by raising inflation they severely restrict the government’s flexibility in setting monetary policy. Just as Mike argued previously on this blog that the falling oil price amounted to a green light for the cutting of interest rates, rising food prices will force many central banks to think again about the pace of monetary easing.  And the problem is most acute in developing countries where the proportion of food in consumer price baskets is far higher than in the richer western economies. For example, according to the US Department of Agriculture, an additional $1 added to income sees 56 cents more spent on food, beverages and tobacco in Burundi, compared to 5 cents more in the United States.

The Russian central bank is a timely case in point when it comes to restrictions on monetary policy. On Friday they announced that they were keeping interest rates the same; as much as growth is struggling and could do with some monetary stimulus, high inflation, fuelled by food prices, is tying the bank’s hands.

Next Week: Big Black Cloud

Mike Dolan

Jul 12, 2012 16:25 UTC

Following are notes from our weekly editorial planning meeting:

Not unlike this year’s British “summer”, the gloom is now all pervasive. Not panicky mind, just gloomy. And there is a significant difference where markets are concerned at least. The former involves surprise and being wrongfooted — but latter has been slow realisation that what were once extreme views on the depth of the credit swamp are fast becoming consensus thinking. The conclusion for many now is that we’re probably stuck in this mire for several more years – anywhere between 5 and 20 years, depending on your favoured doom-monger. Yet, the other thing is that markets also probably positioned in large part for that perma-funk — be it negative yields on core government debt or euro zone equities now with half the p/e ratios of US counterparts. In short, the herd has already  hunkered down and finds it hard to see any horizon. Those who can will resort to short-term tactical plays based on second-guessing government and central bank policy responses (there will likely be more QE or related actions stateside eventually despite hesitancy in the FOMC minutes  and Fed chief Bernanke will likely give a glimpse of that thinking in his congressional testimony next week); or hoping to surf mini econ cycles aided by things like cheaper energy; or hoping to spot one off corporate success stories like a new Apple or somesuch.

So has all hope been snuffed out? The reason for the relapse mid-year depression is only partly related to the political minefield frustrating a resolution of the euro crisis – in some ways, things there look more encouraging policywise than they did two months ago. It stems as much from a realization of just how broken the banks credit creation system remains – a system that had hinged heavily on extensive collateral chains that have now largely been broken or shortened and starved of acceptable high-quality collateral. Curiously, QE – by removing even more of the top quality collateral – may even be exaggerating the problem. Some even say the extreme shortage of this quality “collateral” may require more, not less, government debt in the US and UK and would also benefit from a pooling of euro debt  – but everyone knows how easy all that’s going to be politically.

Despite all this, global markets have remained fairly stable over the past week – in part due to policy hopes underpinning risk markets and in part because there’s not many places left to hide without losing money in “safe-haven” bunkers. World equities are down about 2 percent over the past week,  but still up more than 6 percent from early June. Risk measured by volatility indicesis a smidgen higher too. Oil has firmed back toward $100pb, disappointing everyone apart from oil exporters. Spanish and Italian 10-yr yields are a touch higher. And at least part of the caution everywhere is ae vigil ahead of Chinese Q2 GDP data on Friday – numbers that now almost rival the U.S.  monthly payrolls in global market impact.

Next week finds us in the thick of the Q2 earnings season, but Bernanke’s testimony may well end up stealing the show as QE3 speculation boils again, the IMF prepares to cut world growth forecasts on Monday and a stream of inflation reports from US/UK/euro zone reveal the leeway major central banks now have to ease credit yet again.  Spain borroww again Thursday and the July US Philly Fed index, a major mood setter for the rest of month, will be important. Canadian, Turkish and SAfrican rate decisions will be watched closely. EU/IMF officials hit Budapest to discuss a lending programme for Hungary.

But perhaps the most important metric of the coming week may well be how euro banks react to the disappearance Wednesday of the interest rate on more $800bln of cash they are hoarding  at the ECB. Already we have seen nearly 500 bln shift to similarly 0% current accounts from overnight deposits, but whether some of that will now find its way out the yield curve of euro government bond markets or — shock, horror — into direct business lending will be hugely important in the days and weeks ahead. The passing of the EBA bank capital deadline on June 30 and the ESM-bank deal may encourage some attempt to put this money back to work.

IMF updates World Economic Outlook Mon

Certain danger: Extreme investing in Africa

The Arab Spring, for all its democratic and political virtues,  put a big economic dent in the side of participating North African countries, particularly when it came to attracting foreign investment in 2011.

According to a recent UNCTAD report:

Sub-Saharan Africa drew FDI not only to its natural resources, but also to its emerging consumer markets as the growth outlook remained positive. Political uncertainty in North Africa deterred investment in that region.

So far, so logical. Except that simply can’t be all there is to it.

Why? Because plenty of African countries marred by political uncertainty have succeeded in attracting inward FDI.

The Democratic Republic of Congo is a good example. According to political risk consultancy Maplecroft, the country ranks as “extreme” in its risk index for governance framework, regulatory and business environment, conflict and security and human rights and society. It scores 0.00 on business integrity and corruption. And yet in 2011 it attacted over a billion dollars in FDI, according to the UNCTAD report.

Korea shocks with rate cut but will it work?

Sujata Rao

Jul 12, 2012 13:47 UTC

Emerging market investors may have got used to policy surprises from Turkey’s central bank but they don’t expect them from South Korea. Such are the times, however, that the normally staid Bank of Korea shocked investors this morning with an interest rate cut,  the first in three years.  Most analysts had expected it to stay on hold. But with the global economic outlook showing no sign of lightening, the BoK probably felt the need to try and stimulate sluggish domestic demand. (To read coverage of today’s rate cut see here).

