martedì 30 giugno 2009

Top strategists are looking for a fall in the euro against the US Dollar in H2 09, but we would not count on it

In our previous post How long will the Eurozone (and the ECB) cohabit with an overvalued Euro? 1) Why the euro’s fall is key for the Eurozone economy... we have highlighted how a devaluation of the Euro is the only possible source of growth for the Eurozone economy, at least in the short term. Indeed, a fall of the Euro is likely to have an immediate positive effect both on the countries running a strong current account deficit (i.e. Spain and Ireland) and on the countries with a high dependence on exports (i.e. Germany), even if the latter should be penalised by a slowdown in international trade.
History has clearly shown that a devaluation of the national currency is crucial to overcome a downturn. At the time of the Great Depression, the UK and Japan were the first countries to devalue their national currencies against the Gold (in September and December 1931 respectively) and enjoyed a milder recession than the US.
The Swiss have already expressed a desire to weaken the national currency. We believe that British Pound and US Dollar devaluation against the Euro in the last few months has not been seen as a “threat” by the UK and US Central Banks and Governments.
Nevertheless, this Euro uptrend may be close to an end according to currency strategists. In a recent survey conducted by Bloomberg, the strategists who delivered the best performances in predicting the Euro/USD exchange rate at the end of the first half of 2009, have seen it strengthening as much as 17 per cent in the second half of the year. Deutsche Bank’s Henrik Gullberg, for example, has seen the Euro/USD falling to 1.2 by year-end (a decrease to 1.2 will bring the Euro/USD to a value more in line with the PPP calculated by the OECD, as we suggested in our previous article). The reason for the decline is that the US is pulling itself out of recession at a faster pace than Europe.
Cristoph Kind of Frankfurt-Trust Investment GmbH said to Bloomberg: “If the situation stays as bad as it is, the dollar is a safe haven. And if the economy turns the corner, the U.S. will be the first to get out of the recession. On that basis, the dollar looks like a good investment. We are buying the dollar against the yen and the euro.”
However, for this trend to materialise (the US dollar regaining some ground in the face of an economic recovery) a shift in investors thinking is necessary. Indeed, signs of an economic upswing in the US have been followed by a US Dollar depreciation in the last few weeks.
All in all, we continue to see a series of factors that have the potential to weigh on the Euro in the short term:

  1. A robust US recovery is far from certain. Investors are probably overweighting the positive signals coming from the latest US macroeconomic data: consumer spending is likely to stay anaemic for a long time as consumers are rebuilding their private balance sheets and investments should remain stagnant due to the downtrend in consumer spending;

  2. The interest rate differential is likely to be against the Euro for a long time as we do not see the Federal Reserve rising the Fed Fund rate and the ECB cutting the rate considerably in the short term;

  3. A greater diversification of currency reserves by the BRIC countries is likely to negatively affect the greenback, although a meaningful shift away from the dollar is likely to take years or longer to materialise.

This is why Eurozone fiscal/monetary authorities should not count on a Euro weakening to see a recovery.

giovedì 25 giugno 2009

How long will the Eurozone (and the ECB) cohabit with an overvalued Euro? Why the euro’s fall is key for the Eurozone economy...

