Trade Insight February 2015

Currency wars and volatility

 

Executive summary

  • January 2015 was a volatile month with markets unsettled by the uncertainty generated at the beginning of the month over European Central Bank Quantitative Easing (QE). This uncertainty was compounded by the removal of the Swiss franc’s currency peg to the euro by the Swiss National Bank.
  • Both events have put significant pressure on the euro during the first month of 2015 which Delta Economics expects to continue throughout the year. We are forecasting that the euro and US dollar may well reach parity by the end of the year, if not earlier if current trends continue.
  • Delta Economics is expecting the PMIs published at the beginning of February to be broadly in line with consensus expectations. We expect China’s PMI to fall back while we are expecting PMIs in Europe to improve slightly. It is too soon to herald a recovery but this is a positive start to 2015.
  • The Delta Economics Asset Trade Corridor Index (TCI-A) reflects the underlying volatility in markets with Information Ratios largely negative for equities and currencies. The TCI-A has produced an average monthly paper return of 1.3% over the past 19 months. The average return on an equally weighted portfolio in January 2015 was 2.2%.
  • We expect oil prices and the value of the euro to fall during February. We expect other commodity prices to rise (against consensus), equities to rise and the US dollar to strengthen against most major Emerging Market currencies. However, the tightest strategy that we use suggests a strong downside risk to all these calls because of the underlying volatility reflected in the information ratios.

 


Greeks bearing gifts? The consequence of January for the euro in 2015

 

Delta Economics is of the view that the euro will reach parity with the US dollar by 2015 and has the potential to fall lower if current volatility and pressures on the currency continues. This is for several reasons:

First, Delta Economics considers the euro to have been over-valued for some time, largely as a result of the German trade surplus. Although Europe needs German trade to be strong because of the supply chains that originate in Germany and spread out across Europe, the high value of the euro has made it harder for the internal imbalances of the eurozone to be corrected by export-led growth outside of Germany.

At the outset, markets viewed the eurozone with a degree of scepticism. By June 2001 one euro bought 0.85 US dollars. As time has gone by, eurozone performance has, inevitably perhaps, become more dominated by Germany pushing the value of the euro up and kicking the issues of intrinsic imbalances between Member States down the road. However, instead of resolving imbalances by everyone “becoming more like Germany”, a weaker currency simply reflects the fact that everyone isn’t like Germany.

Second, the fact that QE was necessary in the first place made it abundantly clear that the eurozone is far from a marriage of equals. The euro came under pressure ahead of the announcement and fell to new lows subsequently. But it is here where the facts start to conflict with policy expectations. Theoretically, a lower euro should boost the real economy through trade because exports should become cheaper. However, what we’ve actually seen over the years since the introduction of the euro is a high correlation between the euro’s value and the value of trade: in other words, when the euro goes up, so does trade (Figure 1).

We believe there are two explanations for this: in the first instance, European trade, dominated as it is by Germany France, Italy, the Netherlands and Belgium, is largely at the high end of supply and value chains and therefore does not respond particularly to changes in the value of the currency. Even for weaker nations more dependent on commodities, the importance of Europe-wide supply chains means that the relationship still holds. For example, the correlation of the value of the euro with Greek trade is 0.89.

Furthermore, the value of the euro is actually a signal by the markets about the strength of the European economy: when the economy and institutions seem strong, the value is high and vice versa. In other words, as discussed previously, trade is an important driver of the value of the euro because of its importance as a driver of economic performance in the eurozone generally. While trade is falling, and we are forecasting it will fall by 3.7% within the eurozone in 2015, so too can we expect the value of the euro to fall. The result is that policy can have very little effect on the real economy through currency manipulation.

 

2015-02-03_backToReality_fig01_v01

 

Figure 1  |  Monthly value of eurozone exports, USDbn versus USD per euro spot, Last Price Monthly, June 2001-Dec 2015
Source  |  DeltaMetrics 2015, Bloomberg

 

The third reason why the value of the euro is likely to come under increased pressure is the outcome of the Greek election in January. Syriza is looking to renegotiate its debt and start the process of loosening the tight controls it has had over spending. It will not be helped by a lower-valued euro (Figure 2) because of its inter-dependency with trade in the eurozone as a whole through its role as a trade hub.

