The recent resurgence of economic growth in Europe, in particular in Germany, the largest economy, has also been a key factor.
Political Pressure
France today echoed European worries over the rising euro in a clear attempt to put pressure on the European Central Bank not to imperil eurozone growth prospects ahead of next year’s French presidential election.
Thierry Breton, France’s finance minister, urged on his compatriot Jean-Claude Trichet and ECB colleagues to have “collective vigilance” in the face of the falling US dollar. He promised to raise the euro’s recent rise with fellow Eurozone finance ministers at their monthly meeting in Brussels on Monday evening.
The words "vigilance" is Trichet's code about inflation risks in advance of a certain interest rate increase.
Despite the pressures from politicians playing to the the political gallery, the ECB is expected to go-ahead with another quarter-point rise in its main interest rate to 3.5 per cent next week. A big appreciation in the euro in 2007, would likely have an impact on ECB thinking but developments also depend on money/supply growth.
French concern has been contrasted with a more relaxed mood in Germany, as France's economy experienced zero growth in the in the third quarter, after a strong second quarter. That has prompted economists to cut their growth estimates for the year to the bottom of the government’s target of 2-2.5 per cent.
A French official was reported as saying that Breton had deliberately changed his tone on the euro, from saying it was “fully valued” when it was trading at $1.24-$1.28 against the US dollar, to calling for “collective vigilance” now it was above the $1.30 mark.
Olivier Garnier, economist at Société Générale asset management, said the ECB was becoming “a favourite scapegoat for politicians”, letting them score points with voters by criticising the euro or interest rates, without being punished by financial markets.
Jean-Claude Juncker, Luxembourg prime minister and political head of the Eurozone Eurogroup of finance ministers, played down fears about the impact of the rising euro on exporters. “I don’t think we have to be concerned now,” he said. “We are lengths away from the critical zone.”
Europe takes lead in trade with Asia
US investment bank Goldman Sachs says that Europe is getting a bigger share than the US of the increased trade with leading emerging markets such as Brazil, Russia, India and China. Companies such as French retailer Carrefour SA and German software maker SAP AG are winning customers in emerging markets at the expense of rivals based in other regions.
``It raises eyebrows when people hear it, but Europe is doing well from globalization and greater trade,'' Bloomberg News quotes Erik Nielsen, Chief European Economist with Goldman Sachs in London. ``It stands to benefit much more in the future.''
Europe is currently benefiting from its advantage versus other industrial economies in sectors including pharmaceuticals, mechanical engineering and scientific instruments, says Nielsen, a former International Monetary Fund economist.
Goldman Sachs says German engineering giants Siemens AG and ThyssenKrupp AG have helped build Shanghai's magnetic-levitation railway. Finland's Nokia, the world's biggest maker of mobile phones, controls over 70 percent of the Indian market for handsets. Europe's biggest software company, Walldorf, Germany-based SAP, the world's biggest maker of business management software, is beating US rival Oracle Corp. in Asia, Hans-Peter Klaey, SAP's chief executive officer in Asia, said in an interview last month. In China, SAP recently won orders from Sinopec Group, Asia's largest oil refiner, and from retailer Wumart Stores Inc., he said.
Europe's biggest retailer, Paris-based Carrefour, runs 85 hypermarkets in China to US rival Wal-Mart Stores Inc.'s 66.
EURO on RISE
Stephen Jen who is a Managing Director and Chief Currency Economist at Goldman Sachs' rival Morgan Stanley in London, wrote on Friday: "For a couple of weeks now, I have been warning of the risk of the Eurozone’s economy being re-rated for 2007. In this piece, we formally revise up our forecasts for EUR/USD to 1.31 by year-end and 1.32 by end-June, compared with 1.24 and 1.22 previously. This should be seen as an overshoot in the € and not a fundamental shift in our view that the € is structurally overvalued from a medium-term perspective. Our forecasts for the euro crosses remain broadly unchanged."
Symmetric cyclical dollar correction
Morgan Stanley says that it maintains the view that, as the US economy experiences a benign soft landing, lasting through 2007, and as the rest of the world de-couples from the US, the dollar should weaken. However, while since November 2005 until last Friday, it argued that the ¥ would outperform the dollar, but not the €, it now believes that the dollar should weaken against both the € and ¥, particularly in the first half of 2007. In other words, it now believes that the prospective dollar correction will be symmetric.
The main reason for our change in view is the impressive strength of the Eurozone economy.
Stephen Jen writes that there is a good deal of momentum in Europe and it is likely to register 2.6% growth this year. The impact of the German VAT hike may not be severe enough to arrest this growth in 2007. The ECB, as a result of cumulative above-trend growth of 1.9% in 2007, on top of this year’s performance, should bring its key interest rate to 4.00%, compared with the 3.50% that Morgan Stanley had forecast previously.