So how much impact is the cut going to have?  I wrote yesterday about Brazil, where eight successive rate cuts have borne little fruit in terms of stimulating economic recovery. Korea’s outcome could be similar but the reasons are different. The rate cut should help Korea’s indebted household sector. But for an economy heavily reliant on exports,  lower interest rates are no panacea,  more a reassurance that, as other central banks from China to the ECB to Brazil  ease policy, the BoK is not sitting on its hands.

Nomura economist Young-Sun Kwon says:

We do not think that rate cuts will be enough to reverse the downturn in the Korean economy which is largely dependent on exports.

Exports make up 53 percent of South Korea’s economy, World Bank data showed last year. That’s one of the highest rates in the world, far higher than China’s 29 percent or Brazil’s 12 percent. Nearly half these exports went to China. Europe and the United States –  growth is looking shaky in all these destinations.  Look at the figures to see how this is affecting Korea.   Exports grew 19 percent last year. But in 2012  export growth is estimated at 3.5 percent, half government’s initial forecast.  And correlation is high between exports and manufacturing — no wonder Korean factory activity shrank in June for the first time in five months.

Rather than reassure investors, the rate cut appears to have  spooked, with stock markets falling more than 2 percent and many analysts criticising the BoK for surprising markets.

There could be a bright side. The won fell 1 percent after the shock announcement. It has been flat this year against the dollar while other Asian currencies, including China’s yuan, have lost ground. If the BoK stays dovish (which looks likely) and the won weakens more, that could help exporters compete better with Asian rivals.  As Nomura’s Kwon says, ultimately the cut could limit downside growth risks via “confidence and foreign exchange channels”.

SocGen poll unearths more EM bulls in July

Sujata Rao

Jul 12, 2012 09:35 UTC

These are not the best of times for emerging markets but some investors don’t seem too perturbed. According to Societe Generale,  almost half the clients it surveys in its monthly snap poll of investors have turned bullish on emerging markets’ near-term prospects. That is a big shift from June, when only 33 percent were optimistic on the sector. And less than a third of folk are bearish for the near-term outlook over the next couple of weeks, a drop of 20 percentage points over the past month.

These findings are perhaps not so surprising, given most risky assets have rallied off the lows of May.  And a bailout of Spain’s banks seems to have averted, at least temporarily, an immediate debt and banking crunch in the euro zone. What is more interesting is that despite a cloudy growth picture in the developing world, especially in the four big BRIC economies,  almost two-thirds of the investors polled declared themselves bullish on emerging markets in the medium-term (the next 3 months) . That rose to almost 70 percent for real money investors. (the poll includes 46 real money accounts and 45 hedge funds from across the world).

See the graphics below (click to enlarge):

Signals are positive on positioning as well with 38.5 percent of investors reckoning they were under-invested in emerging markets, compared to a quarter who felt they were over-invested. Again, real-money investors appeared more keen on emerging markets, with over 40 percent seeing themselves as under-invested. SocGen analysts write:

This is positive as it points to potentially higher risk-taking…On this basis one could argue that there is potentially a positive driver for (global emerging markets) if indeed real money investors re-establish their risk positions in the period ahead.

Interestingly SocGen’s head of emerging markets research, Benoit Anne, is out  of sync with his clients on this one. “Give me one single reason to be bullish on emerging markets,” he wrote earlier this week.  Macro data, policies, asset valuations  — all seem to be working against emerging markets these days,  Anne says, though he acknowledges that light investor positioning is a positive.  He adds:

In Brazil, rate cuts but no economic recovery

Sujata Rao

Jul 11, 2012 15:18 UTC

Brazil’s central bank meets today and almost certainly will announce another half point cut in interest rates, the eighth consecutive reduction since last August. But so far there is little sign that its rate-cutting spree – the longest and most aggressive  in the developing world – is having much success in resuscitating the economy.

HSBC’s closely watched emerging markets index (EMI), released this week, shows Brazil as one of the weak links in the EM growth picture,  with sharp declines in manufacturing and export orders in the second quarter.

The government is expected to soon revise down its 4.5 percent growth projection for 2012; the central bank has already done so.  Industrial output is down, and automobile production has slumped 9 percent in the first half of 2012. Nor  it seems are record low interest rates encouraging the middle classes to take on more debt — the number of Brazilians seeking new credit fell 7.4 percent in the first half of this year, the biggest fall on record, according to credit research firm Seresa Experian.

And investors aren’t too happy with Brazil either. Despite the steep rate cuts, Brazil’s stocks are among the worst performing in emerging markets this year. (See here for what I wrote on Brazilian stocks a few weeks back)

Grappling with the slowdown in China and other export markets, Brazil, understandably, is trying to stimulate domestic demand. But its problem (and indeed that of many others such as India) is that it is trying to repeat the strategy it pursued in 2009 when countries resorted to huge stimulus to kickstart growth after the Lehman Brothers disaster.  It worked back then but may not be quite so successful again, says Karen Ward, senior global economist at HSBC who worked on the EMI report. Ward notes that China, in contrast to Brazil, has been measured in its monetary easing this year, even though its growth too is slowing.

China learned its lesson from 2009 and is revamping its stimulus strategy but Brazil is back to doing what it did last time, trying to tempt the consumer, and it is not having the desired effect.  They should be thinking more imaginatively about the kind of stimulus they want. Brazil and India are trying to look at reviving third quarter growth but they should take a leaf from China’s book in terms of using fiscal policy more effectively to generate better quality growth.

Michael Henderson of Capital Economics points out that growth in recent years was propelled by a credit boom and commodity-linked inflows but neither of these factors is now in place. On the other hand, rates of savings and investment remain low at less than 20 percent of GDP (in Asia they are between 30-50 percent). He says: