Critical Macro Investment Themes for 2008
January 04, 2008
By Richard Berner | New York
For the first time in seven years, I approach my annual thematic forecasting ritual on a distinctly downbeat note. Small wonder: The downside risks in last year’s outlook morphed into the Crunch of 2007, which is still playing out. In contrast, at the start of 2007, I focused on the notion that a resilient global economy would promote higher real interest rates. While widespread complacency about risk premiums made me nervous, and I foresaw liquidity dwindling and market volatility rising, I relegated big market moves to ‘tail events’ that seemed unlikely (see “Critical Macro Investment Themes for 2007,” Global Economic Forum, January 3, 2007).
That was then. Today, the tail events have moved to center stage and real yields have plunged 100 bp from their peaks in June. I think the crunch of 2007 will still influence markets and economic outcomes in the coming year. Several of our market conclusions may be surprising. In my view and that of our strategy teams, investors in 2008 should anticipate a stronger dollar, wider transatlantic yield spreads, and a further steepening of global yield curves. These market conclusions flow from the confluence of four critical macro themes. The first two relate to growth: A mild US recession is coming; and US and global growth will recouple, with growth slowing abroad. The third theme is a key reason behind that slowing: The reintermediation of the US and European banking systems will continue, adding to financial restraint. Finally, a significant reregulation of US financial services firms is likely, adding to restraint. I’ll start with the four themes and work back to market conclusions. Theme I: A Mild US Recession Although it has yet to begin, our call for a mild US recession is intact: We expect domestic demand to contract significantly in each of the next three quarters, essentially no growth in overall GDP for the year ending in the third quarter of 2008 and corporate earnings to contract by 5-10% over that period. Three factors triggered our call: Global growth — for us, long the key bulwark against a downturn — is slowing, financial conditions continue to tighten, and domestic economic weakness is broadening into capital spending (see “Recession Coming,” Investment Perspectives, December 13, 2007). Even if the data do not immediately point to such weakness, we think the Fed will insure against these downside risks. Fed officials have indicated that they will continue the Term Auction Facility (TAF) launched in mid-December for as long as needed to realign interbank lending with policy interest rates. However, easing strains in money markets is only one offset to the tightening of financial conditions. To cushion the coming weakness in growth, we also think officials will reduce the Federal funds rate by at least another 75 bp over the next 7-9 months. Such easing will contribute to a steeper US yield curve, but it is important to note that much of this future policy action is in the price, according to Fed funds futures. Theme II: Recoupling of Global Growth The resilience of the global economy — and its “decoupling” from the US slowdown — was a major theme for investors in 2007: Divergent growth rates promoted wider short-term US-overseas interest rate differentials, a weaker dollar, a collapse of transatlantic bond yield spreads (and a move into negative territory), and outperformance of large-capitalization, globally-exposed US growth companies. In contrast, global “recoupling” may well be the dominant issue for the coming year. Global resilience remains a key ingredient in our view that the US recession will be a mild one and the asynchronous character of the global economy will persist this year. However, our baseline global outlook includes a pronounced slowing this year, especially in Europe, the UK, and Japan, resulting in global GDP growth of 4.3% and thus the potential for lower interest rates than are currently priced into those three markets. As detailed below, recoupling is a critical ingredient in our calls for a stronger dollar and a reversal of transatlantic spreads. Courtesy of the turmoil in global credit markets, the coming global downshift will likely mask considerable regional disparities. We expect growth in the industrial world to slow to only 1.4%, while the developing economies, led by China, will hardly miss a beat. But the credit turmoil threatens to cause even weaker growth outside the US as the US downturn spills over into other economies. Critical to the global call is the expected resilience of Asian, LatAm and OPEC economies. Whether the knock-on effects on exports from China, Mexico, Canada, Japan, and other Asian economies tied to China’s supply chain will overwhelm their increasingly strong domestic demand remains uncertain. With China tightening into the teeth of this slowdown, the risks are on the downside of this baseline scenario. With policies in the industrial