Positive comments on the Euro from Morgan Stanley
Global: The ECI and the Euro
Stephen Roach (New York)
Financial market denial is moving into the twilight zone. Excesses have spilled over from equity to foreign exchange
markets. Investors have upped the ante on the American perfection bet while euro-denominated assets are being met with
extraordinary scorn. Meanwhile, the reality check from the data flow is increasingly challenging this fantasy. What will
give?
Slowly, but surely, the forces of cyclical inflation are building in the United States. New paradigmers are quick to take the
other side of this story, but recent trends in both the CPI and the ECI say it all. As Dick Berner has been maintaining for
some time, it?s not just a one-month data blip or an energy shock that is now pushing inflation higher; excluding food,
energy, and tobacco, the core CPI has been accelerating for seven months -- rising from the 1.5% annual pace of last
August to 2.2% in March 2000. A comparable stirring is now evident on the labor cost side of the equation. The monthly
data on average hourly earnings pointed to a 4.8% annualized increase in the first three months of this year, and the ECI
has surged to a 4.3% annual rate in the 12 months ending this March; on both counts, this represents a marked
acceleration from crisis-depressed lows prevailing a year ago.
This is precisely the cyclical response that has long worried Alan Greenspan the most. And with good reason. The Fed
Chairman has voiced a good deal of concern over the possibility that shortages in the pool of available workers would
boost wage inflation. Those fears are now coming to pass. So far, these pressures have been neutralized by truly
extraordinary productivity increases. But in a rising wage inflation climate, productivity growth will have to keep
accelerating in order to hold the line on unit labor costs. In the context of the 5.5% annualized productivity growth over the
second half of 1999, the odds of any further acceleration are quite low. Indeed, David Greenlaw?s estimates suggest that
nonfarm business productivity rose "just" 3.0% in 1Q00 -- quite impressive by standards of the 1980s and early 1990s
but only a little more than half the pace prevailing over the preceding six months. Contrary to the productivity acceleration
required to offset surging wage inflation, productivity gains are actually moderating -- a very predictable outcome that can
only heighten the tension now emerging on the labor cost side of the equation.
Financial markets seem quite perplexed over what to make of these developments. As best we can tell, fixed income
markets are now discounting about 75 bps of Fed tightening over the next six months. Our own modeling team, however,
would be the first to concede the bond market chaos of the past three months has made it exceedingly difficult to discern
the "Fed path" that is now embedded in the price of fixed income securities. Notwithstanding that caveat, I get the strong
sense from my latest discussions with domestic investors that they have become increasingly comfortable with the notion
that the Fed now has a fair amount of tightening to do between now and year end. This is very much at odds with one of
the most sacred tenets of the new paradigm -- that the central bank was always just one tightening away from being
finished.
Foreign exchange markets seem to be marching to a very different beat. The euro has become a one-way bet to the
downside. America?s massive current account deficit hasn?t mattered. Neither did the long-awaited puncturing of the
Nasdaq balloon. Cyclical revival in the Euroland economy hasn?t helped -- nor has the steady tightening of the ECB. In
the eyes of currency market participants, America can do no wrong and Europe can do no right. It?s a perception that held
in the depths if the financial crisis of 1997-98, as well as in the post-crisis healing that has ensued. And it?s a perception
that remains unshaken, even in the face of an increasingly cyclical outcome for the US economy and Fed policy. The
worst-case outcome for the United States is thought to be a soft landing -- far superior to the worst-case Euroland scenario
of structural gridlock and/or an EMU break-up.
The real risk, in my view, is that financial markets have overshot a very different fundamental scenario. Far from perfect, a
late-cycle US economy is now facing an increasingly classic cyclical profile. This underscores the possibility of emerging
pressures on costs, inflation, profit margins, and interest rates. To the extent these pressures now have a greater chance of
materializing, it could well be exceedingly difficult for America to execute its massive external financing needs, without
suffering some meaningful currency concessions. By contrast, an early-cycle Euroland economy has far more wiggle
room: Compared with the United States, it has half the core inflation rate and double the unemployment rate. Euroland is
also running a current-account surplus likely to exceed 1% of its GDP this year, effectively taking the external financing
constraint out of its financial market equation.
