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In 2012, policy makers around the
world may be driven by the realization that the theme of 2011 was not a
Euro-specific crisis, but simply another stage in a global financial crisis.
Central bankers may ramp up their printing presses in an effort to limit "contagion"
concerns. As such, the currency markets may be the purest way to take a view
on the "mania" of policy makers. Market movements may continue to
be largely driven by political rhetoric, rather than company earnings
announcements or economic data. We don't believe this trend will abate over
the foreseeable future, especially given the likely leadership changes
throughout several G-7 nations.
The primary motivating force behind
politicians' decision-making may be quite different, and more often than not,
at odds with those of the broader market or sound economic fundamentals.
Moreover, we have witnessed an unprecedented period of political posturing
and increased polarization of views. This has only served to underpin the
increased levels of market volatility experienced in 2011.
Central banks of the U.S., Japan and
the U.K. have shown they are most willing to put in place expansionary
policies. For one, there will be a more dovish composition of Federal Open
Market Committee (FOMC) voting members in 2012. Many Western and Asian policy
makers have already begun to ease. From a currency perspective, we believe
these dynamics will serve to benefit the currencies of commodity producing
nations, while underpinning Asian economic growth.
Local agitations...
The European sovereign debt crisis
dominated headlines for much of 2011. Market practitioners traded on the back
of any change in sentiment regarding the ability of policy makers to put in
place comprehensive measures to address the issues. Initially focused on the
nations of Greece, Ireland, Italy, Portugal and Spain, the crisis quickly
grew to engulf many core European countries, even having an effect on
stalwart Germany, which suffered a failed bond auction towards the end of the
year. Nonetheless, sovereign spreads over corresponding German bunds were
used as a bellwether for market-ascribed fiscal health of European countries;
we saw many spreads widen markedly during 2011.
Any communication from Germany
(Merkel) and France (Sarkozy) was closely watched. Colloquially known as
"Merkozy," the two leaders took it upon
themselves to meet ahead of important EU summits to set the stage for
subsequent discussions amongst Heads of State. Notwithstanding, differences
in culture and communication only added to market uncertainty. On the one
hand, the French approach appeared to set the bar high, providing optimistic
assessments on the outcome of upcoming meetings. In contrast, the Germans
tended to be the polar opposite, managing expectations to the downside. More
broadly, the differences in cultures and motives across Europe were
epitomized when, after EU leaders painstakingly came to agreement on measures
to address sovereign debt risks in October, then-Greek Prime Minister
Papandreou announced a surprise referendum to vote on whether the Greek
populace backed implementing the austerity measures that were just agreed on.
Many in Europe took this as a slap in the face. After all, amongst the agreed
upon measures was a 50% "haircut" to be applied to Greek government
bonds and an additional injection of €130 billion into Greece. Not
surprisingly, Merkozy told Papandreou, in no
uncertain terms, that if he was to go ahead with the referendum, then the
Greek populace would have to be asked whether Greece should remain part of
the EU and the euro, and by the way, Greece would not receive any aid until
the referendum results were finalized, as there was no certainty that Greece
would still be a part of the EU. Not surprisingly, Papandreou backed down
from the proposed referendum. Ultimately, though, he probably got what he
wanted: to resign and leave the debacle behind him, but not before giving the
markets a heart attack in the process.
The above example is indicative of
the varying motivations that influence different factions within the EU (not
to mention Italy's Berlusconi, or the U.K.'s recent
decision to veto proposed EU-wide fiscal changes). Moreover, it is not a
Europe-specific trait, but a global one: look at the debt ceiling debacle as
a prime example of the shambolic state the U.S. political system finds itself
in. Indeed, that event prompted S&P to subsequently downgrade the credit
rating of the U.S., citing politicians' inability to come to an agreement
when it was most needed, as a leading cause. This severely affected market
optimism and confidence, further weakening the market's trust in politicians.
Compounding matters, Moody's moved the U.S. credit outlook from
"stable" to "negative" on the back of the "Super
Committee" failing to come up with anything regarding a sustainable
long-term fiscal outlook. Political bickering is nothing new, but it appears
we have entered a period of increased polarization. Importantly, this dynamic
is unlikely to abate over the foreseeable future. Unfortunately, it is likely
to result in ongoing market confusion and enhanced levels of volatility into
2012.
Ongoing political uncertainty is
likely to continue to weigh on markets. With ongoing financial tensions in
Europe evolving into contagion risks to global economic growth, we believe
central banks around the world may begin another round of expansionary
monetary policies in 2012. The process is already underway - policy makers in
Asia, notably China, have already begun relaxing policies, while the central
banks of Australia, Norway, Sweden and the ECB have all cut target rates.
There will be a much more dovish composition of FOMC voting members in 2012
and the central banks of Japan and the U.K. have also shown they are most
willing to put in place expansionary policies. We believe these trends will
benefit the currencies of commodity producing nations, as well as the Asian
region.