world turning stimulative, however, we expect a re-acceleration to 4.9% global growth in 2009. Theme III: Reintermediation and recapitalization The third theme is an extension of one begun this summer: The deleveraging and “reintermediation” of the banking and financial system and associated needs for capital that will last well into 2008. That process has reduced risk appetite, raised the price and reduced the availability of credit, thus tightening financial conditions. We see this tightening lasting through midyear. Deleveraging means that institutions and investors are selling assets out of their portfolios or are being forced to take back onto their balance sheets assets previously funded off the balance sheet in Special Investment Vehicles (SIVs) and/or conduits. Issuers unable to roll over maturing asset-backed commercial paper (ABCP) beginning in August called on their bank sponsors to absorb the commitments they made to back them up. In turn, this ‘reintermediation’ of the global banking system is producing a contraction in credit and an increase in its cost — that is, spreads are widening as intermediaries prize liquidity or sell lower-quality assets. Reintermediation promotes a pro-cyclical credit contraction in three ways. First, it forces a shift from a funding source that requires no or very little capital (the SIV or conduit) to one that requires considerable capital, reducing financial leverage. Second, in classic, pro-cyclical fashion, banks are raising the cost of new liquidity and credit facilities; they are now selling such options at prices more appropriate to the risk in today’s market. My colleagues Betsy Graseck and George Goncalves agree that this new pricing regime won’t evaporate any time soon (see Betsy’s “Higher Funding Costs and Higher Credit Losses Drive Down 2008 Estimates,” December 24, 2007, and George’s and Laurence Mutkin’s “Hopeful New Year: Money Market Update,” December 21, 2007). Credit rating downgrades on the structured products moving to bank balance sheets will also hike capital requirements and tighten credit availability. Finally, although European banks are well capitalized for now and can absorb further writedowns, our European banks team believes that these institutions will nonetheless defensively raise capital to show strong capital ratios in a troubled macro environment (see Jackie Ineke, Lee Street and Javier Serna, “European Banks: Supply Shakes,” December 11, 2007). Those moves will further limit credit availability. The extent of this reintermediation process matters for both the cost of credit (as reflected in spreads) and its availability. US banks’ median Tier I capital ratio hasn’t dipped below the 6% “well-capitalized” level, but to prevent declines, banks still must either sell securities, raise new capital, limit lending, or some combination of the three. A proposed “Master Liquidity Enhancement Conduit” or “Super SIV” has been abandoned as banks decided that it was uneconomic, and they are bringing the bulk of SIV-held assets on their balance sheets. Significant capital injections from sovereign wealth funds and the aggressive actions by central banks to add liquidity to money markets have partly offset the effect on spreads of such reintermediation. Beyond the banks, other intermediaries are also in asset-reduction mode; markdowns could contribute to a $500 billion contraction in balance sheets on Wall St. (see “Funding Pressures: More Fundamental than Turn of Year,” Global Economic Forum, November 19, 2007). Moreover, unlike the past, when financial markets and the Street could cushion deleveraging at the banks or vice-versa, this time they are deleveraging and shrinking together, representing a constraint on the supply of credit. This combination will continue to tighten financial conditions and weaken already-slowing US and perhaps global growth. The result – even following aggressive action by five central banks to alleviate money-market pressures, plus the ebbing of year-end market pressures – is that money-market rates remain elevated compared with policy rates, and yield spreads over those money-market rates on loans have stayed high or widened. For example, although three-month dollar Libor-OIS spreads have declined from 108 bp over the past month to 63 bp, they are still 55 bp higher than they were in the spring, effectively reducing the impact of the 100 bp decline in the federal funds rate by half (see “Bold Action: Central Banks Likely to Succeed,” Global Economic Forum, December 14, 2007). In our view, it’s not that central banks have failed in their efforts to alleviate strains in money markets; rather, ongoing reintermediation likely will keep spreads wide — and possibly drive them wider again — at least through mid 2008. Theme IV: Reregulation of Financial Services The fourth theme is microeconomic in nature: The pendulum is swinging back to reregulation of the financial services industry. The subprime mortgage crisis has spurred new regulatory lending