But the biggest plus for Europe may simply be that it is about to start closing the gap with America. That?s true from
standpoints of corporate restructuring, tax policies, and labor market rigidities. It may also be true with respect to
technology prowess, as a powerful e-commerce-driven catch-up finds Euroland beginning to converge on the US norms of
IT endowment; moreover, the possibility of technology leapfrogging -- especially into broadband wireless -- is yet another
plus in the euro column. Currencies, in the end, are nothing but relative prices. And the relative comparisons for Europe are
not nearly as bleak as the currency markets now seem to suggest. I agree with Joachim Fels that America?s emerging
cyclical story is ultimately quite bearish for the dollar. Like it or not, that?s the real message from the ECI.
Important Disclosure Information at the end of this Forum
Global: Currencies and Flows
John Montgomery (New York)
Sharp market movements attract analytical theories like flowers attract bees. The euro's recent fall is no exception. In the
last 24 hours (April 27-28) it has scraped a new bottom below $0.91. For a longer-term comparison, consider the German
mark, which is trading around DEM 2.15 per dollar, a level it last recorded 14 years ago. There has been a rush to attribute
this decline to incompetent European policymaking, or, to take a recent newspaper article, to poor communication of policy
intentions. Similarly, when the yen hit 80 to the dollar in 1995, there was no shortage of rational explanations for what
turned out to be an extreme in the market. Through all of these attempts at ex post rationalization, it is helpful to consider
economic fundamentals, and particularly cross-border trade and financial flows, and how they affect exchange rates.
I find it useful to break up flows into two parts: a set of autonomous flows are not very dependent on financial returns
(although they are responsive to levels of currencies and prices in goods and financial markets more generally,) and those
that are more responsive to expected returns on currencies and other financial assets. In the first category, I would put trade
and other current account flows, and direct investment flows, including M&A. In the second category, I would put the rest
of the balance of payments, in particular, portfolio flows into equity and bond markets, and banking flows. This
classification is not perfect: for example, direct investment presumably responds to perceived economic returns in the
recipient economy, which is presumably correlated with expected market returns. But I think it still provides a helpful
analytic framework. (Some readers will be aware of a concept called the "basic balance." This is defined as the sum of the
current account and long-term capital flows, which is somewhat broader than direct investment. It is not quite the same
concept, and anyway the classification of long-term capital flows is rather outmoded in international economics.)
What do the numbers say about major economies? I analyzed this issue in great detail in my recent quarterly. The balance
of autonomous (i.e., current account plus direct investment) transactions for Euroland was a deficit of $109 billion in
1999. This is the result of three years of steady deterioration. Euroland autonomous flows registered a surplus of $53
billion in 1997 and a deficit of $47 billion in 1998. Europe continued to run a deficit on autonomous flows for
January-February 2000. The UK and the US also recorded large autonomous deficits in 1999, while Japan had a surplus.
These numbers imply that Euroland (as well as the UK and US) needed to attract substantial return-sensitive inflows. In
rough terms, that was done through the banking system in Euroland, which actually recorded outflows of stock and bond
investment. The other regions were net takers of portfolio investment. The United States got portfolio flows that almost
exactly filled its autonomous deficit, and the UK got flows that well exceeded its deficit, while portfolio flows
supplemented Japan's autonomous surplus. Only Euroland needed net banking inflows. I think this is a key reason for the
euro's weakness in 1999 and early 2000.
As the need to attract flows rises, the required return will have to rise relative to other countries to attract those flows. If not,
the currency will weaken. In my quarterly, I devised a "financial pressure index" to capture these ideas. It is a composite of
the value of an economy's currency and the level of returns in that economy's assets relative to foreign returns. I stick to
fixed income returns to keep things relatively simple. To benchmark the index, I use the last ten years of history. The
returns are both short-term interest rates and bond yields. For Euroland/Germany, the index is two standard deviations
above its 10-year average, the highest over that period. The currency (DEM/USD), is the weakest it has been in a decade,
while short- and long-term interest rate differentials (with the US) are close to their peaks. At the other extreme, Japan's
financial pressure index is two standard deviations below average, indicating very low pressure.
This framework helps explain the euro's decline since its inception, but does that explain the euro's weakness over the past
month? I doubt it. The macroeconomic flow story does not seem to have gotten suddenly worse. There hasn't been a
sudden rash of outward M&A from Euroland. If anything, news in the last month has been positive for Europe's current
account, with the price of oil declining. And nothing has made the quality of European policymaking look suddenly worse.
So in my opinion, the recent weakness of the euro is more a function of market momentum, with changes in short-term
market positions feeding on themselves. Yes, the macro flows have not been kind to the euro since its birth, but that's not a
new story. I think the euro should turn around before long and validate at least the direction of MSDW currency
economist Joachim Fels' forecast. |