"We have, for some time now, expected the majors to break out of their familiar ranges before the year is over. Solid performance of the economies outside the US (e.g., Eurozone, the UK, Sweden, AXJ and Japan) forcing further monetary tightening will be a key propellant for the USD index to weaken, in our view. Judging the cyclical trajectories of exchange rates is more a game of ‘searching for the bluest patch of sky’ than ‘hiding from the storm’. In other words, this prospective dollar correction will take place in a ‘positive’ environment (i.e., the rest of the world staying robust) rather than a ‘negative’ environment (i.e., the US falling into a recession)," Jen says.
The global backdrop
Morgan Stanley says that it believes that the global economy is in the middle of a powerful structural uptrend, with the US is experiencing a benign and desirable soft landing, allowing global growth to rebalance toward the rest of the world. Extraordinary global growth in the past four years, with low inflation, was due primarily to the effective doubling of the global labor force.
Stephen Jen says that in the next four years, he suspects that global capex will stay strong, rebalancing the world’s capital-to-labor (K/L) ratio. The main reason why the world’s realized investment has been so low, relative to savings, is that this marriage of capital and labor needs to take place ‘locally,’ i.e., most of the new capex should take place in China, India and Eastern Europe and not in Japan or Switzerland. But due to policy, economic and political uncertainties and constraints on implementational capacity in these developing countries, realized investment has not been as high or as fast as theories would suggest.
In the meantime, the world will experience savings-investment surpluses and real interest rates will remain low. Long bond rates will normalize, i.e., the bond market conundrum will disappear only when a critical amount of capex takes place in the world to absorb the excess savings.
"If my thesis is correct, global growth in the coming four years will remain robust, again accompanied by relatively low inflation, since capex is both demand and supply. Energy prices will likely remain supported by strong global demand," Jen says.
The structural outlook for the dollar
Morgan Stanley's Chief Currency Economist says: "We have long (since 2004) been of the view that ‘C/A (current account) deficit = dollar crash’ is an erroneous notion because of financial globalization. The global capital markets are so uneven in terms of level of development that the new-found wealth, derived from goods globalization in other parts of the world simply has had few places to go other than the established, well-developed financial markets. Since the US offers not only the most liquid sovereign debt market but also the most liquid risky asset markets (corporate bonds, equities and other higher-risk assets), the dollar cannot collapse. Financing the US C/A deficit does not require foreigners ‘doing the Americans a favor’, and the notion that non-US citizens could suddenly stop investing in the US is greatly mistaken as, in my view, the ‘Sudden-Stop’ problem applies to emerging markets, not the hegemonic and the numeraire currency.
Similarly, I believe that investors may have been too easily excited by the term ‘reserve diversification’. In my view, this is a very gradual process, dictated in part by the liquidity of the targeted market. It is very difficult for Asian central banks to diversify in size into markets that are small. Our analysis suggests that most of the diversification we will see in the coming year or so will be cross-asset diversification and not cross-currency diversification.
In sum, the point I stress here is that, even though I am cyclically bearish on the dollar, I am still structurally constructive on the dollar."
Morgan Stanley's cyclical view for 2007
Here are its key thoughts:
- €/$ has the best chance of staging an overshoot in the nearer term, i.e., 1H07. Just as our economists have recently upgraded Eurozone’s outlook, we expect others to do the same, possibly after seeing that the German VAT hike will not have such a devastating effect on consumption in Germany. Another round of re-rating of Eurozone in the first weeks of 2007 is a distinct risk. By mid-2007, we expect the ECB to be winding down its tightening campaign.
- €/$ and €/¥ to overshoot. We think that the € is prone to overshooting partly because of the sensitivity of investors to the opaque issue of diversification. I have my view, which is quite different from the prevalent view, that the major central banks have indeed been diversifying away from $ assets. $ weakness, even though it may be cyclical in nature, could easily trigger an exaggerated market reaction, pushing both €/$ and $/¥ toward the ECB/Europe’s threshold of tolerance, which I suspect may be 4-5% away from the current spot rates.
- Our view on $/¥ remains unchanged. Frustratingly, $/¥ has not declined in the past months; but it has not risen either. We continue to believe that the JPY has already established a medium-term floor against the dollar, and is close to doing so against the € (I’ve mentioned the levels 120 and 150-155 before). Central banks have, I suspect, reversed their long-standing strategy of reducing their ¥ exposure in the FX reserves. From a low point of 3.3%, ¥ assets, I believe, will start to rise as a share of total official reserves.
- We remain positive on the AXJ (Asia ex-Japan) currencies. If the global economy remains robust, as I expect it will, and the US soft-lands, the AXJ currencies should perform well.
- Stronger paths for the NOK and SEK. We have kept €/£ unchanged (cable now peaks at 2.00 by 2Q07). However, we believe that €/NOK and €/SEK should have a sharper sell-off in 2007 as both Norway and Sweden outpace Eurozone, and pent-up inflationary pressures come through to justify more aggressive monetary tightening.
- Commodity currencies to weaken. We have not revised our forecasts for the CAD, AUD or NZD, and expect these overvalued currencies to be vulnerable to even a modest slowdown in the global economy and unwinding of ¥ carry trades.
