Forces Shaping the Investment Climate

The US dollar is beginning the new week under modest pressure after the soft close before the weekend.  All the major currencies are gaining against the greenback, as are most of the emerging market currencies, including the Israeli shekel, which had weakening in light of the increased hostilities.

The euro, however, has remained below the $1.2800 level.  Stops are thought to be above last week's high seen just above there.  Additional resistance is seen near $1.2845.  Sterling did move through last week's highs (~$1.5915), but has been unable to make much headway from there after recovering a full cent since last Thursday's lows.  The greenback was initially pushed to almost JPY81.60 in early Asian trading, but Japan-based offers pushed back sending the dollar to almost JPY81.10.  In effect, the dollar has traded in about a 20-25 tick range on either side of Friday's North American close of about JPY81.35. 

 

The dollar-bloc currencies staged impressive recoveries late Friday and have benefited from follow through buying today.  The Australian dollar is challenging the $1.04 level after have traded below $1.03 before the weekend.  The US dollar is trading near last week's lows against the Canadian dollar.  A break of CAD0.9980 could signal a move in the coming days toward CAD0.9900 and the month's low near CAD0.9875. 

Global equities are mostly higher.  The MSCI Asia-Pacific Index rose almost 1%, helped by what is potentially an upside reversal after falling to new 3-year lows.  European bourses are also higher, with the Dow Jones Stoxx 600 gaining a full percentage point, led by financials and technology.   Bond markets are mostly softer. 

There are four main forces shaping the investment climate.  The newest has been the shift in sentiment towards the yen.  LDP-leader and likely the new prime minister of Japan has done with a few aggressive comments what the Noda government and the BOJ have failed with achieve with QE and threat of intervention and that is to break the link between the yen and the more general risk environment.   The BOJ's two-day meeting concludes tomorrow and after extending its asset purchases program in both September and October, the BOJ is likely to sit pat.  

The anticipated policies of the Abe government and the feud with China are spurring a change in investor behavior.  While Chinese officials have been boycotting international meetings that have taken place in Japan (both public and private sector), Japanese investors are striking China.  Several funds that were to have been launched that focused on China have been pulled.  At the same time, the Financial Times reports today how retail investors in Japan are reducing their foreign currency denominated investments, preferring domestic equities and deposits.  In the global space, some new funds are trying to tap into the resource theme, with a focus on Australia, New Zealand, Canada and Norway.  The FT notes some funds being launched that focus on the Asian region.  

How Abe's declarations get operationalized is a different story, but it will not be clear for a couple of months, at least.  The more pressing issue is tomorrow's euro area finance ministers' meeting that must ease the immediate funding pressure on Greece or incur the market's disappointment.  The most likely outcome seems to be an agreement to ease the debt servicing costs, without a reduction in the principal (i.e., no official sector haircut) to meet Greece's funding needs for next year and 2014.  Reducing interest rates and lengthening the maturities have been used before and are still the easiest way to reach an agreement.  Funding for 2015 and 2016 will be deferred until some later date.  

The IMF will not be happy about this, but since there are not new funds needed (at this juncture), the IMF's leverage is limited.  The IMF wants to see a longer-term solution.  It is easy for it to push for a official sector haircut because it has recused itself from participating.   It will likely be dismissed by pundits as 'kicking the can down the road'.  

It is more than that.  By 2015, Greece's negotiating position will be vastly improved if it can have a primary budget surplus.  This would allow it to insist on the haircut that even Bundesbank President Weidmann says is necessary.  Yet it also seems true, from a tactical point of view, that to concede to an official sector haircut now would ease pressure on Greece to implement and execute structural reforms.  The OSI will be a post hoc reward for the reforms.  

If shift in sentiment toward the yen is the newest development and the European finance ministers' meeting is the most immediate, the US fiscal cliff is the largest force.  At issue is whether the world's largest economy is going to contract next year.  If it goes over the cliff, the CBO projects a sharp contraction in H1 that will take more than a couple of quarters to recover the lost output and  heal the likely deterioration of the labor market.  

A few months ago, going over the cliff was inconceivable.  Now it has not only become conceivable, but  some, like ourselves, see it as increasingly likely.  In any event, the key decisions will not take place this week with the President in Asia.  Moreover, given the dynamics, investors should be prepared for a drawn out brinkmanship game.  

The Federal Reserve will not have the luxury of waiting out politicians.  It will have to make a decision a few weeks.  Operation Twist will be completed and there does not seem to be a sufficient amount of short-term securities to seriously extend it.  The FOMC minutes reinforce our expectation that long-term Treasury buying under Operation Twist will be rolled into QE3+, essentially doubling the monthly outright purchases.  

The fourth development comes from a force outside of the financial crisis but also exerts pressure for adjustment.  The most recent string of Chinese economic data suggests the world's second largest economy has stabilized after slowing in recent quarters.  Data released over the weekend showed housing prices in more cities rose.  The HSBC flash manufacturing PMI for November is reported early Thursday in China.  It is expected to confirm a modest improvement.  

The transition of power in China has been made, even if it not complete.  A fine balance was achieved between the forces of order and the forces of change.  Cutting across the "princeling" and Communist Youth factions, the agents of change appear to hold the top leadership position, but are not a majority of now seven (down from nine) key politburo.  

In the larger picture, this is likely to prove an interregnum period.  The new configuration will last five years.   It will likely be consolidative in nature and may not see bold new initiatives.  At the end of that term, however, over half of the new politburo will be forced to retire due to age limits.  This will give the Chinese Troika (Xi Jinping, President, Li Keqiang, Premier and Wang Qishan, Vice Premier a clearer path in the second five year term.