guidelines from the Fed and other bank regulators, and proposed amendments to Regulation Z (Truth in Lending) to protect consumers from unfair or deceptive home mortgage lending and advertising practices. The new rules, which the Fed would adopt under the Home Ownership and Equity Protection Act (HOEPA), would restrict certain practices and would also require lenders to provide certain mortgage disclosures earlier in the transaction. Parallel proposed legislation from both the House (HR 3915) and Senate (S 2452) is aimed at the same goal. The sponsors of the legislation — Barney Frank (D, MA) and Christopher Dodd (D-CT) — believe that deregulation fostered abuses and that the Fed’s proposals do not go far enough to correct them. These proposals may not be implemented quickly in the current political environment. But in my view, while their goals are in many cases laudable, the uncertainty surrounding significant regulatory change will ironically have adverse macroeconomic consequences: It will be one more factor that will keep financial conditions and willingness to lend tight as we go through 2008. The broader context for reregulation is also important. Regulators are concerned that financial innovation has fostered laxity in risk management and due diligence by lenders and investors. Some want to beef up supervisory initiatives or capital requirements under the Basel II framework. Similar to proposals aimed at mortgage lending troubles, these initiatives are aimed at real problems, but the uncertainty surrounding them may also keep lenders wary and restrained. And for investors, reregulation probably means a downward re-rating of the longer-term earnings potential of financial services firms. Market calls Against this backdrop, we expect that the dollar will strengthen, especially against the major currencies; transatlantic yield spreads likely will reverse and widen again as growth in Europe fades; and global yield curves — not just in the US — will steepen. These conclusions from our rates, currency and credit strategy teams flow from our US recession call last month. All hinge on the important insight that a lot of the bad US news is in the price, but that the deterioration outside the US and the policy reactions to it are not. The dollar call, articulated by Stephen Jen as the “dollar smile,” is a prime example of this logic. While near-term US economic weakness may well put additional downward pressure in the dollar, the downside surprises in the global growth outlook are more likely to come in Europe, the UK and Japan. And we think that neither Asia nor Latin America is immune from the forces depressing growth in the industrial world. Finally, the dollar in our view is grossly undervalued against the euro and sterling. As a result, we anticipate a moderate dollar rally in coming months (see “The Return of the Dollar,” December 21, 2007). Another example: Jim Caron and I believe that our US recession and "recoupling" calls imply a reversal of transatlantic yield spreads, which have gone from +120 bp in mid 2006 to -30 bp today. The logic is similar to that for our stronger dollar call: There is a lot of US recession risk priced into US yields but little recoupling risk in European yields. In our view, such spreads have bottomed and will move significantly higher; if we are right, spreads could move back to +20-30 bp or more. This dovetails perfectly with a trade we advocate: Sell EUR FX vol vs. Buy EUR vs. sell US swaption receivers as the EUR comes off and the US-EUR rate and volatility gaps narrow. The driver of this trade is that a move to lower policy rates in the US is already in the price, but lower European rates will be the surprise. Risks Lingering inflation risks may delay these moves in currencies and rates by keeping central banks on hold for longer. In fact, many investors fear that a new wave of inflation may emerge from the booming economies of Asia, OPEC and Latin America. But we think upside inflation readings in the industrial economies will put growth in the US and abroad at risk and ultimately will make these market moves even more likely. The extent to which markets, policy, and economies are linked may also enter the debate, as tighter financial conditions require aggressive and/or unconventional policy responses, such as the one launched in mid December by five central banks to provide market liquidity. Indeed, there is talk of fiscal stimulus in Washington, as some lawmakers view monetary policy as incapable of dealing with the current economic malaise. While such talk may spur hopes for a quicker turnaround, fiscal policy action is unlikely as long as the President has the power to veto. Finally, as was the case a year ago, the direction of liquidity and volatility are the biggest wildcards in the outlook for financial markets. Near-term, the direction of each seems clear to me: The risks that liquidity will remain in short supply and that volatility spikes higher are both significantly greater than 50%.