 

2015-02-03_backToReality_fig02_v01

 

Figure 2  |  Monthly value of Greek total trade (USDm) versus USD per euro spot price, Last Price Monthly, June 2001-Dec 2015
Source  |  DeltaMetrics 2015, Bloomberg

 

Greece’s trade to GDP ratio is 0.4: in other words, there is a fairly strong pull of trade on Greece’s GDP. Oil is a critical part of this; the correlation between Greece’s trade and the oil price is 0.80 – largely because of the importance of oil in Greece’s total trade structure. Greece’s exports of refined oil, for example, are twice as high as the second-largest export sector – medicines.

 

  2015-02-04_tradeInsight_fig03_v01

 

Figure 3  |  Greece’s debt and the challenge of trade
Source  |  DeltaMetrics 2015

 

Greece’s trade is just 0.4% of Europe’s total trade; however, their trade is nevertheless important both because of the impact that it has on the prospective growth of the Greek economy and as a portent for the negotiations about debt restructuring, austerity and structural reform ahead. Put simply, if a low-valued euro is unlikely to help boost Greek (or eurozone for that matter) trade more generally, then there is little that monetary policy at a European level can do to help long-term growth in the peripheral nations. Greece’s debt is, according to Syriza, not repayable and imposes too many restrictions on the Greek economy. One option is to set debt repayments against growth targets but, given falling oil prices and falling intra-European trade, this looks ambitious.

The eurozone needs more than QE and a low value of the currency for growth. The eurozone’s peripheral nations’ struggle for growth is accentuated by the fact that they must trade in euros internally and externally. Given “austerity” constraints attached to their sovereign debt, this makes it very difficult to grow. There will continue to be sustained political dissent between Member States on the best way to resolve the issue of Greece, and there is a danger that the debate will spill over to other nations, like Spain, Ireland and Portugal.

The likely outcome of all of this is continued market pressure on the euro (Figure 4).

 

2015-02-03_backToReality_fig04_v01

 

Figure 4  |  Monthly value of Eurozone exports versus USD per Euro spot price and linear forecast, Jan 2014-May 2016
Source  |  DeltaMetrics 2015, Bloomberg, Delta Economics analysis

 

The pressure on the euro over the last year has mostly been downwards. The Delta Economics asset price forecasting model, which is itself based on country-sector-partner trade flows, is indicating short positions on the euro for most of 2015. Even if the trend continues in a linear way as it has done over the past 12 months, this suggests parity by the end of the year.

 


 

Outlook for PMIs February 2015

 

The Trade Corridor Indices (TCIs) measure the trade flows of any one country and forecasts these forward using its proprietorial forecasting methodology. Each index is specific to the country it relates to in that the trade corridors and flows will differ for each country. The rate of change in the index is correlated with the Purchasing Managers’ Index (PMI) for that country.

The TCIs are based on actual data and although they are highly correlated are in no sense an alternative to the PMIs since the methodologies differ. PMIs, being survey-based, are sentiment indicators while the TCIs give an actual and a forecast indication of how underlying trade conditions, including trade finance, are moving. In other words, the TCIs provide a predictable and quantifiable view of how changes in the global economy are affecting trade at an individual country level.

Generally we are expecting manufacturing PMIs to move in line with consensus this month with very little movement on their December values. The only exception is French services where we are expecting a bigger increase in the service sector PMI compared to consensus. However, although the accuracy of the predictions has been reasonable over the past 12 months, the correlation is substantially lower.

The predictions are based on:

  • The correlation of a country’s top 500 trade corridors with that country’s Manufacturing PMI to create a trade corridor index associated with the PMIs/sentiment (TCI-S)
  • Correlation of the rate of change in that index (6 month moving average) with the Manufacturing PMI
  • The monthly change in the six-month moving average (positive change suggests PMIs will improve while negative suggests they will deteriorate).

