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Stephen Tierney MBMG International Ltd.


Which currency is best for calm waters?

My business partner, Paul Gambles, was chatting again recently with John Noonan, Senior FX Analyst at Thomson Reuters. Like us, John sees the Swiss Franc as overvalued, although I do not share his faith in Europe's ability to move towards fiscal consolidation as an immediate factor in generating an Euro-Swiss Franc cross rally. John even broached the recent rumours of the SNB setting a peg against the Euro for the Swiss Franc at 110 even though this brought to mind the disastrous Sterling peg against the Euro's predecessor, the ECU, which fell apart dramatically and saw George Soros famously make billions on the trade as desperate attempts to raise UK interest rates to the best part of 20% during a single dramatic day failed ignominiously. Goldman Sachs apparently claimed that the CHF is even more overvalued than the Brazilian Real, by one reckoning more than 70% over. But if a peg is nonsense then what is the alternative for an economy reliant on both currency stability and exports?

Equally trapped is the Yen - although the Japanese central bank's strategy of stepping in and out of the markets in 'stealth mode' seems to be doing little to weaken the Yen in any meaningful way, although John sees this as more pragmatic - "Rather than drawing a line in the sand which gives the market a target, I think what they're doing now, which makes a lot more sense, is keeping the markets off balance. Working out when the markets are over-doing it and panicking and buying the Yen as a safe haven form of security and coming in at the right time when the markets are positioned would be far more effective, but we also know that any kind of interventional loan without the co-operation of other central banks is always going to be difficult; you're fighting a losing battle, but certainly this would be more effective than just saying at 76.25 we're not going to let the Yen strengthen any more. It makes sense that they're doing it this way.”

John has yet to come round to our certainty of major weakness in the Australian Dollar, seeing a more benign economic outlook than my view. Also, it now appears to us that there is really only one currency trade right now - US Dollar versus everything else. Everything seems to have been inversely correlated to the Greenback and we have not yet seen significant breakdown in those correlations despite Japanese intervention and Swiss talk.

The level of equity correction has generally not seen the expected extent of US Dollar strength in all cross rates, with Sterling certainly holding up very well. The Australian Dollar seems to have been the most risk-on currency. Just as whenever US Dollar has weakened over the past couple of years it has been the Australian Dollar that has strengthened the most, the AUD was the biggest victim of recent USD strength. I still see AUD rivalling Real and Swiss Franc as the most inflated currency, supported by carry trade monies.

To my mind the Australian Dollar is a good candidate as perhaps being the single most vulnerable currency in the world to correction right now. Any economic weakness and consequent strengthening in the USD is terrible news for the Australian Dollar. We see carry trade contributing around 15 cents to the current value to Australian Dollar. In short, we see the AUD being susceptible to re-testing previous intermediate lows of USD 0.60 whereas John sees that as less likely than his base case of moderate weakness - "All those instruments for carry, playing the emerging market story and the good times, with the investor fright that we saw last week that would take it off. As far as the Australian Dollar is concerned, I would agree that if we had a major systemic event, a systemic failure somewhere around the world and investors were pricing that in, as we saw in 2008, the Australian Dollar would be targeted. Back then it went from 98.50 40% down to 60 cents. I don't think it will go down that far. I'm more in the 10% camp, but I think we would need an event like that because not only is the Australian Dollar a beneficiary of the pure carry trade on yield, it's also a way to play the China story, and the China story still looks strong. The numbers that we're seeing coming out of Asia on the trade data is all suggesting that they're coping quite well with this pronounced slowdown in the US and Europe. So I think there's momentum in those economies, so while that's the case and we don't see a systemic event, the Australian Dollar will probably hold around these levels, but I agree that if we see the markets roil up again and they start fearing a Lehman-like event then the Australian Dollar will be extremely vulnerable.”

Basically, many of the world’s leading currencies are, potentially, vulnerable. If you want a safe haven then you will not do a lot worse than the Singapore Dollar.

The above data and research was compiled from sources believed to be reliable. However, neither MBMG International Ltd nor its officers can accept any liability for any errors or omissions in the above article nor bear any responsibility for any losses achieved as a result of any actions taken or not taken as a consequence of reading the above article. For more information please contact Stephen Tierney on [email protected]


Does Fed Model justify buying equities?