In Europe, we are likely to witness a
protracted process towards greater integration, but we must stress that it is
unlikely to happen in a timely fashion. We have long argued that the process
will be drawn-out and likely to be ugly at times. That's because policy
makers have differing motivations - namely reelection and thus, pandering to
their respective constituencies - that muddies the political debate. The market
simply needs to come to grips with this reality. Importantly, we don't
believe it is in any country's interest to leave the Eurozone, either weak or
strong. Former Greek Prime Minister Papandreou's quick decision to cancel the
referendum as soon as Greece's euro membership came into question is a prime
example. On the other side of the coin, Germany's economy would be nowhere
near as strong as it is today if it weren't a part of the euro; Germany is
effectively operating with an artificially weak Deutschemark, which has
propelled its export-driven economy, and policy makers realize this. That
said, we do believe that sovereign nations may
eventually default, Greece being the primary candidate, but if the European
financial system is adequately protected, the Eurozone may ultimately emerge
from this crisis stronger.
Germany in particular, finds itself
in a challenging situation. The Eurozone needs a clear leader, a country to
steer the bloc in the right direction and implement tough decisions and
fiscal austerity across nations, for the good of the whole. Germany is the
natural choice for such a role, but given its history in Europe, the Germans
still appear reticent to take up this mantle. They are in a tough position,
not wanting to be seen as imposing their will on the European populace, yet
understanding some form of fiscal discipline is sorely needed. This only
compounds the problems faced in Europe and is likely to exacerbate the length
of time to come to agreement on comprehensive reform.
Our view is that European politicians
must focus on saving the financial industry - European banks - instead of
overtly focusing on the sovereigns themselves. Unfortunately, political
dynamics and realities make this very difficult. To protect their respective
financial industries, the fiscal position of sovereigns must be compromised;
politicians have to make the choice to essentially sacrifice their country's
credit ratings for the good of the whole. This is politically unpalatable,
but in our view, an eventuality should the Eurozone survive. Politicians need
to embrace this reality; the problem is that it could be a very messy road
getting to that point. Furthermore, politicians are not known for taking
proactive decisions, for the obvious reason that should the decision prove
unpopular or disastrous, they lose their job. In this context, it is the bond
market that has been forcing policymaker's hands. It is only when spreads
widen to such a level that funding costs threaten long-term fiscal sustainability, that politicians jump to action. Said
another way: market volatility and stress is implicitly required for
politicians to implement any substantive reform.
Global ramifications...
This dynamic has been seen in the
Eurozone, but is lacking in the U.S. The bond markets haven't forced
Washington to implement any stringent austerity measures to date. It is
likely that Europe continues to muddle through, putting in place piecemeal
fixes, as markets force politicians into action. What is sorely needed is a
defined process that clarifies how rescue funds are to be deployed, which may
help mitigate the patchwork approach to addressing issues anytime a crisis
flares up. Nonetheless, austerity measures have been put in place in Europe,
and on this front; Europe is ahead of the curve relative to the U.S.
What is important to realize is that
this is not a Europe-specific problem; it is a truly global one. We believe a
key reason why central banks decided upon their coordinated action to provide
dollar swap facilities (primarily aimed at thawing European dollar funding)
was to alleviate global contagion fears. Indeed, after the announcement,
Asian currencies exhibited some of the greatest strength. In our opinion,
there is a very good reason for this. Asian countries may have the most at
risk should the European banks decide to pare down their dollar exposures.
The coordinated action was aimed at
putting a cap on the cost to access dollar funding via the swap market for
European banks. These costs were approaching untenable levels. The Fed
provided the ECB with cheaper access to dollar funding so that the ECB could,
in turn, provide such funding to the European financial industry. The ECB
also relaxed collateral requirements, making it cheaper to access such
funding. European banks were demanding dollar liabilities (through the swap
market, swapping euro payments for dollar payments). Why? To manage asset and
liability risks. A bank aims to approximately match asset-liability risks,
such as duration and currency exposures, such that market movements have
little effect on the equity component of their capital structure. In this
circumstance, European banks were demanding dollar liabilities to match
dollar-denominated assets. The largest assets for a bank are typically loans;
thus as the costs to access dollar liabilities increased, so too did the risk
that European banks would simply pare down dollar-denominated loans.
So why did Asian economies benefit
from the dollar swap announcement? In our view, it is because Asian
businesses have accessed dollar denominated loans from European banks; the
dollar-denominated assets sitting on European banks books are loans made to
emerging market Asian economies, amongst others. Asian businesses' reliance
on European funding may have been magnified with restrictive policies put in
place in the region. For instance, China had increased the reserve
requirements for domestic banks and in some cases restricted lending
altogether. Therefore, Asian economic growth may be at risk should European
banks decide to pare down their dollar-denominated assets.
Faced with rising costs to access
dollar liabilities, a bank has options: stomach and/or pass on the increased
costs, raise more capital, or pare down dollar-denominated assets
(de-leverage). With the coordinated announcement, the intent was to limit
costs; concurrently, however, policies are incentivizing de-leveraging.