Outlook for PMIs February 2015  |  Outlook risk

  • The above information is based on the PMI tickers as listed.
  • The predictive capacity of the model is strong, but not perfect as they are based on correlations rather than causal relationships
  • Note – the correlations and values given are against the Tickers listed and not with the Flash PMIs although the Flash PMIs follow similar patterns
  • Note – forecast values are indicative of scale of change only and should not be seen as absolute values

 2015-02-04_tradeInsight_fig05_v01

 

Figure 5  |  PMI outlook, February 2015
Source  |  Delta Economics

 


 

Trade Corridor Index Asset Price Calls

 

Overview

The Delta Economics TCI-based asset management strategy takes the top 500 trade corridors (trade between two countries by sector) against and asset price. It creates an optimum corridor index of those trade corridors each month and has been tracking its performance over the past 19 months. This is a systematic model and assets are included in the portfolio if one of the following conditions is met:

  • The signal strength, which measures the percentage of trade corridors that are pointing to a long or short call: this must be higher than 95%
  • The signal strength is greater than 85% and the Information Ratio (which measures the performance of that optimum corridor relative to benchmark returns) is greater than 0.5 (indicating good or very good back-tested performance)
  • Where there is a signal strength of 100 and only one corridor in the index, the Information Ratio must be above 0.5.

The returns, which are not optimised and based purely on an equally weighted portfolio strategy, were 2.2% in December 2014. This means that over the past 19 months, returns have averaged 1.3% per month with above average returns in 11 months.

 

2015-02-04_homepageGraph_v01

 

Figure 6  |  TCI-A returns, June 2013-January 2015
Source  |  Delta Economics

 

The calls for February 2015 reflect underlying volatility in markets with Information Ratios largely negative or mildly positive. Although the TCI-As across a portfolio of assets produced a return of 0.7% in October, this was against a similar backdrop of low or negative Information Ratios, which arguably underpinned the correction in the middle of the month. Because of these low, even negative, IRs our portfolio suggestions potentially have substantial downside risk attached to them.

 


 

Commodities

 

The short call on oil reflects continuing downward pressure on oil prices despite the mild rally at the end of January 2015. While the signal strength is low, the information ratio is high suggesting that this is a strong call. Similarly, the long call on Gold has weak information ratio but strong signal strength suggesting that Gold may continue its upward path as a hedge against deflation. Because of underlying uncertainties in the global economy and the fragility of commodity markets, the long calls on copper and steel appear contrary to market sentiment currently. However, our trade outlook for the world in 2015 is mildly more positive than it was during 2014 and Asia in particular is forecast to grow strongly. A long call on copper and steel suggests prices may start to increase during February as a lead indicator of manufacturing activity increases towards the end of Q1 2015.

 

2015-02-04_tradeInsight_fig07_v01

 

Figure 7  |  Delta Economics TCI-A based strategy, commodity calls for February 2015
Source  |  Delta Economics analysis

 


 

Equities

 

We are expecting all equity markets to increase this month, but the signal strengths are weak and the Information Ratios largely negative. A long position arguably reflects the sustained flight to equities following European QE, but the negative information ratios reflect volatility and substantial downside risk.

 

2015-02-04_tradeInsight_fig08_v01

 

Figure 8  |  Delta Economics TCI-A based strategy, equity calls for February 2015
Source  |  Delta Economics analysis

 


 

 

Currencies

 

The calls generally suggest that the euro will continue its weaker path against the US dollar this month. The information ratio on this call is strong, but the signal strength relatively weak. Other emerging market currencies similarly paint a picture of a strengthening dollar as expectations of an increase in US interest rates later this year versus perceived weakness in Europe and Japan continue to stoke up its value.

 

2015-02-04_tradeInsight_fig09_v01

 

Figure 9  |  Delta Economics TCI-A based strategy, equity calls for February 2015
Source  |  Delta Economics analysis

 

 

Delta Economics Trade Insight February 2015  |  Author  |  Rebecca Harding  |  CEO Delta Economics


tradeInsight_TCI-BasedStrategy

Greece’s future is its past

Why trade holds the key to debt renegotiation  |  A deal was done at the last minute: Greece’s €172bn debt bailout was extended for a further four months after a turbulent week of bluff and counterbluff. Even now, there are no formal agreements on the required reform process ahead and without these agreements the deal will not be ratified. It appears that the Greek government is keen to demonstrate its willingness to reform by focusing on tax evasion and civil service reform, but it is unlikely that this will be sufficient for either Germany or the ECB.