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2008 to Transfigure from Fear to Greed
January 04, 2008
By Stephen Jen | London
Summary and conclusions While the Year of the Rat will likely be marked by extraordinary uncertainty and volatility, we see 2008 as a year of two halves: a weak-growth 1H where fear dominates, followed by a strong 2H where greed dominates. For the dollar, this means that a rally similar to the one witnessed in 2005 is probable. The more ‘V-shaped’ the US economic trajectory for 2008, the better the ‘Dollar Smile’ will work to support the dollar index. The flatter the trajectory of US growth – i.e., a gentle deceleration, short of a recession, followed by a gentle recovery (a flat, deformed ‘U-shaped’ economic trajectory for the US), particularly accompanied by aggressive Fed rate cuts and with investors not turned risk-averse, the more difficult it will be for the dollar index to stage a recovery. In the latter case, yield differentials could drive exchange rates, with negative implications for the dollar. In bilateral terms, we see the USD being stronger against the GBP and EUR throughout much of this year (our year-end targets are 1.86 and 1.32, respectively). In 1H, we see downside risks to USD/JPY and other JPY crosses, with a mid-year target of 106 for USD/JPY. For 2H, we believe that the JPY crosses should recover as investors’ risk-taking appetite recovers. Against EM (emerging market) currencies, the dollar should head sideways or slightly upwards in 1H, but should resume its structural descent against these currencies. US weakness could suspend the appreciating trends in EM currencies, but these trends are structural in nature and should persist for multiple years. In this note, we build on the key points made in an earlier note (see The Dollar Smiles in a Recession, December 10, 2007) and highlight themes that will dominate financial markets this year. From fear to greed
Out of tradition and habit, analysts like ourselves work hard to come up with a unified theme for every calendar year. But the calendar year is quite an arbitrary period. For 2008, we believe that economies, financial policies and asset prices, including currencies, will likely exhibit two quite distinct phases: a weak phase followed by a strong phase. The stylised call we have is that each phase will last about a semester. We believe that the Fed will ease (by 75bp) in 1H; the US economy will register a technical recession; equities – US and elsewhere – will likely be soggy; and fear and risk-aversion will likely intensify in 1H. In times of fear, capital flows into EM should abate, and speculative EUR/USD longs should be moderate in size. Since EUR/USD is still over-valued, in our view, investors adopting a neutral posture on the dollar should lead to a fall in EUR/USD. In times of greed, however, capital flows into EM should accelerate, but speculative EUR/USD longs should not build in size because of rising interest rates in the US. This win-win diagnosis on the USD versus the EUR reflects our view that (i) the dollar is grossly under-valued, (ii) bad news is very much priced in for the USD, but not for the EUR and (iii) the US ‘twin deficits’ are shrinking fast (see To Gisele and Jay-Z: US Twin Deficits Are Shrinking, November 15, 2007). Key structural themes for 2008
We will not dwell on the cyclical aspect of the debate, given that every scenario comes with a great deal of uncertainty. What we presented above is the most probable scenario, from our perspective, with a bias to the upside on the US and the global economies, and on risky assets. Instead, we highlight some key structural themes that will become evident this year. Such tectonic forces will even skew the cyclical variations of the US and the global economies, and are more certain, we’re pleased to note. Tectonic force 1. SWFs to be a source of support for risky assets. This was a theme that surprised many investors and commentators last year. We believe that SWFs are not a fad; they are a ‘game-changer’ for financial markets and financial policies. Not only are they already large in size (with more than US$2.8 trillion under management (see Tracking the Tectonic Shift in Foreign Reserves and SWFs, March 15, 2007) – larger than hedge funds, which have US$1.7 trillion under management), but they will likely surpass the world’s total holdings of official foreign reserves within the next five years, and grow to around US$12 trillion by 2015. We believe that SWFs will significantly alter the balance of power along several dimensions. Specifically, they will skew the balance against the private sector investors and in favour of public sector investors, against developed and in favour of developing countries, against safe assets (bonds) and in favour of risky assets (equities), and against the ‘core’ currencies (USD and EUR) and in favour of EM currencies. It is important for investors to appreciate that this is indeed a legitimate tectonic force. Let’s take the GCC (Gulf Cooperation Council) countries as an example. The six members of the GCC have close to 500 billion barrels of proven oil reserves. At today’s market prices, this is worth some US$44 trillion. Including the value of proven gas reserves, the total underground wealth of the GCC countries could exceed US$50 trillion (see GCC: Transforming Oil into