Firstly before we even start this debate, it is only fair to take a step back and explain what the Fed model is and what it attempts to do. In simple terms it is a model that compares the valuations of 10 year bonds to equities by comparing their respective yields. It argues that when earnings yields are above bond yields, shares are cheap relative to bonds and vice versa. Interestingly enough this model has not actually been endorsed by the Fed, but was penned by Ed Yardeni who came up with the concept when working at Prudential Securities (Some of our readers might remember Ed Yardeni as the analyst who rose to fame over concerns about Y2K, but I digress.)

In the graphs on this page, one can see that earnings yields are currently way above bond yields and, in fact, if the earnings yields are subtracted from bond yields, the difference sits at over 7%, the highest it has been in over 25 years. Based on this information, surely one should throw caution to the wind and buy equities and sell bonds?

However, as the FT has recently argued, the problem with the Fed model is that it does not always work (proving once again that there really are no holy grails in markets). If history is any guide, the Fed model would have indicated that shares were a lot more attractive at the start of the 1970s equities bear market than at the start of the bull market that began in 1982. In addition, earnings yields are a notional concept and tell one nothing about real cash flow, whereas bond yields are a true account of cash flow yield, for bond investors have no choice but to pay.

The same cannot be said for the dividend yield, which for the most part is a good indicator of actual cash paid by companies and in this respect, equities are indeed offering a better alternative to bonds. The graph indicates the difference between the dividend yield and the 10 year real bond yields (adjusting for inflation) and in every region, shares are offering value on this measure. Naturally one is assuming that dividends will grow, unlike coupons which are fixed, hence the reason for comparing dividends to real bond yields. As an example, the Euro Stoxx 50 yields 5.32 percent - more than double German Bunds. But, before you mortgage the house, take note of the fact that this has been the case in Japan since 08 and it has not helped the hapless Japanese investors.

Bottom line: Dividend yields on stocks are attractive and help justify buying stocks in absolute terms, if one believes earnings forecasts (a topic for another weekly view). But to just compare bond yields to equity yields is not reason enough to buy shares. All it might be telling us is that bonds are expensive, not necessarily that shares are a screaming buy.

The above data and research was compiled from sources believed to be reliable. However, neither MBMG International Ltd nor its officers can accept any liability for any errors or omissions in the above article nor bear any responsibility for any losses achieved as a result of any actions taken or not taken as a consequence of reading the above article. For more information please contact Stephen Tierney on [email protected]


Currency - A River of Opportunity?

There's a great deal of talk about Asian currencies of late - especially the Chinese Renminbi which has joined the ASEAN currencies and the Yen on our list of currencies where we see tactical opportunities for investors wishing to enjoy opportunities for returns in the established major western currencies.

We are holding some Renminbi hedged assets, so we were happy to see it break through the 640 mark recently, but our big concern is strategically how far RMB can go and how quickly. There is a reason why China accumulated so much US debt and that is because it did not want to convert that and therefore see its own currency strengthen, in the same way that Japan has done over the years. Germany thought it had found its way around that eternal exporters problem by the Euro, but then it found out that that solution maybe was not as great as it could be. I think that we expect RMB to strengthen; it has to strengthen. The inflationary pressures on China are so great now that letting the Renminbi strengthen is the lesser of two evils, but there is a limit to how far and how quickly it can let that happen, but we are happy to take that and ride up gradually with it.

It is so difficult for China because of the size of its US Dollar holdings, accumulated over the years - what is there that is large enough and liquid enough to actually go and buy with it? China has been playing around the margins by diversifying into hard assets and it can just stop re-buying treasuries once they mature, but it is really difficult to make a major move overnight. The size of the Dollar holdings and the size of the T-Bill holdings are just so large that you risk imploding the entire market, and they do not want to do that. It is obviously suited China to buy more Euros in recent times but I do not necessarily think that is a currency choice so much as a trading strategy. It has been exporting a lot more to the Eurozone and receiving Euros, so it has just been sterilising those export proceeds that it has been receiving rather than risk the appreciation associated with converting export proceeds into Renminbi. While this has delayed appreciation it has created huge upward pressures.

In addition, I think we are seeing a lot more interest in the Singapore Dollar, internationally. A couple of years ago, people were not really talking about the Singapore Dollar as an asset allocation choice, and now we are seeing a lot of international money managers, including our main affiliated managers, Martin Gray and Scott Campbell, talking about the Singapore Dollar. I think that this is for good reason. If you look at the fundamentals, the growth is in South East Asia. If you are going to invest in South East Asia, the first place you are going to go to is Singapore. Hong Kong has historically also been a conduit into Asia, but with Singapore, the Dollar is more freely traded, although the Hong Kong Dollar peg coming off is another interesting idea. There are good reasons for investing in the Singapore Dollar. Steady appreciation is a good place to be right now. Take the gentle current and avoid the rapids.