The inherent design of bank
regulation carries much of the blame. National regulators typically consider
their own government debt risk-free. In the U.S., Treasuries are risk-free by
regulation. Similarly, European banks are incentivized to carry much of their
capital in their respective sovereign debt, as those securities comply with
capitalization rules. This has caused significant stress in the inter-bank
lending market, where those banks perceived to have large exposures to risky
sovereigns (e.g. Greece, Italy) are shunned. In
Europe, where each Eurozone government regulates its own banking system, it's
urgently necessarily to centralize bank regulation, so that each member
country's bank is not ex-ante over-exposed to their own government paper.
Naturally, the respective governments are opposed to such moves, as it may
increase the cost of government funding, should banks have to evaluate the
creditworthiness of their own governments.
Rather, banks appear to favor
following a concerted effort to shrink outstanding loans to meet capital
requirements. Indeed, PriceWaterhouseCoopers
recently noted that European banks are expected to sell unprecedented levels
of loan portfolios over the foreseeable future. Those same loans underpin
ongoing business investment and expansion. Moreover, much of the
dollar-denominated loans have been made to emerging economies in Asia and
Eastern Europe; given that Asia has been the engine of global growth, there
is a significant risk to the outlook for the global economy. This is why it
is a truly global problem.
What the world needs is a change of
oil, to keep the motor running smoothly; indeed, Chinese policy makers
recently reversed the aforementioned restrictive policies, relaxing required
reserve ratios for banks and even temporarily weakening the currency (albeit
moderately). Chinese issuance of dim sum bonds in Hong Kong has exploded in
recent times, and may be an additional source of funding that will take an evermore-important role in substituting European bank
financing, should European banks continue to pare-down assets. Indeed, the
three biggest underwriters of dim sum bonds - HSBC, Standard Chartered, and
Deutsche Bank anticipate that issuance will double in 2012. Other Asian
policy makers have followed step, implementing easier policies and in many
cases, intervening to weaken their respective currencies. We believe this is
the start of another period of easier monetary policy globally.
With ongoing European bank
deleveraging acting as a headwind to global growth, central banks are likely
to favor a more expansionary stance in 2012. We have already witnessed the
central banks of Australia, Norway, Sweden and the ECB cut target rates. The
ECB in particular has also offered two three-year long-term refinancing
operations (LTROs), the first of which garnered demand from 523 banks for a
total of €489.2 billion (approximately €193 billion in additional
lending). We believe it is only time before the Fed, Bank of Japan and Bank
of England get back on the horse and restart their printing presses. In the
U.S., the composition of voting members of the FOMC is set to become much
more dovish in 2012. The Bank of England has shown the willingness to expand
the balance sheet even with inflation running around 5%, and the Bank of
Japan has applied expansionary policies to the purchase of a broad range of
asset classes, including listed REITs, ETFs and corporate debt. Should we
enter another period of easy monetary policy, we believe the beneficiaries
will be the economies of commodity-producing nations, and in turn result in
strength of their respective currencies.
Asia matures...
In 2012, we will also witness one of
the more significant leadership changes of recent years - we're not talking
about the U.S. Presidential election in November, but the transition of power
in China. The Communist Party is set to appoint seven new members to the
currently nine-member Politburo Standing Committee - China's topmost
leadership body. Xi Jinping and Li Keqiang are set to become the President and Premier of
State, respectively, replacing Hu Jintao and Wen Jiabao.
Given that China maintains centralized government control over much of the
country, even a marginal change in leadership composition may have deep and
far reaching implications for China and investors globally. We believe that
current and expected initiatives, in concert with economic realities and
political dynamics, are likely to lead to the adoption of more flexible
market dynamics and ongoing gradual strengthening of the Chinese currency
through 2012.
We consider China will increasingly
focus on growing the domestic economy and middle class, while relying less on
the export sector as a driver of economic growth. Moreover, Chinese
politicians are likely to allow a gradual appreciation of the Chinese Renminbi, as a natural valve in addressing inflationary
pressures. For an in-depth analysis of the implications of China's leadership
transition, please read our White Paper
on the topic.
In the U.S., it is unlikely that
long-term fiscal reform will be implemented ahead of the November election.
That said, the debt-ceiling debacle and inability of
the Super Committee to come to agreement has only frayed the confidence in
Washington. Ultimately, we believe these dynamics serve to erode the safe
haven status the U.S. dollar has held for so long, and combined with the Fed
reopening the monetary floodgates, may underpin ongoing weakness in the U.S.
dollar. We continue to see asymmetric risks to the outlook for U.S.
Government paper. Should the market aggressively price-in the unsustainable
fiscal situation, we may witness a substantial increase in yields. Such an
event may precipitate government action similar to that seen in Europe.
Unfortunately, the market is simply not applying the pressure on Washington,
seemingly giving U.S. policy makers a pass. As such, there is little
incentive to implement fiscal reform in the U.S. and thus the long-term
situation is likely to deteriorate over the near term. On a relative basis,
those countries that are putting measures in place to get their houses in
order may appear more attractive investment propositions.
With so many dynamics set to unfold
throughout 2012, we are excited by the potential investment opportunities, Specifically, we believe strategic value may be found
outside of the U.S. dollar, in the Asian region and commodity producing
nations.
Axel Merk
Manager, Merk Hard Currency Fund
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