Time to dust off the risk-pricing monitors
With momentum building towards a further round of quantitative easing (QE2) in key developed economies and several countries with capital surpluses now putting their policy tightening on hold, excess liquidity threatens to produce a new bubble in global financial markets. While this flood of money will push up asset prices in the short term, it comes with new geopolitical risks that investors should be careful not to underestimate.
Against this backdrop, we believe it is prudent to develop a framework to monitor when markets may begin to ‘under-price’ these growing risks. Indeed, as financial assets have rallied in recent weeks, increased geopolitical tensions have emerged with:
In the near-term, the International Monetary Fund’s (IMF) willingness to mediate has moderated the risk that these simmering disputes spill over into what Brazil’s finance minister described as a ‘currency war’. We view the IMF’s intercession as a positive, albeit stop-gap, measure to keep individual countries from becoming too inwardly focused and losing the context of the impact of their actions on the broader global economy. But the development of these relatively minor disputes needs to be monitored closely, given the risk that they may lead to more disorderly moves in currency markets.
While the risks to the global financial system have not fully receded, there has been a shift away from the synchronized global policies of 2008-09 in reaction to the credit crisis. This shift raises the threat of disorderly currency moves, which we believe should now be on investor radar screens.
If other currencies continue to rally against the dollar as momentum builds toward QE2 in the US, possibly followed by the UK, individual nations may choose to pursue domestic political agendas (including trade restrictions/tariffs) or even more far-reaching capital controls. This could damage the functioning of the global financial system and overall growth prospects of the global economy.
Monitoring the price of risk
Measures worth watching to gauge whether investors in general are underestimating these risks include the dollar’s value against key currencies and the relative valuation above fair value of financial assets, such as 10-year bonds and Asian equities. In addition, investors should also monitor inflationary pressures in China and other emerging markets from the growing pool of cheap money coming from developed markets.
Despite steep declines in recent weeks, the dollar is only 5-10% undervalued against sterling and the yen, based on purchasing-power parity (PPP), a measure of fair value for currencies, according to Bloomberg. The dollar is 15-20% undervalued against the euro, compared with previous troughs of 25-40% on a PPP basis. Even against currencies such as the Canadian dollar and Swiss franc, the dollar is 5 percentage points shy of its trough.
However, it should be noted that sterling is capped by expectations for QE2 in the UK, while Japan’s struggle with deflation over the past two decades has had the effect of boosting its PPP. Japan has also clearly demonstrated a reluctance to allow further gains in the yen, which is already at its highest against the dollar since 1995.
Because it is restricted in the pace at which it can rise, China’s currency has gained 2% against the dollar since June, but has fallen by as much as 10% against the euro and 7% against the yen. The renminbi sits 4% below the upper end of its Real Effective Exchange Rate (REER) trading range that has been in place since 1993, suggesting it could appreciate more without exceeding its long-term policy channel.
Our base case for a continued moderate weakening of the dollar against emerging-market currencies remains intact, but this is likely to depend on further strengthening in the renminbi (which we expect). With the dollar approaching historical lows against other developed-market currencies, or even exceeding them in the case of the Australian dollar, this one-sided trade may be due for a correction.
On the bond front, US 10-year Treasury yields have fallen sharply in recent weeks, dipping below 2.4% to their lowest levels since January 2009. However, they remain just above the upper end of our fair-value range of 1.8-2.3%, which assumes that core CPI, which excludes volatile food and energy prices, falls to 0% in 2011. This suggests that 10- year bonds are just beginning to properly price in the 0% core CPI we expect for early-2011.
In contrast to the views of many commentators, we do not believe 10-year US Treasuries are currently in a bubble, but rather reflect expectations of a continuing decline in core inflation.
However, if yields push below the fair-value range, this would suggest that the market is over-pricing the prospect of outright deflation and underestimating the potential for QE2.
The September rise in Asian equities was also impressive. But on our composite valuation indicator, which includes such measures as dividend yields and the ratio of prices to earnings and book value, remains short of the peaks seen in 1996-97, 2000-01, and 2006-07. This suggests room for further increases in these valuations as QE2 momentum continues to build.
Lastly, while CPI momentum in China has been sticky to the upside in recent months, our leading indicators suggest that the peak in CPI remains likely in the 4th quarter of 2010 allowing decelerating headline inflation in early-2011. Indeed, core CPI has begun to peak providing some comfort in the prospects for a broader CPI peak in coming months.
As rally builds, so will the risks
Our expectation is that the recent rally in government bonds and Asian/emerging equities, and corresponding weakness in the dollar, could well continue over the coming months, with geopolitical risks rising in tandem. The warning signs are not yet flashing red, but we believe it will be prudent to keep a wary eye on them.
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