Go long the dollar, says strategist
Credit Agricole Asset Management says most macro scenarios will support the greenback.
The coming 12 months are likely to see a continuation of recent macro trends of liquidity and low volatility, but currency may provide investors a way to maintain decent returns, says Marco Piersimoni, Milan-based head of strategy at Credit Agricole Asset Management. In an interview with AsianInvestor, he explains why.
AI: Are macro drivers such as liquidity going to change?
Peirsimoni: LetÆs look at the components of this booming liquidity. First, extraordinarily loose monetary policy by the major central banks, including the Federal Reserve, the European Central Bank and the Bank of Japan, and to a lesser extent the Bank of England.
Second, Asian central bank reserves. Third, the recycling of dollars by oil-producing countries. And fourth, the yen carry.
Global monetary policy has tightened, though.
Yes. Real rates in the United States are now at their historical average. The Bank of England raised rates. The ECB is adjusting rates toward a normalised rate of 4%. Only the Bank of Japan has paused raising interest rates. So the US is no longer a source of liquidity, but the BoJ and banks in Europe continue to be.
The build up of Asian reserves continues and wonÆt end tomorrow. Flows may slow but the stock of their reserves wonÆt be affected. Oil producers continue to sell oil and buy US fixed income. Although we saw a big correction in the oil price last year, this has stabilised and oil is now around $60/barrel. At this level, the recycling of dollars will continue.
ThereÆs been talk in the markets of the end of the yen carry trade.
This has been a pure money creator for several years. But while it would be a shock of the Bank of Japan raises interest rates, even at 75 basis points, investors still make money. So all the drivers of liquidity remain in place.
Where has all this liquidity gone and will this direction change?
To date, the excess liquidity has inflated the fixed-income markets. Bond yields remain quite low. The Federal Reserve has raised its federal funds rate 4.75% since 2003 and yet the 10-year Treasury yield has risen only 50-75 basis points. The worldÆs equity markets have also performed very well, but unlike fixed income, there is no clear overvaluation.
There are doubts about fixed income, with its tight spreads in credit and emerging-market debt. But the fundamentals in major equity markets are not in doubt. Some markets are at fair value on a historic basis, or below. Companies are making good profits, and corporate earnings have still been ahead of market index gains. Profits are way ahead of earnings and cash flow. So there is still room for inflation in the equity markets. Share multiples havenÆt expanded yet.
Will equities be the next bubble?
Who knows? But weÆre not in one yet.
If liquidity will remain, what about the lack of volatility?
We have been in a low-volatility world for all asset classes. But in equity markets, it is not unusually low. In the US, equity markets usually have low volatility of around 10-15%. Having 30% or more is the anomaly. TodayÆs implied volatility in US equities is 13-14%.
What about the events of May and June last year?
We saw a spike, but it was suppressed. The last high-volatility period we had was 1998-2001, when volatility ran at over 30% for three years in a row. But the periods before and since havenÆt been like that. The 1993-1997 period also saw consistenly low volatility. What is unusual is not that US equities donÆt have a lot of volatility. What is unusual that this is the case for all asset classes worldwide.
How sustainable is this quietude?
There has been a structural shift of disintermediating risk, with structured products and diversification. There are now more sellers of volatility than used to be available. Yes we had a spike last spring but volatility remains consistent because of liquidity and because of the structural ease in trading volatility.
What has been the successful asset allocation in recent years?
The successful allocation has to be in everything. Equities have performed strongly, bond returns have been decent. The bond markets didnÆt collapse despite the Fed raising interest rates. The strategy has been to have premium, in equity, in credit, in emerging markets.
Will this change?
One theme investors should play is the reversal in the dollar. The dollar was weak in 2006 but it could appreciate. It is undervalued against a basket of major currencies. It is in fact at a 10-year low. And yet the US offers very high yields for cash, over 5%.
If the predicted æsoftÆ landing of the US economy doesnÆt happen, then we face one of two scenarios. The US economy may reaccelerate, in which case you should obviously be a dollar bull. Or it goes into recession, which makes for an ever stronger case to be dollar bullish.
Because of the flight to quality.
Yes, the US dollar is still the worldÆs reserve currency. So for 2007, we recommend investors increase their exposure to the dollar, continue to be overweight equities and be sceptical about fixed income. Bonds must remain as a defensive part of the portfolio, of course. They will not create a disaster for investors but they wonÆt deliver a lot of satisfaction either.
Will the dollar appreciate across all currencies?
It will rise against the euro and commodities markets, but not much against Asian currencies.
All last year we heard the mantra that the US economy will head for a slowdown, the æsoftÆ landing. Yet recent data about the US economy suggests otherwise. Are you changing the tune on that?