By letting its focus continue to be on austerity, debt renegotiation, and structural reform, Syriza and now the Greek government, seem intent on playing by the same rules as the Troika, the ECB and Germany. For an economy that has shrunk by 25% since the beginning of the financial crisis, this is extraordinary. Instead it should be looking at debt re-payment over the longer term. If an economy is growing, then its debt is affordable; if the debt is extended for four months, then growth should be made central to subsequent discussions.

At present the outlook does not look good for several reasons: first, Greece is a service economy yet, despite the improving external position represented by the declining euro, its service sector trade is set to decline sharply over the next three years and pick up only gradually into 2019 (Figure 1). Given Greece’s already weak domestic demand, the decline in service exports, which includes tourism, is worrying.

 

2015-02-23_CommentsAnalysis_012_fig01_v01

 

Figure 1  |  Outlook for Greek service sector trade to 2020
Source  |  DeltaMetrics 2015

 

Second, Greece’s goods trade to GDP ratio is 0.4. In other words, there is a fairly strong pull of trade on Greece’s GDP. Oil is a critical part of this: the correlation between Greece’s trade and the oil price is 0.80 – largely because of the importance of oil in Greece’s total trade structure. For example, Greece’s exports of refined oil are twice as high as the second-largest export sector: medicines.

 

2015-02-04_tradeInsight_fig03_v01

 

Figure 2  |  Greece’s debt and the challenge of trade
Source  |  DeltaMetrics 2015

 

The importance of oil to Greece’s trade explains its resistance to the EU’s extension of sanctions against Russia in January and is the third reason why Greece’s situation more broadly looks vulnerable. Turkey is Greece’s largest trading partner and its import/export portfolio is dominated by oil, gas, cars and infrastructural products. Russia is a growing trade partner for Greece but Russia predominantly exports oil and commodities while Greece exports clothes and fresh or stoned fruit to Russia. Greece’s growth in exports since the financial crisis has been because of its role as an oil and infrastructure distributor with a heavy reliance on Turkey, its largest trading partner and, increasingly, Russia (Figure 3).

 

2015-02-23_CommentsAnalysis_012_fig03_v01

 

Figure 3  |  Greek imports from Turkey and Greece (% annual change) 2010-2016
Source  |  DeltaMetrics 2015

 

Imports from both countries have been volatile, but two things are clear: First, Greece has been attempting to switch its imports of oil from Turkey to Russia, evidenced by the steep increase in imports in 2010 from a small base. Second, and arguably more interestingly, imports from Turkey and Russia have been inverse to one another: when Russian imports have increased, Turkish imports have declined and vice versa. Even in the forecast period, from 2015 to 2016, Greece’s imports from Russia are falling at a slower rate than those from Turkey.

If Greece is to have a path to debt repayment then it must do two things: First it must seek to restore its greatness as a trading nation, both in services and goods, through reforms that focus on skills development, innovation, inward investment and port redevelopment. Supply side reforms alongside structural reform may make debt serviceable more quickly than just one in isolation since both are necessary and neither is alone sufficient.

But second, and in spite of history, Turkey may yet hold the key to Greece’s growth through trade and this is a bullet that should be bitten quickly. Europe’s geopolitical relationship with Russia is difficult at present to say the least and while this continues, it is unlikely that Greece will be able to restore its role as an energy and infrastructure distributor in the near future. Greece’s trade relationship with Turkey reflects mutual trade interests.

Market nervousness about the possibility of a “Grexit” heightened by the rhetoric of the past week may yet prove to be unfounded, however. The Greek public voted for Europe but against austerity. This is as much about politics as it is about economics. Greece, in trade and geopolitical terms, sits on an emerging fault-line between Russia and Europe. As sanctions build against Russia, Greece’s position is arguably more secure within Europe than it is, say, aligned with two of its major and more volatile trading partners, Turkey and Russia. And let’s not forget, the history defined by the Stability and Growth Pact and monetary union means Germany’s banks are exposed to the risks of Greece’s sovereign default and of a Grexit more than any other nations. “Necessity is the mother of invention”: let us hope that the Realpolitik of a Grexit is the driver for the resolution of the crisis.

