Half-time: Pass Me the Smelling Salts
Few of the big questions being asking at end-2014 have been answered in a convincing way. The Greek saga rolls into its sixth painful month but may finally be coming to at least a temporary conclusion. I still think a copout (new loans in exchange for reform) is more likely than a full-blown bailout (another large debt reduction) or burnout (Greece defaults and leaves eurozone).
Central bank watchers, including policy-makers, have repeatedly pushed back their expected take-off date for the US Fed and Bank of England rate hiking cycles. The Fed seems poised for a September hike but the market’s confidence is lukewarm at best. Global growth remains on a soft footing despite ultra-low rates and the ECB finally joining the QE party.
UK general elections had a clear-cut outcome, removing much policy uncertainty and helping put a floor under sterling. A referendum on European Union membership – if it materializes – is likely to see the UK remaining in the EU, in my view, and in any case is far enough away not to seriously bother sterling or the UK rates markets for now.
Emerging markets, from China to Brazil, have had a turbulent six months. Throw in tepid global growth and the specter of US hikes and unsurprisingly monthly portfolio inflows into emerging markets slowed to $14bn in H1 from a $22bn average in 2010-2014, according to the IIF, dragged down by outflows from Emerging Europe, Middle East and Africa.
Weaker portfolio inflows coupled with disappointing exports have resulted in EM central bank FX reserves edging lower from record highs. But Non-Japan Asia (NJA) central banks certainly have the firepower to ride-out the current financial storms. Indeed, NJA currencies have been broadly stable in the past two months and I see few compelling reasons why this should change dramatically near-term.
Greece – Copout still more likely than Bailout or Burnout
There have been so many ups and downs, u-turns, false dawns, set-backs, last-minute appeals and veiled threats, it’s hard to believe that the Syriza government has been in power less than six months.
Prime Minister Tsipras’ call for a referendum is the latest in a series of increasingly desperate ploys but may actually speed up this sorry story by ushering in a new government. I am therefore sticking with my core scenario, expressed in Greece Lightening (28 January 2015), that creditors will give the Greek government further loans in exchange for signing up to strict reforms and that Greece will remain within the eurozone, for now at least – outcome ii) below.
The Troika, effectively Greece’s main creditors, has not wavered in its stance even if some eurozone policy-makers have shown a greater degree of willingness to negotiate than others (see Greece – too many chefs spoil the broth, 23 June 2015). While the ECB and bilateral creditors are still seemingly in denial that they will likely post large losses on their loans to Greece regardless of whether Greece stays in the eurozone, the IMF has acknowledged that the Greek government is unlikely to ever be able to reimburse even a fraction of its €320bn in public debt.
- It has plundered local budget and quasi-government budget and the coffers are dry;
- It can barely pay pensions and civil servants;
- It has used its IMF SDR reserves to reimburse its May debt maturity to the IMF;
- It is late on its June debt payment of €1.6bn to the IMF;
- It is asking to borrow to meet near-term maturities;
- The ECB has capped the Emergency Liquidity Assistance, forcing Greek banks to impose capital controls; and
- Anemic GDP growth makes it near impossible for the government to generate a sizeable primary surplus.
So I see only three possible outcomes, none of which are appealing to both parties:
- The “Bailout”: Greece’s debt is given another significant haircut in exchange for the government adhering to serious fiscal and structural reforms, creditors take a hit, Greece is given faint chance to grow, deliver primary surpluses, tap secondary debt markets and slowly start paying back some of its outstanding debt to official creditors;
- The “Copout”: Greece is given new loans to pay back maturities/interest on existing loans, so effectively its debt stock remains broadly unchanged and eurozone creditors are still owed €320bn; or
- The “Burnout”: Greece defaults on the bulk if not all of its debt, leaves the eurozone, its economic growth collapses near-term and eurozone creditors are left with significant losses.
In neither outcome 2) or 3) do creditors get their €320bn back, the main difference being that in scenario iii) that loss is effectively crystallized.
Emerging Markets – Turbulence but no crash landing
Emerging markets have had a turbulent six months, punctuated by the Chinese equity roller-coaster, the Petrobras scandal in Brazil, the economic turmoil in Venezuela and inconclusive Turkish elections. Throw in tepid global growth and the specter of US hikes and unsurprisingly monthly portfolio inflows into emerging markets slowed to $14bn in H1 from a $22bn average in 2010-2014, according to the IIF, dragged down by outflows from Emerging Europe, Middle East and Africa.
EM central bank FX reserves, adjusted for currency-valuation effects, have edged lower from record highs (see Figure 1), but central banks, particularly in Asia, have the firepower to ride-out the current financial storms (see Figure 2).
|Figure 1: EM central bank FX reserves edging lower from record highs||Figure 2: Aggregate data mask intra regional and country differences|
|Source: www.olivierdesbarres.co.uk, Investing.com Note: Assuming reserve composition: 66% USD, 22% EUR, 4% GBP, 4% JPY, 2% CAD, 2% AUD||Source: www.olivierdesbarres.co.uk, national statistical offices Note: only EM countries where the fall/rise in central bank reserves was greater than 2% of GDP are included in this figure|
Asian currencies – Calm in a world losing its head
Indeed, Non-Japan Asia (NJA) currencies have been broadly stable in the past two months, as depicted in Figure 3 and in line with my expectation (see Asian currencies still on the straight and narrow, 15 May 2015).