Financial Wealth, November 15, 2007). Since 1985, in SDR terms, the composite value of equities has risen seven-fold, while bonds have risen only around four-fold. Crude oil has actually performed very poorly – doubling in value during the past two decades. Thus, from a financial perspective, it makes much more sense for the GCC countries to convert their underground wealth into above-ground wealth. The market capitalisation of the world’s equity markets is around US$52 trillion. This gives some perspective on the likely impact of the GCC’s oil reserves on global risky asset prices. In addition to the GCC members, there are the non-GCC energy exporters as well as the Asian exporters, which, collectively, are likely to accumulate balance of payments surpluses at a pace that is faster than that for the oil exporters. Tectonic force 2. Declining ‘home bias’ in various countries to introduce new cross-currents in global capital flows. This is a new theme – various countries raising their exposures to non-local currency assets – that is just emerging. I believe that this process, which we call a decline in the ‘home bias’, will accelerate in 2008. Relative to what is implied by CAPM (Capital Asset Pricing Model), investors are still holding too many domestic assets and not enough foreign assets, though the ‘home bias’ in general has declined somewhat due to better information about foreign markets, capital account liberalisation (which has permitted capital inflows to some countries) and better policy making (which has earned credibility with foreign investors). However, a good part of the decline in the ‘home bias’ in recent years has been accounted for by the official sector of the capital-surplus countries acquiring assets of the capital-deficit countries, leaving the private sector with concentrated holdings of domestic assets. This imbalance applies to Japan, China, Korea and most EM economies. I believe that there will be a definitive change in how private investors in these countries view ‘foreign’ assets. First, the global economy is becoming increasingly multi-polar. This requires more active diversification to hedge against downside shocks to consumption (this is sometimes referred to as ‘international risk-sharing’). Second, the capital-surplus countries are now actively encouraging the private sector – both institutional and retail – to invest overseas to help vent the accumulating balance of payments pressures. China is a good example, and we calculate that China’s private sector is ‘short’ US$1.2 trillion worth of foreign assets (see China’s Private Sector Is US$1.2 Trillion Short of Foreign Assets, November 15, 2007). With the floodgates fully open, the capacity of Chinese private investors to buy non-CNY assets is immense. Third, the unfavourable demographic realities have forced pension funds (sovereign and otherwise) to invest more proactively and professionally, including broadening the universe of their asset holdings to include foreign assets. Japan’s GPIF, Kempo and Korea’s NPS are all good examples of large pension funds seeking to raise their exposure to equities and foreign assets. Initially, much of these outflows will head towards the larger, more liquid financial markets. However, gradually, there should be more intra-EM flows. Whether this prospective decline in the ‘home bias’ will be USD-positive or negative depends on the direction of these flows. My guess is that these flows will, initially, be USD-supportive. These flows will, effectively, partially offset the USD divestment flows by central banks. Tectonic force 3. The positive powers of globalisation will quickly resurrect the global economy. I remain in awe of the powers of globalisation – both trade and financial. In my eyes, the world is in great shape. The widespread investor angst is essentially about the first part of the ‘20% balancing down; 80% balancing up’ scenario that I have long argued should take place for the world to rebalance while maintaining good growth momentum. A housing market correction (not a crash) and deflating credit markets are both unsurprising and desirable. By the middle of the year, I expect the world to start healing and recovering. From a long-term perspective, 1H08 will be a ‘buy-on-dip’ opportunity for risky assets, commodities, EM and commodity currencies, even though it may be a bit ‘scary’ at times. Tectonic force 4. Assets remain out of sync, favouring equities over bonds. While the yield curve has steepened in the US, they have flattened in most of the rest of the world, as global long-term real interest rates remain very depressed, reflecting yawning excess savings worldwide, which will once again be supportive of risky – but not ‘reckless’ – assets. The cost of capital will remain significantly below the return on equities. Global P/E ratios still look very reasonable, even cheap in some cases. Tectonic force 3 (above) should keep corporate earnings supported, even though they may dip temporarily in 1H08. Bottom line
Three conditions are required for the dollar to rally: (i) the US falling into a recession in 1H; (ii) investors turn risk-averse as a result; and (iii) the US starts to recover in 2H. Without (i) and (ii), the dollar could weaken again in the first weeks of 2008. However, we believe that the most probable scenario for the dollar is a repeat of 2005.