 

Greece’s future is its past  |  Author  |  Rebecca Harding  |  CEO

Webcast 029 | Europe at a Crossroads

Delta Economics CEO, Dr Rebecca Harding and the Associate Editor of Pieria Frances Coppola, discuss the effect that Quantitative Easing may have on the European economy and some of its likely consequences for businesses. They also analyse issues surrounding Greek debt and weaknesses in the Russian economy.

 

 

Webcast 029 Author  |  Rebecca Harding  |  CEO

Back to reality

Why Dollar-Euro parity is possible  |  Following a turbulent January in Europe, the once unthinkable is now becoming thinkable. Mario Draghi, as was widely trailed, launched €1.1 trillion of Quantitative Easing (QE) to September 2016. And following Syriza’s victory in the Greek election, the prospect of a Grexit is now actively being discussed.

So here’s another “unthinkable”: the euro will reach parity with the US dollar by 2015 and has the potential to fall lower if current volatility and pressures on the currency continue. Is this really unthinkable or is it simply a return to the reality that we saw in the early days of the euro?

First, the Delta Economics view is that the euro has been over-valued for some time, largely as a result of the German trade surplus. Although Europe needs German trade to be strong because of the supply chains that originate in Germany and spread out across Europe, the high value of the euro has made it harder for the internal imbalances of the eurozone to be corrected by export-led growth outside of Germany.

At the outset, markets viewed the eurozone with a degree of scepticism. By June 2001 one euro bought 0.85 US dollars. As time has gone by, eurozone performance has, inevitably perhaps, become more dominated by Germany pushing the value of the euro up and kicking the issues of intrinsic imbalances between Member States down the road. However, instead of resolving imbalances by everyone “becoming more like Germany”, a weaker currency simply reflects the fact that everyone isn’t like Germany.

Second, the fact that QE was necessary in the first place made it abundantly clear that the eurozone is far from a marriage of equals. The euro came under pressure ahead of the announcement and fell to new lows subsequently. But it is here where the facts start to conflict with policy expectations. Theoretically, a lower euro should boost the real economy through trade because exports should become cheaper. However, what we’ve actually seen over the years since the introduction of the euro is a high correlation between the euro’s value and the value of trade: in other words, when the euro goes up, so does trade (Figure 1).

We believe there are two explanations for this: in the first instance, European trade, dominated as it is by Germany France, Italy, the Netherlands and Belgium, is largely at the high end of supply and value chains and therefore does not respond particularly to changes in the value of the currency. Even for weaker nations more dependent on commodities, the importance of Europe-wide supply chains means that the relationship still holds. For example, the correlation of the value of the euro with Greek trade is 0.89.

Furthermore, the value of the euro is actually a signal by the markets about the strength of the European economy: when the economy and institutions seem strong, the value is high and vice versa. In other words, as discussed previously, trade is an important driver of the value of the euro because of its importance as a driver of economic performance in the eurozone generally. While trade is falling, and we are forecasting it will fall by 3.7% within the eurozone in 2015, so too can we expect the value of the euro to fall. The result is that policy can have very little effect on the real economy through currency manipulation.

 

2015-02-03_backToReality_fig01_v01

 

Figure 1  |  Monthly value of eurozone exports, USDbn versus USD per euro spot, Last Price Monthly, June 2001-Dec 2015
Source  |  DeltaMetrics 2015, Bloomberg

 

The third reason why the value of the euro is likely to come under increased pressure is the outcome of the Greek election in January. Syriza is looking to renegotiate its debt and start the process of loosening the tight controls it has had over spending. As with the eurozone more generally, it will not be helped by a lower value of the euro (Figure 2) because of its inter-dependency with trade in the eurozone as a whole through its role as a trade hub.

 

2015-02-03_backToReality_fig02_v01

 

Figure 2  |  Monthly value of Greek total trade (USDm) versus USD per euro spot price, Last Price Monthly, June 2001-Dec 2015
Source  |  DeltaMetrics 2015, Bloomberg

 

Greece’s trade to GDP ratio is 0.4: in other words, there is a fairly strong pull of trade on Greece’s GDP. Oil is a critical part of this: the correlation between Greece’s trade and the oil price is 0.80 – largely because of the importance of oil in Greece’s total trade structure. Greece’s exports of refined oil, for example, are twice as high as the second-largest export sector – medicines.