The above data and research was compiled from sources believed to be reliable. However, neither MBMG International Ltd nor its officers can accept any liability for any errors or omissions in the above article nor bear any responsibility for any losses achieved as a result of any actions taken or not taken as a consequence of reading the above article. For more information please contact Stephen Tierney on [email protected]


Domino Effect, part 2

The idea of the Euro project was also at least partly underpinned by an impetus that has been a constant theme in European history throughout the last three millennia; namely the evolution of hundreds of tribal states in the face of hegemony from a succession of various dominant empires from within or from outside Europe.

When the 19th century dawned, modern Italy and Germany did not even exist while the various Slav and Balkan states were embarking on a course of self-determination that has ultimately resulted in the tortuous journey to the status that they enjoy today. The Ottoman, Russian and Austro-Hungarian Empires which had once been the major bulwarks on the eastern side of Europe were already declining. Balancing ageing empires against the nascent force of nationalism preoccupied the major European powers throughout much of the 19th century and was a significant factor in the conflicts of the last century, with very mixed results.

Italy in 2011 has achieved the successes that it has despite its strong sense of being a collection of disparate regions and city states that were simply united by a post-Napoleonic desire to achieve a home-grown democratic republic rather than pay homage to rulers whose power base was imposed from outside. However, the greater the economic stresses that Italy faces, the greater is the risk that regional tensions will rise ever closer to the surface, as they did in the 1930s.

While Italy may still be very much a work in progress, Germany seems to be the finished article. Germany was established in installments from the series of agreements leading to the customs union, or Zollverein, to its galvanisation as a nation by successful military campaigns against France and Denmark. Despite talks of various secessions in 1918, Germany remained together until 1945 and even then successfully re-unified once the Berlin Wall came down. Perhaps this is a good indicator of where the Euro project has gone wrong. The EU has no such ties that bind it: There is no real sense of a single Union within the EU, merely a collection of self-interests that have become fatally interwoven and inter-dependent.

Angela Merkel is aware that the entire German banking system and economy could ultimately be brought to collapse by a chain reaction of events beginning with Greek or Irish or Portuguese or Spanish or Italian default right now. Like a row of dominoes, one falling would knock over the next. Yet Merkel also cannot fail to recognise the anger felt by German taxpayers is not far behind that expressed this week by the Greek protesters (whose anger is fuelled by the triple whammy of surging unemployment, lower wages and high inflation).

Hence the need to wring the concessions that so upset the Greek protesters. We expect these problems to intensify throughout 2011. Debt has always been a zero-sum game - the borrowers have to either repay the debt or default to the detriment of the lender. But in the Euro-zone experiment, like in the sub-prime madness in the States, this reality was suspended. The problem now is that it is very much back in play and no-one wants to be the loser in this high stakes game. Whatever method is used to unwind it - for example default, restructure, or extend at sub-market rates - will result in an effective loss to the lenders.

The recent "Cucumber Wars" between Spain and Germany are a sign that tensions between lenders and borrowers are rising while competitive divisions are also appearing between the recipients of bailout funds as each justifies its actions to its own electorate by insisting that it negotiated better terms than its peers had before. This merely adds extra spice to the merry-go-round of bankrupt countries taking turns to queue up with their hands out.

The day of reckoning for debtors, and therefore the creditors linked to them by the umbilical cord of debt, is getting closer - Irish government debt is just one level above junk with a worsening outlook, and Greek borrowing costs have soared, not just because of recent protests but because of the dawning realisation that whatever austerity is now imposed, Greece and the fellow GIPSIs, having spent a decade being force-fed more than they could chew by the ECB, will never be able to repay.

These irreconcilable interests cannot be held together much longer with the sticky tape of more bailouts. The instant that any party in this hugely expensive co-dependency walks away from its perceived obligations, the game is up and the Euro-zone experiment will implode. With stakes continuing to rise, the moment of my Big Fat GIPSI Divorce keeps getting closer and closer.

The above data and research was compiled from sources believed to be reliable. However, neither MBMG International Ltd nor its officers can accept any liability for any errors or omissions in the above article nor bear any responsibility for any losses achieved as a result of any actions taken or not taken as a consequence of reading the above article. For more information please contact Stephen Tierney on [email protected]