According to all major international agencies, 2009 and 2010 economic growth is likely to be more subdued in the Euro area than in the US. In their latest Reports, both the IMF and OECD have predicted a contraction above 4% for the Eurozone in 2009 with a slightly negative growth rate also expected in 2010. By contrast, the two agencies have estimated flat US growth in 2010 in the face of a less severe downturn in 2009 (-2.8% and -4% for the IMF and OECD respectively). In the recently published Global Development Finance report, the World Bank has been more positive on the Eurozone’s outlook for 2010, assuming a 0.5% growth rate. Nevertheless, this is well below the 1.8% rate forecast for the US.
All European countries have been hit hard by the global turmoil, even though for different reasons. Indeed, while countries such as Ireland and Spain have borne the brunt of the bursting of the housing bubble, Germany, Europe’s largest country, has suffered the consequences of a slowing international demand due to the manufacturing sector’s strong dependence on exports. France has weathered the crisis relatively well so far, while Italy has felt the pain of the credit crunch without the possibility of taking effective countermeasures as the high public debt level is a big constraint for the Italian government.
Notwithstanding the monetary and fiscal stimulus packages launched in the last few months, the outlook for the Eurozone remains gloomy. No economic factors are likely to provide any boost to economic growth.
The countries that have reaped the benefits of the house prices bubble in the last few years (i.e. Spain and Ireland), which increased consumer spending and broadened the current account deficit, are now paying for past excesses and should post modest growth (if not negative) in the years to come.
On the other hand, the countries that are highly dependent on exports (i.e. Germany) should not be favoured by an upswing in global demand, which should to remain sluggish for a long time. Indeed, demand in emerging markets is highly unlikely to offset a weakening demand trend in the US, at least in the near term. The real challenge facing these countries will be building a stronger domestic demand going forward.
With the Refi rate at 1% and the ECB unwilling to carry out a sweeping quantitative easing programme following the EUR60bn package established to fix the covered bond market, the only boost for the European economy could come from the Euro’s devaluation. A study presented in 2001 by some OECD’s economists (“Standard shocks in the OECD interlink model” by Dalsgaard, Andrè and Richardson) indicated in +0.6% both in the first and second year of estimate the increase in Eurozone GDP due to a 10% depreciation of the Euro. The projected rise in the inflation rate (+0.4% in the following two years) should not be cause for concern in this current scenario as the yearly inflation rate was flat in May and negative readings are expected in coming months.
Moreover, researches conducted by the INSEE and Morgan Stanley in the last few years have highlighted that Eurozone GDP would react to a currency shock with almost no lag, while a rate cut in short-term interest rates would take much longer to feed through the economy.
In spite of the decline against the US Dollar from the record level hit in 2008 (slightly above 1.60), the Euro remains overvalued against the greenback: according to the Purchasing Power Parities estimate of the OECD, for example, a fair Euro/Dollar exchange rate should be 1.20, implying depreciation potential of above 15% for the single currency. The nominal effective exchange rate relative to the 12 major international countries calculated by the ECB suggested that the Euro is 10% above the long-term average and various measures of real effective exchange rates painted a similar picture.
Based on the above-mentioned researches, it is easy to understand that the overvaluation of the Euro is heavily weighing on the economic prospects for the Euro area. A fall in the Euro to a level more in line with the long-term average and with the PPP should help lessen the uncertainty over the Eurozone outlook...

lunedì 22 giugno 2009


The last two years have been extraordinary for the global economy. The bursting of the credit and house price bubbles in the US and some European countries, following the eruption of the subprime crisis in the spring/summer of 2007, has brought the US economy, and the whole of the world economy owing to a domino effect, into a deep recession. An unbalanced world has found itself on the road to evil, particularly in the aftermath of the Lehman Brothers bankruptcy in September 2008. Fiscal and monetary authorities all around the world, albeit with a different magnitude, have had to implement tough expansionary measures to avert an economic collapse.

Some signs of economic recovery have emerged in the last few months but a rapid end of what is considered the worst recession since the great depression is far from certain. The economist’s consensus is for a world economy that will experience subdued growth in the years to come, but a lot of unanswered questions remain in place: when will the current recession end? What kind of growth can we expect? Will the crisis result in a more balanced and less leveraged world economy? What will be the likely repercussions of the economic stimulus packages approved in the US and the UK on the public budget? Is deflation the real threat or will the monetary stimulus spark an inflationary spiral? What will be the consequences of a more regulated financial world?
Finding an answer to these questions will be crucial to taking the most coherent investment decisions going forward. We will try to give our contribution to finding the right answers by analysing the main economic events from the perspective of a European economist and investor. However, the commentary in this blog in no way constitutes a solicitation of business or investment advice.