 

2015-02-04_tradeInsight_fig03_v01

 

Figure 3  |  Greece’s debt and the challenge of trade
Source  |  DeltaMetrics 2015

 

Greece’s trade is just 0.4% of Europe’s total trade; however, their trade is nevertheless important both because of the impact that it has on the prospective growth of the Greek economy and as a portent for the negotiations about debt restructuring, austerity and structural reform ahead. Put simply, if a low-valued euro is unlikely to help boost Greek (or eurozone for that matter) trade more generally, then there is little that monetary policy at a European level can do to help long-term growth in the peripheral nations. Greece’s debt is, according to Syriza, not repayable and imposes too many restrictions on the Greek economy. One option is to set debt repayments against growth targets but, given falling oil prices and falling intra-European trade, this looks ambitious.

The eurozone needs more than QE and a low value of the currency for growth. The eurozone’s peripheral nations’ struggle for growth is accentuated by the fact that they must trade in euros internally and externally. Given “austerity” constraints attached to their sovereign debt, this makes it very difficult to grow. There will continue to be sustained political dissent between Member States on the best way to resolve the issue of Greece, and there is a danger that the debate will spill over to other nations, like Spain, Ireland and Portugal.

All of which brings us back to reality with a harsh bump. The likely outcome of all of this is continued market pressure on the euro (Figure 4).

 

2015-02-03_backToReality_fig04_v01

 

Figure 4  |  Monthly value of eurozone exports versus USD per Euro spot price and linear forecast, Jan 2014-May 2016
Source  |  DeltaMetrics 2015, Bloomberg, Delta Economics analysis

 

The pressure on the euro over the last year has mostly been downwards. The Delta Economics asset price forecasting model, which is itself based on country-sector-partner trade flows, is indicating short positions on the euro for most of 2015. Even if the trend continues in a linear way as it has done over the past 12 months, this suggests parity by the end of the year. Whether this will bring the eurozone “back to life” is uncertain, but we are certainly “back to reality”.

 

Back to reality: why Dollar-Euro parity is possible  |  Trade View Author  |  Rebecca Harding  |  CEO

Webcast 028 | Back to reality

Why Dollar-Euro parity is possible  |  January was a turbulent month in markets and politics. There was really only one story in town: European quantitative easing and the Greek election. What does this mean for trade and markets?

 

 

Webcast 028 Author  |  Rebecca Harding  |  CEO

Webcast 016 | Whisky and aspirin: is this the future of Europe?

In light of Delta Economics negative forecast for European growth, CEO Rebecca Harding and OMFIF Founder David Marsh explore the reasons behind the slowing in trade and how it is affected by, amongst other things, the recent slowing in Asian markets and uncompetitiveness. The discussion also examines the internal imbalances in the European economy, with particular emphasis on Germany and also looks at some of the fundamental differences between countries such as Greece and Spain with a view to understanding differences in trade growth patterns. This webcast also discusses the relatively positive trade growth in European periphery economies as well as they challenges they will face in the short and longer term.

 

Webcast 016 Author  |  Rebecca Harding  |  CEO

Europe

Europe’s trade is forecast at best to be flat in 2014, which is a mild improvement on an estimated slight drop in 2013 and all countries are forecast to be seeing slower export growth compared to 2013. Some of the peripheral countries, Portugal and Greece in particular, are still growing significantly above the European average, but the large drop in Germany’s export growth forecast for 2014 is worrying and arguably reflects its dependency on Chinese growth. Ireland has to some extent grown its way out of crisis through Foreign Direct Investment led export growth, but again this is forecast to slow during 2014. Growth in “emerging Europe” (particularly Poland) is robust suggesting that the region’s supply chains are strong and that Poland, Bulgaria (3.2% export growth in 2014) and Romania (4% export growth in 2014) are taking over from some of the emerging countries in Asia as drivers of intermediate manufacturing within Europe.