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So what is going on? As I wrote in my outlook for the year, one of the few things I have learned in my career is to be careful of a lazy consensus when it comes to financial markets. As we came into the year, it seemed to me that the notion of a crippled crisis-ridden Europe was front and centre of most people’s expectations for the year we are now into. While the European Monetary Union (EMU) indeed has lots of serious dilemmas and many of the smaller, so-called peripheral countries have major challenges; this is only part of the equation. Let me take each of the three major financial instruments separately: currency, bonds and equities. But before I do that, I want to start by focusing on the critical topic of Germany and its economy and mood. GERMAN GROWTH POWERING AHEAD As I tried to point out to large group of macro investors in New York this week, many people believe that Europe’s problems can bring the world down, but that is very unlikely unless of course they bring down their own economies first. In order for that to happen, it would have to start showing signs in published data. Germany is about one third of the Euro Area and, last year, Germany essentially boomed, growing by 3.4 pct. Last week , Germany’s all-important monthly IFO index of business confidence showed a stronger than expected rise. This index is one of the more accurate leading indicators, not only for Germany, but also for the rest of Europe. The strength of the index immediately raises the possibility that German growth will surprise on the upside again. Looking at many German indicators in detail – including employment and unemployment – as Francesca Fornasari, one of GSAM’s currency portfolio managers pointed out to me this week, in a direct comparison between the US and Germany, Germany would currently win hands down. And this is despite the improved state of health that the US is showing. Of particular importance, Germany continues to show signs of improving domestic confidence, especially for its consumer. On some level, Germany is showing its most balanced expansion since its pre-unification days. Against this background, many German policymakers and commentators are not surprisingly thinking that perhaps all is not wrong with German economic policies, and perhaps others shouldn’t lecture them so much. Indeed, on many levels, the current strength of the German economy has a direct link to the EMU crisis. Probably in two ways. One, it encourages German policymakers to think that their policies should be adopted by others. Two, the accommodative stance of ECB monetary policy is perhaps adding to the momentum of domestic spending in Germany. And, if it weren’t for the crisis, this might not be quite the case. i.e., the crisis had caused Euro Area financial conditions to be easier than otherwise. Despite the immense challenges for many troubled EMU countries, the importance of the German economy for many cannot be ignored. Indeed, this is at the core of why the EMU exists, since inter-Euro Area trade is so important and, for most, Germany is their key trading partner. I haven’t seen the details within the IFO, but it is generally a good leading indicator for Europe, not just Germany. The strength reported in the Belgian and French leading indicators simply adds to this impression. EUROPEAN PERIPHERAL BONDS The peripheral bond market has seen a very strong rally in the past two weeks more than reversing the sharp declines in the first few days of the year, although spreads are still much wider than a year ago, or than at the beginning of the Winter. Why have they rallied? There are a number of related causes. First, a number of bond auctions have passed successfully in a few troubled countries, suggesting that there are some buyers out there. Second, the ECB has continued to buy bonds, although analysts don’t know in advance how much and when. In this regard, it can perhaps be regarded as akin to rather clever FX intervention of days gone past, something which a number of ECB staff, and their President, know a thing or two about. Third, important holders of wealth, notably those in Asia, have made it quite clear that they intended to buy peripheral European bonds, with China at the forefront of those that have aired such views. As I mentioned a couple of weeks ago, for me, the public statement made by Japanese policymakers that they intend to invest in the first fundraising by the EFSF was an especially important sign. Not only does it suggest that the co-operative spirit amongst G20 member countries is alive and well, but more importantly, this could be a critical signaling mechanism to Japanese institutional investors that it is “ok” to invest in European bonds. If it is ok for the policymakers, then it might just be for many of the private sector, with the Yen so expensive and peripheral yields so high relative to their liability needs. Why wouldn’t they consider investing for the first time in years? In this regard, it is very interesting to see some