Hanging in the balance

FX & MM, 22 Mar 2010

Uncertainty continues to stalk the markets already rattled by the continuing Greek debt debacle. For instance, the Bank of England’s trade-weighted sterling index dropped like a stone in the wake of the currency’s swift fall against major currencies, principally in response to concerns that the imminent general election will result in a hung parliament. Drew Hillier reports how the world’s delicate economic recovery remains dangling, literally, by a thread.

Latest UK figures show how Gordon Brown’s fag-end government was obliged to borrow £4.3bn in January merely to plug the growing hole in the country’s finances, a move which Andrew Goodwin, senior economic advisor to the highly regarded Ernst & Young ITEM Club, summed up the general reaction in two words: “pretty ghastly”. In the grand scheme of things, of course £4.3bn might not sounds a lot, but as Mark Deans, Corporate Client Dealing Manager, Moneycorp, reminds us, the timing is key. “Since records began (in 1993), tax payments have always made January a month of surplus for the national coffers. And investors expected another £2.8 billion to roll in this time around” says Deans, who concludes: “When they saw a deficit the alarm bells rang once again, with The Times claiming, ‘On borrowed time: shock deficit threatens UK recovery.’ The FX market sympathised with that sentiment, as it did with the Telegraph’s ‘Britain at risk of worse deficit crisis than Greece’.”

Stirring into the mix the additional ingredients of political uncertainty and Prudential's monster acquisition of AIG's Asia operation, then - as Nick Beecroft, Senior FX Consultant at Saxo Bank - says, "sterling has sailed into a Perfect Storm of negativity." Thus, at the time of writing, the UK currency finds itself languishing at a 10-month low amid the realisation, based upon opinion poll projections, which suggested the Likeliest outcome of the upcoming UK election will result in a hung parliament. Prime Minister Brown has to go to the country by June, until which time, the GBP looks set for a white-knuckle ride as the fiscal face-off between the opposing
Conservative and Labour parties keep the UK's hefty deficit in the headlines. Generally, analysts are united that foreign exchange markets are likely to keep up the pressure on sterling, at least until they see the detailed tax and spending plans of whatever
government gains power. Meanwhile, "the prospect of maintaining the current Government for another few years," said Hans Redeker head currency strategist at BNP Paribas, suggests "the markets have
reacted and are giving a vote of no confidence in Gordon Brown."
Not helping matters, the world's biggest bond fund manager, PIMCO (or Pacific Investment Management Company, the California based unit of German insurance giant Allianz) has gone on record saying he is concerned about UK government debt unless drastic action is taken. PIMCO'sh ead, Mohamed El-Erian, told BBC World News that
the UK's creditors would become "significantly concerned" if the UK did not cut spending and grow quickly. Reminding us to keep a sense of perspective, David Bloom, head of foreign exchange strategy at HSBC, reckons once the election is out of the way, attention will
turn to another large economy with a devastated financial sector, a spiraling budget deficit and an election in the offing:
the US, where the state of the public finances is likely to be a key issue in the November mid-terms.

US DOUBLE-DIP?
The US Federal Reserve repeated its vow to keep rates exceptionally low for an extended period, with boss Bernanke at pains to point
out that the move did not mean it had changed its outlook for the economy or monetary policy. But investors were nevertheless wary that the decision represented an important step in its exit
from the liquidity measures deemed crucial in supporting assets during the past year. The elephant in this particular room,
however, must be the fear that US growth will fall when President Barack Obama's $787bn fiscal stimulus package comes to an
end, with some openly raising the spectre of a double-dip recession and a return to economic contraction. But it isn't a foregone
conclusion. John Silva, chief economist at Wells Fargo, is not a double-dipper, pointing out how, "...historically, the double-dip of
1980-82 was driven by a sharp change in monetary policy."
Instead, Silva prefers to see the current recovery being led by federal spending and gradual recovery in consumer spending and
business investment. "I do not expect the Obama administration to make any drastic turn in fiscal policy," says Silva, adding that
low inflation "will stay and allow the Fed to maintain low short-term rates, with only a limited decline in the balance sheet."