The soft landing is still more likely. We are in a mid-cycle slowdown, and it is typical of these periods for data to be misleading or confusing. One month the numbers for the jobs market look good, the next month theyÆll disappoint. Indicators are not clear. But that is what youÆd expect in this cycle. WeÆre not in an obviously expanding or contracting phase.
What about the much-ballyhooed problems in the US real-estate sector?
AmericaÆs real-estate market is in recession. But the real weakness is in residential real estate. Infrastructure real estate is doing well. Nonetheless, falling housing valuations wonÆt cause a recession. For one thing, the sector is small, comprising only 6% of US GDP.
So what is the worry?
The fear isnÆt about the sector itself but the impact of a housing contraction on consumer spending. But the real determinant of spending isnÆt housing valuations, but take home wages. And income growth for labour has been solid, growing at 4% on an annualised basis. The financial wealth of US households is in good shape, because all asset classes have performed well. So while real-estate assets are not healthy, wages and other investments are. And the probability of these other factors collapsing is low.
If not housing, then, what is the risk to your macro view?
Old-fashioned inflation. A slowdown will moderate growth and therefore should contain inflation. But we could be wrong. WeÆve seen income growth from rising salaries. To our surprise, companies have not passed on higher commodity-price or labour inputs. But if this changes and consumer prices rise, the monetary authorities will raise interest rates beyond expectations. That would be bad for bonds, bad for equities, bad for spread products. ItÆs a global risk that would impact any asset class. In that event, investors just want to hold US cash.
Another risk is the Bank of Japan surprising the markets with an aggressive hike in interest rates, which would halt one of the major engines of money generation.
Is the alleged political interference in the BoJÆs recent decision to not touch interest rates a concern?
There appears to be some political interference but this is not interesting for investors. WhatÆs interesting is what the BoJ will do this year, and to understand that, you have to look at the data. Focus on what the economy is telling you, not on tensions between the BoJ and the government. Will the Japanese economic recovery create inflation? I think you can expect two or three rate hikes this year. We expect the overnight call rate to reach 75 basis points. It wonÆt mean the end to the carry trade but it will be a surprise to the markets.
What kind of returns can investors expect this year?
Equities performance in the past three years has been good, 15-20%, thanks to earnings growth. Corporate earnings have also expanded by 15-20%. Earnings growth in 2007 are likely to moderate, however, to around 10%. Equity markets could expand a little above this, if we see inflation in multiples, so it should still offer a nice return, particularly in US dollar terms. In fixed income, investors wonÆt get much more than cash, or 5% on a dollar basis. To get more, investors should add more high-yield bonds. Investment grade is expensive, you can get only 20-30 basis points of carry, but you can still get 200-300 bps from high yield.
AI: Are macro drivers such as liquidity going to change?
Peirsimoni: LetÆs look at the components of this booming liquidity. First, extraordinarily loose monetary policy by the major central banks, including the Federal Reserve, the European Central Bank and the Bank of Japan, and to a lesser extent the Bank of England.
Second, Asian central bank reserves. Third, the recycling of dollars by oil-producing countries. And fourth, the yen carry.
Global monetary policy has tightened, though.
Yes. Real rates in the United States are now at their historical average. The Bank of England raised rates. The ECB is adjusting rates toward a normalised rate of 4%. Only the Bank of Japan has paused raising interest rates. So the US is no longer a source of liquidity, but the BoJ and banks in Europe continue to be.
The build up of Asian reserves continues and wonÆt end tomorrow. Flows may slow but the stock of their reserves wonÆt be affected. Oil producers continue to sell oil and buy US fixed income. Although we saw a big correction in the oil price last year, this has stabilised and oil is now around $60/barrel. At this level, the recycling of dollars will continue.
ThereÆs been talk in the markets of the end of the yen carry trade.
This has been a pure money creator for several years. But while it would be a shock of the Bank of Japan raises interest rates, even at 75 basis points, investors still make money. So all the drivers of liquidity remain in place.
Where has all this liquidity gone and will this direction change?
To date, the excess liquidity has inflated the fixed-income markets. Bond yields remain quite low. The Federal Reserve has raised its federal funds rate 4.75% since 2003 and yet the 10-year Treasury yield has risen only 50-75 basis points. The worldÆs equity markets have also performed very well, but unlike fixed income, there is no clear overvaluation.
There are doubts about fixed income, with its tight spreads in credit and emerging-market debt. But the fundamentals in major equity markets are not in doubt. Some markets are at fair value on a historic basis, or below. Companies are making good profits, and corporate earnings have still been ahead of market index gains. Profits are way ahead of earnings and cash flow. So there is still room for inflation in the equity markets. Share multiples havenÆt expanded yet.
Will equities be the next bubble?
Who knows? But weÆre not in one yet.
If liquidity will remain, what about the lack of volatility?
We have been in a low-volatility world for all asset classes. But in equity markets, it is not unusually low. In the US, equity markets usually have low volatility of around 10-15%. Having 30% or more is the anomaly. TodayÆs implied volatility in US equities is 13-14%.