signs that the long post-crisis downtrend in the EUR/Yen exchange rate might be turning. Fourth, although there is the usual day-to-day confusion and alternative proposals, Europe’s policymakers seem to have identified their March meeting as a key event to put EMU and its finances on permanently better footing. Now we can never ignore Europe’s policymakers’ ability to disappoint, but that is an issue for after the meeting, not before. And, ahead of the March meeting, it is likely that we will hear more about ideas to “solve” the crisis. Not only in terms of a bigger rescue fund, if necessary, but also a better Growth and Stability Pact. Fifth and finally, a large number of professional investors have been short, and frankly, caught. Added to the above ingredients especially the fourth, and just as night follows day, a powerful move in the opposite direction to what the consensus positioning may have, and I don’t need to elaborate. We have all seen it before. EUROPEAN EQUITIES AND THE EURO For many of the same reasons, European peripheral equity markets have risen. Probably significant short positions, especially in banks, have been covered against the background of the above. What will now be interesting is that if the banks are less pressured, and if the German recovery deepens further, it is now conceivable that some of these doomed European economies, especially the more open ones, could positively surprise. While they have many troubles, at a time of the strength of the BRIC economies, and the recovery of Germany and the US, they are going to see some of that in their export sectors. Turning to the Euro, the mood is so lopsided. I have been in New York briefly twice already this year, and four separate people have asked me whether the Euro would survive the year! This is how strong the bias is. Just like any other currency, the Euro is a relative currency pair. If investors really don’t like the Euro because of its supposed fiscal problems, then take a closer look at other countries more closely. The GDP-weighted fiscal position of the Euro area is much better than that of the US, the UK and Japan. This is not a reason to be bearish on the Euro. If investors don’t like the Euro because they don’t have confidence about how a currency can survive for disparate countries, this is a stronger rationale than above, but not necessarily a new one. And, compared to a year ago, the Euro has one new member, not one less. As I said at the macro event in New York, while as humans we can opine as to what we think should happen, as investors, we should try to remain focused on what is likely to actually happen, rather than what should happen. Currencies are usually driven, not by the above, but by relative cyclical fundamentals and relative current and expectations about, future monetary policies. And, they usually move around an underlying trend that is driven by a nation's relative inflation rate and productivity trends. If you believe that the Fed will stay easy for ever, irrelevant of the speed of near term US recovery, then the Dollar is going to struggle to rally against anything. If you believe that the US recovery is still going to surprise people, possibly including even the Fed, then in fact, after this “surprise” rally in European markets, the Euro might ironically go back down again for a while. My basic stance remains the same. When the Euro moves 5 pct plus in one direction, as it is the most liquid currency in the world, then I would hesitate about chasing it. I can’t really see the case for the Euro/$ exchange rate to move outside a 1.20—1.40 range. There are strong reasons on both sides. Within that range, it seems to me that a lot of money can be made or lost, but you have to be careful of being with the crowd, especially when it is about to be wrong. OTHER THINGS Three other interesting observations for me this week. First, the latest weekly US job claims tend to confirm that there is a more sustained recovery taking hold in the US. Having been there twice in 3 weeks, I can also detect a growing, less negative, mood shift. This will probably result in more shifts in market pricing and suggests once more than the next monthly payroll data will get a lot of attention. Second, it adds to my view that the Yen is in the process of turning. The Yen is fundamentally overvalued, but it can be justified by what the Fed has done. If the US is indeed developing a stronger recovery, then the markets are going to reprice the future Fed path. The Yen will lose a lot of its gains if this occurs, especially if the EUR/Yen pressure is fading. Thirdly, a certain well known international business newspaper seems to have mistakenly decided that we/I am expanding the BRIC group. It is inaccurate. These four countries are in a league of their own within the changing world and, while there are more countries that should be regarded as “Growth Markets,” there are none that can be regarded to be as strong as Brazil, Russia, India and China. Jim O’Neill |
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