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The Revenge of the Low-Yielder
January 04, 2008
By Luca Bindelli | London
Summary The global economy is slowing, and our global economics team now foresees global growth declining from 5.1% in 2007 to 4.3% in 2008 (the figures are 2.4% and 1.4%, respectively, for industrialized countries). Also, as we already suggested in past comments, the re-pricing of risk will likely take some time – and remaining uncertainties owing to the financial crisis spillover to the real side of industrial and emerging economies should help keep volatilities relatively higher for longer. This is an environment in which the CHF should thrive, at least in the beginning of this year. Global slowdown and uncertainty will favor the CHF The mild US recession our economists have in mind for the first half of the year (R. Berner & D. Greenlaw, US Economics: Recession Coming, December 10, 2007) and its implications for the USD (S. Jen, The Dollar Smiles in a Recession, December 10, 2007 and 2008 to Transfigure from Fear to Greed, January 3, 2008) reinforce our view that the CHF is poised to appreciate in the beginning of this year (see The US Consumption Play, November 15, 2007). Moreover, the only currencies that tend to appreciate regularly against the USD in a bear market (and in a period of higher uncertainty) are the JPY and the CHF. We examined the role of G10 economic activity, and the ‘uncertainty’ linked to the degree of divergence among G10 economic cycles through short-term interest rate developments. Several points are worth noting here: 1. The CHF tends to appreciate whenever we observe global easing of monetary policy. (The global interest rate is defined as the GDP-weighted average of the G10 economies’ three-month rates.) 2. The CHF tends to appreciate during periods of increased economic uncertainty, as reflected by the diverging nature of the central bank monetary paths. 3. The combination of monetary easing and higher global uncertainty reinforces the momentum in CHF changes. This is particularly visible in early 1995. One notable exception to these regularities occurred right after the 1990-91 US ‘consumption-led’ recession. While global growth uncertainty was growing across G10 economies, Switzerland witnessed one of its worst period over the last 20 years. Indeed, Swiss growth averaged -0.3% during 1991-93. (The rise in volatility observed in late 1992 is reminiscent of the Exchange Rate Mechanism (ERM) crisis. The peak in September 1992 corresponds with the exit of the UK (and Italy) from the ERM (owing to the speculative attacks on the GBP.) This suggests to us that for the CHF to lose ground in a period of global slowdown and increasing uncertainty, a US recession would need to turn into a nastier ‘worldwide’ recession affecting Switzerland significantly (a scenario we do not foresee currently). The likely narrowing yield differentials with the US, UK and Canada will add to the appreciating potential of the CHF, we think. (The US, UK and Canada together account for 50% of the weight in our G10 interest rate metric (US alone is 41%). Hence, despite the fact that other G10 economies should remain on hold on average, we will likely face an environment of declining global rates in 1H08 (our US economists forecast the FFR target at 3.50% in 2Q) and increasing divergence.) While we already have argued for a declining USD/CHF path in the past, a mild US recession would likely put additional pressure on the de-coupling thesis. Therefore, as the Canadian economy is the most exposed to a US slowdown, an obvious trade appears to be short CAD/CHF in 1H. (We already suggested this trade back in December (see “SNB – The Only One in Control?” FX Pulse, December 6, 2007.) In our November piece cited earlier (The US Consumption Play), we suggested that USD/CHF would breach below 1.05 by year-end. This did not happen, but the year-end effect (position-squaring) helped the USD throughout December last year. Also, according to the model presented in that report, we could now reach the parity level in USD/CHF (possibly as soon as end-1Q), which means that CAD/CHF parity is also within reach. (This forecast is based on a further decline in US Personal Consumption Expenditure in 1H (0.6%Q in 1Q and 0.1%Q in 2Q), and a simultaneous decline in the S&P 500 from