What about the events of May and June last year?
We saw a spike, but it was suppressed. The last high-volatility period we had was 1998-2001, when volatility ran at over 30% for three years in a row. But the periods before and since havenÆt been like that. The 1993-1997 period also saw consistenly low volatility. What is unusual is not that US equities donÆt have a lot of volatility. What is unusual that this is the case for all asset classes worldwide.
How sustainable is this quietude?
There has been a structural shift of disintermediating risk, with structured products and diversification. There are now more sellers of volatility than used to be available. Yes we had a spike last spring but volatility remains consistent because of liquidity and because of the structural ease in trading volatility.
What has been the successful asset allocation in recent years?
The successful allocation has to be in everything. Equities have performed strongly, bond returns have been decent. The bond markets didnÆt collapse despite the Fed raising interest rates. The strategy has been to have premium, in equity, in credit, in emerging markets.
Will this change?
One theme investors should play is the reversal in the dollar. The dollar was weak in 2006 but it could appreciate. It is undervalued against a basket of major currencies. It is in fact at a 10-year low. And yet the US offers very high yields for cash, over 5%.
If the predicted æsoftÆ landing of the US economy doesnÆt happen, then we face one of two scenarios. The US economy may reaccelerate, in which case you should obviously be a dollar bull. Or it goes into recession, which makes for an ever stronger case to be dollar bullish.
Because of the flight to quality.
Yes, the US dollar is still the worldÆs reserve currency. So for 2007, we recommend investors increase their exposure to the dollar, continue to be overweight equities and be sceptical about fixed income. Bonds must remain as a defensive part of the portfolio, of course. They will not create a disaster for investors but they wonÆt deliver a lot of satisfaction either.
Will the dollar appreciate across all currencies?
It will rise against the euro and commodities markets, but not much against Asian currencies.
All last year we heard the mantra that the US economy will head for a slowdown, the æsoftÆ landing. Yet recent data about the US economy suggests otherwise. Are you changing the tune on that?
The soft landing is still more likely. We are in a mid-cycle slowdown, and it is typical of these periods for data to be misleading or confusing. One month the numbers for the jobs market look good, the next month theyÆll disappoint. Indicators are not clear. But that is what youÆd expect in this cycle. WeÆre not in an obviously expanding or contracting phase.
What about the much-ballyhooed problems in the US real-estate sector?
AmericaÆs real-estate market is in recession. But the real weakness is in residential real estate. Infrastructure real estate is doing well. Nonetheless, falling housing valuations wonÆt cause a recession. For one thing, the sector is small, comprising only 6% of US GDP.
So what is the worry?
The fear isnÆt about the sector itself but the impact of a housing contraction on consumer spending. But the real determinant of spending isnÆt housing valuations, but take home wages. And income growth for labour has been solid, growing at 4% on an annualised basis. The financial wealth of US households is in good shape, because all asset classes have performed well. So while real-estate assets are not healthy, wages and other investments are. And the probability of these other factors collapsing is low.
If not housing, then, what is the risk to your macro view?
Old-fashioned inflation. A slowdown will moderate growth and therefore should contain inflation. But we could be wrong. WeÆve seen income growth from rising salaries. To our surprise, companies have not passed on higher commodity-price or labour inputs. But if this changes and consumer prices rise, the monetary authorities will raise interest rates beyond expectations. That would be bad for bonds, bad for equities, bad for spread products. ItÆs a global risk that would impact any asset class. In that event, investors just want to hold US cash.
Another risk is the Bank of Japan surprising the markets with an aggressive hike in interest rates, which would halt one of the major engines of money generation.
Is the alleged political interference in the BoJÆs recent decision to not touch interest rates a concern?
There appears to be some political interference but this is not interesting for investors. WhatÆs interesting is what the BoJ will do this year, and to understand that, you have to look at the data. Focus on what the economy is telling you, not on tensions between the BoJ and the government. Will the Japanese economic recovery create inflation? I think you can expect two or three rate hikes this year. We expect the overnight call rate to reach 75 basis points. It wonÆt mean the end to the carry trade but it will be a surprise to the markets.
What kind of returns can investors expect this year?
Equities performance in the past three years has been good, 15-20%, thanks to earnings growth. Corporate earnings have also expanded by 15-20%. Earnings growth in 2007 are likely to moderate, however, to around 10%. Equity markets could expand a little above this, if we see inflation in multiples, so it should still offer a nice return, particularly in US dollar terms. In fixed income, investors wonÆt get much more than cash, or 5% on a dollar basis. To get more, investors should add more high-yield bonds. Investment grade is expensive, you can get only 20-30 basis points of carry, but you can still get 200-300 bps from high yield.
¬ Haymarket Media Limited. All rights reserved.