lunedì 17 agosto 2009

A weak Pound is welcome, BoE’s Governor King indicated

In the article What future for UK economy we highlighted that most economists believed that the Bank of England will be the first to implement an exit strategy from its expansionary monetary policy, (i.e. by raising interest rates), as the economic outlook has been improving and markets have been discounting that inflation will be higher in the United Kingdom than in the others major developed economies. However, the meeting of the Central Bank’s Monetary Policy Committee on August 6 and the Governor Mervin King’s press conference on Wednesday 12 indicated that the BoE’s exit strategy is far from close.

Indeed, the Bank of England’s projections both on economic growth and inflation have shown that the medium term outlook for the UK economy remains very uncertain. As regards the economic outlook, there were two main items of interest. The first one is that the signs of economic recovery appeared in the last few weeks (i.e. the manufacturing PMI’s increase above 50 in July and the PMI service’s jump at 17 months high), have not changed the medium-term economic base scenario: the British economy is likely to suffer the consequences of the last two years crisis’ for a long time. The second one is that even if the BoE forecasts for a return to a GDP growth of 3% y/y starting from the second half of 2010, in line with the average growth rate pre-crisis, were right, this would not be enough to close the gap with the lower growth recorded in the last two years, leaving intact the deflationary pressures. The process of debt reduction for companies and households, whose debt reached in Q1 the threshold of 173% of disposable income, will require many years. Personal consumptions should also be penalized by the negative trend of the labour market, which is expected to worsen over the coming months. To date, jobs losses (the number of unemployed exceeded 2.4 million) were less than in the previous recessions and a worsening of the labour market is very likely in the coming months: the number of unemployed is expected to exceed 3 million in the coming months. Consumptions and investments are also likely to be restrained by the tightening of the credit market as the banking sector is still in a bad way and it will take several years for it to repair balance sheets.

The main item of interest was the outlook for inflation. The Governor King indicated that the risk of a fall in deflation is higher than the risk of an unwelcome increase of inflation. Mr King said that a drop of inflation below 1%, which would force him to write a letter to the Chancellor of the Exchequer to explain why it was not complied with the inflation target of 2% with a tolerance limit of + / - 1%, is very likely in the autumn. The thesis of the Bank of England is that the risks of deflationary pressures are greater than the risks of higher inflationary pressures as the nominal expenditure and the monetary aggregates’ growth are expected to remain weak and the impact of the assets purchase program (it was increased to 175 billion Pounds on August 6) is difficult to assess.

The Bank of England’s projections indicated that should interest rates remain unchanged at 0.5% and the asset purchasing program unchanged at 175bn Pound throughout the reporting period, inflation is expected to reach the 2% target in 2 years, while should interest rates follow the trend implicit in the market rates the 2% level would not be reached. Therefore, this projections indicated that the market expectations that rates could rise to 4% in the last quarter of 2011 may be too optimistic about economic growth and inflation. For these reasons the main indication from the King’s press conference on Wednesday 12, was that the rates should be lower and for longer than expected by the investors.

Expectations of lower rate increases over the next few quarters weakened the Pound, risen during the week above 0.86 against the euro, breaking the downward trend started in December 2008 with the Euro/Sterling close to 1 that brought the exchange ratio below 0,85.

However, the Bank of England showed that the Sterling decline in 2008 played a positive role for economic recovery, both increasing the profitability of exporting companies and containing the deflationary pressures. Considering the general rule that an increase of 6% (the last quarter’s rebound in the Pound versus the others major currencies) corresponds to an increase in rates of 1,5%, it seems difficult that the Central Bank may accept passively a further Pound increase should this happen without an upward revision in the outlook for inflation. For these reasons, in the case of a new Sterling appreciation the Bank Of England may increase its expansionary monetary policy, with an increase of the Asset purchase program as the main possibility.

lunedì 10 agosto 2009

Does the ECB really need an exit strategy? The Euro/Dollar exchange rate factor…

During the last’s week press conference, the ECB’s president Jean Claude Trichet did not offered main item of interest, except confirming that the incipient economic recovery could be slightly better than expected. Mr Trichet also announced a slight upward revision of the Eurostaff Economists’ growth’s estimates in September.
The expectations that during the press conference Mr Trichet would have indicated some news about the future “exit strategy" from the strong monetary stimulus implemented in recent months were disappointed.
Notwithstanding the interest on the way the exit strategy will be carry out is very high, the moment of its implementation appears far from close.

Indeed, even if some positive macroeconomic data in the last few weeks have showed that the worse of the economic crisis might be behind us, other economic data have continued to indicate that the health of the major Eurozone economies remains very weak.

The main business and consumer confidence indexes, considered good leading indicators for the business cycle in the Euro area, have recorded signs of improvement from the low levels recorded at the beginning of the year but they have remained well below the historical average levels. As an example, the European Commission’s Economic Sentiment Index fell to an all time low at 60.4 in March and has recorded 4 consecutive increases since then, rising to 75 in July. However, this value is only slightly higher than the previous historical low at 74,2 recorded in 1992. The ECB’s tightening monetary policy in November '99 and December '05 began with the index above 100.