the current level.) Given the likely appreciation of the USD across the board, the CHF should perform well against other crosses as well (with the exception of JPY). EUR/CHF, while still affected by the heightened global uncertainty, should heavily depend on the EUR/USD path. A stronger resilience of the euro area economies would further validate the ECB’s stance and pose upside risks to both EUR/USD and EUR/CHF. However, as was apparent in the most recent risk-reduction episodes, the ‘safe haven’ role of the CHF should prevail in investors’ minds, and EUR/CHF should decrease. Domestic economy of secondary importance for CHF path While the main driver for the CHF will be related to the global economic and financial context, domestic issues should play an important but secondary role. Swiss growth remains extraordinarily robust and diversified. The contribution of external growth is clearly set to decline with the global slowdown. But even in this case, the relatively greater exposure to emerging markets will provide a certain cushion for the economy. (The Swiss export share to Asia (11.6%) exceeded the US one (10.3%) already back in 2006.) Domestic consumption is set to remain one of the biggest contributors to growth, thanks to the very healthy labor market situation. (Swiss firms still report increasing vacancies across all sectors, suggesting high demand for labor. Also, according to the SNB, real wages are set to increase 5.3% in 2007 after increasing 2.9% in 2006.) The investment environment will likely deteriorate moderately, owing mainly to increased economic and financial uncertainty. However, while construction investment already slowed, we expect equipment to slow more modestly. Moreover, in light of the high capacity constraints, and the high utilization rate of inputs, Swiss firms will need to keep a certain level of investment to accommodate these demand pressures. In support of this process, we should note that the real rate of interest will likely decline in the coming months, as inflation will continue to drift higher and nominal rates will likely be kept on hold. (Obviously, a sharper-than-expected global slowdown would offer downside risks to this scenario, but this is not our central case so far.) The SNB made clear that it would maintain a ‘wait and see’ approach going into 2008. (The way the SNB dealt with this funding crisis, thanks to its flexible monetary policy strategy, is likely to help investors and markets retain confidence in the ability of the SNB to deal effectively with internal financial stability issues, during a period of global financial stress. We are not saying that the CHF will command a higher ‘safe haven’ premium in relation to this development though.. Despite the strong fundamentals, and the still-present capacity pressures, the SNB justifies such a stance based on the higher uncertainty surrounding global financial and economic developments. Moreover, the SNB expects the inflation surge above 2% reported in the December policy assessment to be temporary. 2H08 could become a struggle for CHF though That being said, we are still convinced that the ‘safe haven’ role of the CHF has declined in the last few years. During this period, the EUR has emerged as an important reserve currency. Also, as attractive as the Swiss financial platform may be, international investors have generally converted most of their assets into USD or EUR in light of the interest rate differentials. In short, we think that once the global uncertainty has been put to rest, the CHF will struggle again. Second, with the recovery of the US economy expected to take place in 3Q already, our economists foresee the Fed raising the FFR as soon as 4Q (to 3.75%). In light of the evidence we examined, this perceived directional change in US policy should be associated with stabilizing market uncertainty and re-emergence of risk taking. Bottom line The CHF is poised to appreciate in the first months of 2008, we think. Long CHF against USD and CAD seem the best trades to us in 1H. We also expect GBP to face the same difficulties against the CHF. The second half of the year should present more of a struggle for the CHF. Resolving the uncertainty surrounding the financial turmoil and the global economy will dictate the transition from a positive to a more negative outlook for the CHF.
