Global Markets Weekly 4 October 2010

• Investors overcome their pessimism as China bolsters growth outlook, while hopes for QE2 offset bad news in developed economies
  The best September on Wall Street since 1939 is an unexpectedly positive outcome when the outlook for the economy remains resolutely downbeat. Weak US economic data was at least marginally better than expected, and certainly not sufficiently bad to suggest a return to recession. The data was also perversely encouraging in the sense that continued weakness is likely to be enough for the Fed to justify further quantitative easing (QE2), with such hopes pushing yields lower on US Treasuries and other major government bonds. Emerging equity markets, which we have favoured over developed equities for some time, continued to outperform amid news of the reacceleration of the Chinese economy. Industrial commodities also gained, with oil back to $80/barrel and copper hitting a two-year high, while modest gains were enough to secure at new record high for gold at $1,310/oz.
• But strains in the global economy are still visible – most obviously in FX markets
  Exchange rates will be upper-most in policy-makers minds ahead of the annual meeting of the International Monetary Fund next weekend, even if political sensitivity pushes currencies off the agenda. The Brazilian Finance Minister spoke this week of an “international currency war”. Notably, Japan spent 2 trillion yen ($25bn) pushing the yen down from its mid-month peak, while the US House of Representatives passed the Chinese Currency Bill proposing punitive duties on Chinese imports to combat the theoretical undervaluation of the renminbi. Additionally, dollar and sterling weakness has been one of the clearest reactions to expectations for the Fed and Bank of England to embark on QE2. And that is just the tip of the iceberg, with FX dealers reporting that central banks of South Korea, India, Malaysia, Taiwan, the Philippines and Singapore were all active in trying to stop their currencies appreciating this past week.
• We expect G4 currency depreciation, with gains concentrated in Asian currencies…
  So far the main ‘beneficiary’ of the moves in the FX markets has been the euro, but that seems more based on the belief that the ECB is reluctant to countenance QE or currency intervention, rather than any fundamental strengths. Our concerns over the long-term structural problems with the euro were highlighted by the plight of Ireland. Further funding of Ireland’s restructuring of the banking sector has pushed the cost to €35bn and the budget deficit to 32% of GDP. There is more pain to come as further budget cuts are required and the new ‘worst-case’ scenario indicates a final cost of €50bn for the banking bail-out.
• …but intervention will produce more volatility and some painful ‘squeezes’ in the market
  By contrast Asian currencies are being pushed higher by the relative strength of their economies, and officials remain wary of the impact of currency appreciation on their export industries, especially given the unfortunate example of rapid yen appreciation in the 1990s. We have seen renewed flexibility this year in the renminbi, rising by 2% against the dollar, but China’s latest PMI survey still showed a reacceleration in business activity, rising to 53.8 from 51.7 in August. We conclude that strong fundamentals will mean appreciation for currencies of most emerging markets and other outperforming economies, such as Canada and Australia, compared with G4 currencies, which will be undermined by QE2 and other measures to combat economic weakness.

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