Furthermore, economic data better than expected, such as the surge of German industrial orders in June (+4.5% MoM, but -25.3% YoY), have come in coincidence with disappointing data, as the decline in June’s retail sales in the Eurozone and the fall of the Italian industrial production in June (-1.2% MoM and -21 , 9% YoY). The more disappointing pieces of news came from the fall in June’s German industrial production (-0.1% MoM versus consensus of +0.5% MoM).
Therefore, the recent published data have confirmed that the Refi rate should remain on a very low level for a long time. A useful benchmark for understanding the monetary policy’s perspective, the Taylor rule, illustrates that the need to raise rates should be present only in many quarters.

A tightening role for the Eurozone economy has been played since last March by the single European currency’s increase. Our monetary condition index, which consider the real exchange rate and short-term rates’ trend, remains well above the long-term historical average and it is likely to worsen in the coming months in the case of a further Euro’s increase and/or in the case of an inflation rebound, as penciled in by the ECB. The negative effect of the Euro’s rise against major international currencies on European economic growth was studied by the major international agencies. For example, the IMF estimated that a 10% increase in the Euro real exchange rate is followed by a lower economic growth between 0.25% and 0.75%.
Therefore, the upward trend of the Euro/Dollar could play a key role in the next ECB’s moves. It is no coincidence that Mr Trichet said during the last press conference that he considered appropriate the Fed chairman Bernanke and the US Treasury secretary Geithners’ statements in favor of a strong US Dollar.

Overall, the ECB’s monetary policy decisions could be influenced by the developments of the Euro should the international economies’ recovery be temporary, with the economy following a W-shaped profile (i.e. a rebound followed by a brief contraction and a growth in the future), as recently suggested by the professor of economics at New York University Nouriel Roubini, and not a V shaped profile. The fact that the recovery process has been led by strong fiscal and monetary stimulus, while many economic imbalances that have caused the crisis are far from being solved, makes it almost impossible that can be placed the end word on the international crisis in the short term. In this case, with a Euro strengthened against the US Dollar well above the Purchasing Power Parity estimated by the OECD (at 1,17), it is not excluded that the ECB might be forced to implement a new monetary stimulus well before they could implement any exit strategy.

domenica 2 agosto 2009

Overweighting emerging markets

Most international asset classes performed very well in July from European investors’ point of view. Indeed only few asset classes posted negative results, which were by the way broadly offset by the improvement in other asset classes, as was the case for investors holding a well-diversified portfolio. The negative performances came from the US and the UK bond and monetary markets and commodities, which were penalised by the Euro/Dollar exchange rate’s behaviour. By contrast, emerging markets equity indexes posted very positive performances.
The buoyant trend shown by international stock markets was inspired by US indexes, which were favoured by signs of recovery in the macroeconomic scenario and by above-estimate quarterly results in Q2 09. Therefore, assessing the outlook for the US stock market is crucial to predict the behaviour of major financial markets in the months to come. Corporate profits will represent the key variable. Following the positive surprises in Q2 09, analysts have become much more optimistic: based on Standard & Poor’s estimates, operating profits are expected to grow by 12% in 2009 and 33% in 2010. Corporate profits should therefore achieve the level seen in 2003, which is 37% lower than the 2006 historical high.

Nevertheless, the analysis of accounting profits provides some reasons to stay cautious about the extent of the above-mentioned improvement in profitability. On the one hand, the high spread between 10-year and 2-year US government bonds suggests that there is much likelihood that corporate profits will rise in coming quarters, on the other hand, the high level achieved by profit margins (accounting profits/GDP) in recent years shows that corporate profits will likely see modest growth going forward. Indeed profit margins, though decreasing from the historical highs hit in 2006, are still above the long-term historical average (7.2% vs 6%), in line with a future growth rate of around 3% per year based on a drop in profit margins and on the weighted average profit growth in the following 5 years.

Based on this simple model, corporate profits would be still lower than in 2006 in five years. Although the short-term prospects are relatively rosy for major US equity indexes due to the forecast rise in profits, European investors should overweight equity markets other than the US. Indeed, in the short term the upward trend of US indices could be accompanied by a decline in the US Dollar against the Euro, in line with the trend shown in recent months. But investors willing to bet on a continued upward trend in major international equity indices should overweight emerging markets. Indeed, over the last few months emerging markets have enjoyed much greater strength relative to western markets and could continue to do so in the months ahead. Emerging markets could benefit from the recovery of leading western economies, from the bounce in commodity prices (which would boost exports), and from a lower risk premium on international financial markets.

The trend of a declining risk premium on financial markets will also likely benefit emerging countries’ bond market.

The western bond market outlook is clouded in uncertainty. The US bond market scenario is similar to that of the Eurozone. Over the last few months the yield curve has steepened sharply, with the differential between 10-year and 3-month T-Bond exceeding 3% in the US. This phenomenon has been usually followed by a decline in long-term bond yields and an increase in short term bond yields. However, investing in long-term US government bonds could prove to be risky in the face of the low yields they carry, which could fall even sharper due to either a weakening of the US dollar or to an even slight increase in inflation expectations. As regards the European bond market, failing exchange rate risks the short end of the curve will likely benefit from the fact that the ECB is highly unlikely to raise interest rates for several months. The long end of the curve, although offering a greater risk profile, could be positively affected by contained inflation expectations going forward and by the convergence of government bonds of peripheral countries running large current account deficit following the widening of the spread in recent months. Betting on high-rated corporate bonds might be an alternative to invest in bond markets and obtain higher yields. Indeed, corporate bonds could benefit from a lower risk premium on financial markets even though the spreads have already contracted sharply in recent months.