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CAD: U-Shaped
January 04, 2008
By Charles St-Arnaud | London
For the fourth year in a row, Canada enjoyed a robust economic performance in 2007, with growth of around 2.5% defying expectations formulated at the same time last year. 2008 is likely to be another story. We expect growth to moderate in the first half of 2008 before accelerating in the second half of the year. In addition, weaker growth in the US and elsewhere should moderate commodity prices. As a result, the CAD should depreciate in the first half of 2008, before recovering in the second half, when both the US and the Canadian economy rebound. We recommend short CAD/CHF or CAD/JPY positions in 1H, while short GBP/CAD or short EUR/CAD positions look interesting for 2H. Outlook for the Canadian economy The end of 2007 gave a preview of what to expect for 2008. The Bank of Canada pre-emptively cut interest rates by 25bp in early December, as the combined impact from the sharp CAD appreciation, tighter credit market conditions and weaker US growth outlook will likely slow the Canadian economy in 2008. At the end of 2007, our US economics team announced in its latest forecast update that it expects a mild recession in the US in 2008. This should have a major impact on growth in Canada, given the strong economic ties between the countries. However, thanks to a sound policy framework and buoyant domestic demand, the Canadian economy is well placed to withstand a US recession and is unlikely to be dragged into recession itself (see “CAD: If the US Sneezes, Will Canada Catch a Cold Again?” FX Pulse, September 6, 2007). We therefore expect growth in Canada to slow to 1.6% in 2008 from 2.5% in 2007. Most of the slowdown will happen in the first half of the year, before growth reaccelerates in the second half as the US economy rebounds. On the inflation front, headline inflation will be distorted for most of the year by the one percentage point cut in the GST. However, removing this effect, decreasing capacity constraints coupled with a negative base effect will likely moderate both headline and core inflation. Core inflation is expected to fall bellow the 2% targeted by the BoC in the first half of 2008. However, inflation will likely rise again in the second half of the year on the back of higher global commodity prices. In reaction to the slowing economy and decreasing inflationary pressures, the Bank of Canada is likely to continue cutting interest rates. We expect the Bank of Canada to cut rates by 25bp in 1Q and again in 2Q, bringing overnight rates to 3.75% by mid-year. Outlook for the CAD As the Canadian economy slows in the first of the year, the CAD is likely to come under pressure, especially since the currency is seen as somewhat overvalued. In addition, the recession in the US and the spillover effect to the global economy will likely drive commodity prices lower, which would offset some of the terms of trade gains enjoyed by Canada over 2007. In the second half of the year, as both the Canadian and the US economy rebound and commodity prices start to rise, the CAD is likely to perform well. In this context, we recommend taking a short CAD/CHF position in the first half the year, as the weakness of the CAD will be coupled with a strengthening of the CHF (see “CHF: Revenge of the Low Yielder” in today’s GEF for our views on the CHF).The pair could even cross parity in the first half of 2008. Alternatively, short CAD/JPY would also benefit from higher risk-aversion. For the second part of the year, we recommend taking short GBP/CAD or short EUR/CAD positions. These trades would allow investors to take advantage of the expected depreciation of GBP and EUR against the USD throughout the year and the CAD appreciation of the second part (see “G10: 2008 to Transfigure from Fear to Greed” in today’s GEF and “G10: Top Eight Trades for 2008” in the January 3 FX Pulse for our views on the GBP and EUR. These two crosses could reach levels close to 1.80 and 1.30, respectively by year-end. Risks There is a fair amount of uncertainty around this outlook. On the upside, stronger Canadian growth or higher-than-expected commodity prices could provide further support to the CAD. On the downside, the US recession could have a more severe impact on the Canadian and world economy. In this case, we could see a drop in commodity prices and a sharper depreciation of the CAD. All things considered, we think the risks to the outlook are slightly tilted to the downside.
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