|Figure 3: A basket of NJA currencies has been trading in a range for the past couple of months||Figure 4: Asian currencies less volatile than during the last Greek crisis in summer 2013|
|Source: www.olivierdesbarres.co.uk, Investing.com Note: Includes INR, IDR, KRW, MYR, PHP, SGD, THB and TWD||Source: www.olivierdesbarres.co.uk, Investing.com Note: Includes INR, IDR, KRW, MYR, PHP, SGD, THB and TWD|
Whereas in summer 2013 they weakened during the Greek crisis, NJA currencies have, on the whole, been largely immune to the more recent market concerns about Greece, global growth and Fed policy tightening (see Figure 4). Year-to-date, there is admittedly a greater degree of differentiation, with perhaps unsurprisingly the commodity currencies (MYR, IDR) weakening. Conversely, CNY and TWD have been the best performers (see Figure 5).
|Figure 5: MYR and IDR have underperformed, CNY and TWD have outperformed||Figure 6: CNY NEER continues to appreciate and depreciate within narrow confines|
|Source: www.olivierdesbarres.co.uk, Investing.com Note: *Includes INR, IDR, KRW, MYR, PHP, SGD, THB and TWD||Source: www.olivierdesbarres.co.uk, Investing.com|
I see few compelling reasons to expect NJA central banks to depart from this preference for broadly stable currencies in coming weeks. Underlying flows are unlikely to support rapid or sustained. Modest global growth and demand is likely to continue to curb weak Asian exports (see Figure 7) while the uncertainty about the timing of Fed rate hikes may dampen FX inflows into Asia.
Noticeably, JPY/KRW has been broadly stable in the past six weeks, but this does not mask the won nominal effective exchange rate’s 30% appreciation versus the yen NEER in the past two years (see Figure 8).
|Figure 7: Asian export weakness||Figure 8: Competitive yen has seemingly assisted Nikkei’s outperformance|
|Source: www.olivierdesbarres.co.uk, national statistical offices Latest data are April for Malaysia and Philippines, May for China, India, Indonesia, Singapore, Taiwan, Thailand and June for Korea and Vietnam||Source: www.olivierdesbarres.co.uk, Investing.com|
European Central Bank QE – Does what it says on the tin but no panacea to weak growth
The expectation of ECB quantitative easing (QE) helped weaken an uncompetitive euro while the actual bond buying has seemingly put a lid on eurozone yields so the program’s short-term objectives have arguably been hit. The million-euro medium-term question remains whether QE can stave off deflation and boost eurozone growth and inflation. Evidence at this early stage is inconclusive. Growth has picked up, inflation has not. I’m sticking with my view that the ECB’s QE will fall-short medium-term – not that markets care at the moment as the focus is very much on what happens in Greece in the next few hours, days and weeks.
My main concern remains that the ECB’s bond buying is quite late to the party. The Fed stopped its purchases of mortgage-backed securities and Treasury notes in October 2014 while the BoE’s last QE size increase was in July 2012. Bearish growth and inflation expectations for the eurozone are well entrenched which leaves the QE having to work harder to achieve the same result. Wholesale fiscal and structural reforms need to go hand in hand with QE for it to have the desired impact on eurozone growth and employment. And that’s when things break down. Appetite for reform of labour markets, tax, administrative, and services market competition is weak – not just in Greece but also in far larger economies such as France.
First Bank of England rate hike – Little sense of urgency or market concern
The UK election’s clear-cut outcome has removed much policy uncertainty but shed little light on when the Bank of England’s Monetary Policy Council (MPC) will start hiking its policy rate. The rates market expects the MPC to start in Q2 2016, with almost four hikes priced in the subsequent two years. This is an even more dovish outlook than portfolio managers and industry and finance experts’ who, in a survey I conducted in mid-June, thought the BoE’s hiking cycle would start in Q1 2016 – well after the Fed’s – and would be very slow and gradual. They forecast only 50bp hikes between now and September 2016 although a third of respondents thought the first rate hike could take place before end-2015.
Since then data have been mixed. Weekly earnings jumped 2.4% yoy in April but this number is deceiving. Earnings deflated by the retail price index actually fell slightly in April from March and are still about 7% lower than five years ago (see Figure 9). If CPI inflation – which turned negative for the first time in 55 years in April – is anything to go by there is still a bit of slack in the labour market. The MPC will have to factor the impact of the Greece fall-out on eurozone growth and the BoE’s chief economist is unbiased about whether next move is a rate cut or hike.
Figure 9: UK has created many jobs at the expense of higher earnings
Source: www.olivierdesbarres.co.uk, ONS
UK referendum on EU membership – Don’t underestimate will to stay within a union
I would expect electors to vote in favour of the UK remaining within the European Union, should such a referendum take place at some point in 2017 as the government has promised.
Prime Minister Cameron is campaigning in favour of the UK’s membership to the EU. The recent Scottish referendum on UK membership suggests electors’ willingness to stay within unions should not be underestimated, nor should the government’s ability to campaign on that basis. In any case a referendum is far enough away not to seriously bother markets for now.
Olivier Desbarres currently works as an independent commentator on G10 and Emerging Markets. He has over 15 years’ experience with two of the world’s largest investment banks as an emerging markets economist, rates and currency strategist.