EUROLAND
Anxiety about the health of the euro, which has spread from Greece to Portugal, Spain, Ireland and Italy, is not simply a crisis of debts, rating agencies and volatile markets. The issue has at its heart elements of a political crisis, because it goes to the central dilemma of the European Union: the continuing grip of individual states over
economic and fiscal policy, which makes it difficult for the union as a whole to exercise the political leadership needed to deal
effectively with a crisis. Ken Dickson, Investment Director
Money Markets and Foreign Exchange, Standard Life Investments, says how some commentators are concerned about the
possibility of default by some European governments, "potentially forcing a member to leave the EMU. A sizeable build-up of
government debt in parts of the Eurozone raises this default risk," comments Dickson, who also foretells of similar growth in
current account deficits in these countries forces a reliance on "imported capital to fund bank and public debt." In Dickson's
view, the probability of a member leaving the Euro is very low as EMU is a political construction. "Contagion would become rife if one country was forced out of EMU. Hence, it is expected that eventually there will be sufficient funds, from a range of European institutions, to help countries adjust over time to the pressures they face. "Nevertheless," adds Dickson, "we remain negative on the Euro currency for the foreseeable future. We already expected European growth rates to underperform and we note, even after the recent events, that the common currency remains significantly over-valued."
When the euro was launched critics said you couLdn't have a currency used by 16 countries where "one size fits all". The past 10 years seemed to prove the critics wrong but now those early doubts are returning. As it is, the IMF stands in the wings, ready and willing to administer its harsh medicine. Adding fuel to that particular fire, ex-IMF chief economist Simon Johnson, reckons the UK should be seen in the same category of countries as Greece and Spain. Johnson also described the G7 group of leading economies as "fundamentally useless". Johnson may no longer speak exclusively for the IMF, but as
its former chief economist, his proclamations certainly carry a lot of weight. "The G7 countries are completely asleep at the wheel," continued Johnson. "I looked at the information they put out from their meeting I was absolutely shocked," he said, adding that the G7 "seem to show no awareness at all that much of Europe is facing a serious crisis and it's not limited to Spain, Greece and Portugal, it's also going to include Ireland. I think Italy is also very much in the line of fire. There's a very serious crisis inside the Eurozone." Enter, stage left, Greece. Certainly the so-called European Dream is being "tested to its core," says Simon Denham, MD of Capital Spreads, referring to the Greek bailout, the cost of which "will take years if not decades
to recover from." Denham adds that "we're not just talking about banks anymore, but countries who in the past few years have
spent and spent and spent. The PIIGS have to achieve the near impossible by reducing their deficits whilst at the same sustaining
growth and expanding. Such drastic measures are the civil unrest that we've had a little taste of so far will most Likely augment." George Dowd, First Vice President, Head of Chicago Foreign Exchange, Newedge Group, highlights how the market is still very focused on whether or not there will be any contagion through the other vulnerable PUG economies. "The yield spread of Greek sovereign bonds to German Bunds has started to widen out again and is currently
approaching its recent widest point. Greek Credit Default Swaps are also well bid," says Dowd, who identifies the debate on Greece seemingly centred on two main themes. "First," says Dowd, "is it politically feasible for Germany to endorse a Greek rescue plan? German Chancellor Merkel has been critical of the Greek falsification of statistics that has recently come to light. And the Greeks' recent accusation of Nazi era gold thefts and demands for war reparations has done nothing to increase their image in the eyes of most German
voters. Second," adds Dowd, "is it politically feasible for the Greek government to carry out their proposed austerity measures? Greece's two biggest unions, the ADEDY and GSEE have threatened strikes and further austerity measures from the government could make matters worse," Dowd concludes. In any event, as Luxembourg Prime
Minister Jean-Claude Juncker proclaimed recently, "Greece won't get "money for free," and would first have to satisfy other European governments that it has done all it can." Such statements effectively run counter to EU treaty clauses restricting bailouts of euro member countries, and show how the global financial crisis is pushing
reluctant European governments toward deeper economic and political integration.

THANK GOODNESS FOR ASIA!
Away from the febrile goings on in Euroland, where it remains to be seen whether investors will wait patiently for a satisfactory outcome, or - as Moneycorp's Mark Deans says - they will take the view that hope deferred is hope denied. Over in East Asia, the Chinese yuan faces a very different problem; if a self-inflicted undervaluation
can be called a problem. China, India and other emerging Asian countries have caught the full attention of investors over the past year. With near triple-digit stock returns and world-beating economic growth prospects, it's easy to see why. Developing markets in Latin America, on the other hand, have often been ignored. But being an impressive growth engine in its own right that also boasts attractive relative valuations, investors are bound to start taking more notice.
More tactically, however, the region stands out from emerging Asia, says Simona Paravani, global investment strategist, HSBC Global Asset Management. Ms. Parvani said Latin American equities are trading at a discount to Asian stocks, which does not appear justified
based on future earnings growth. "Our view on Brazil's GDP growth
in 2010 is more bullish than consensus, driven by a rebound in domestic demand as witnessed by recent retail sales growth,"
she said. "In addition, due to its commodity based economies, Asian economic growth will benefit Latin American economies," Ms Parvani concluded.