Long Term Outlook For Commodity Currencies

Stepping back from the day-to-day market noise, we remain long-term bulls on the commodity currencies.

Long Term Outlook Commodity Currencies

O ne way to value commodity currencies is to compare their real effective exchange rates against their terms of trade. Despite being near multi-decade highs, the Canadian, Australian and New Zealand dollars are trading at a discount to the levels implied by their terms of trade.

There are many potential sources of upside in the commodity currencies.

First, the current level of commodity prices and terms of trade will drag these currencies higher over time to simply close the undervaluation gaps. The “mean reversion” suggests there is about 10% upside from today’s levels.

Second, assuming that our long term view on commodities is correct, the terms of trade will rise further, placing additional upward pressure on the fair value of the commodity currencies.

Third, there is the potential for overshoots. Canada, Australia and New Zealand are small economies. If global investors (both private and public sector) want to increase their allocation to these relatively small and illiquid currencies, they can very easily overshoot their fundamental values.

Finally, the resource boom will boost domestic incomes and spending, which will force their central banks to keep interest rates relatively high. In a world where the Fed, ECB, BoJ, BoE and SNB have policy rates near zero, investors will be attracted to the higher interest rates in Canada, Australia and New Zealand.

Bottom line: Our Foreign Exchange Strategy service remains a long-term bull on commodity currencies.

Stick With Gold Shares

Gold still has upside, and gold shares could soon play “catch up”.

Stick With Gold Shares

O ur Commodity &  Energy Strategy believes that it is too soon to give up on gold and the same is true for gold shares. Gold miner profits track gold prices and this has not changed in the past few years, although the tracking is far from perfect. What has changed is the traditional 2:1 relationship between changes in gold shares and underlying prices. Global gold shares are flat year-on-year in dollar terms, yet the dollar price of gold is up 22%. This is despite the fact that gold company hedge books are leaner than they have been in years.

One possible explanation is that commodity-sensitive currencies have been strong in recent years. This places a wedge between revenues and costs for many gold producers. Put another way, gold in C$, A$ and SA rand terms has been weaker than in U.S. dollar terms. However, that has not been the case in recent months as the commodity currencies have dropped in the face of investor risk aversion.

A more likely explanation relates to the ETF phenomenon.

Gold company multiple compression accelerated as ETF holdings hit successive new highs in 2010 and 2011. While the divergence is unsustainable, it is difficult to tell when it will end. Even if gold shares are in a bear market versus gold prices, they are stretched relative to the downtrend in place since 2006. P

erhaps global reflation and a softer dollar will spur a “broadening” of interest in lagging liquidity plays, such as gold shares.

Bottom line: Continue to hold strategic positions in gold and gold shares.

Eurozone Growth Remains Weak In Q3

The euro area managed to eke out a 0.2% growth rate in Q3, matching the previous quarter

T he solid growth in Germany and France (at 0.5% and 0.4%, QoQ respectively) seems to be the only remaining driver of the struggling euro area economy, according to Eurostat’s flash figures for Q3 GDP growth. Growth in Spain came to a standstill, while the Portuguese economy continued to contract. Going forward, the downward trending confidence indicators and PMIs suggest that the entire euro area is headed towards a recession. Also, additional fiscal drag and the prospect of raising bank solvency ratios by shrinking assets will not bode well for the European economy.

A worrying implication of the lack of growth is that the periphery countries will find it harder to reach their deficit targets by implementing austerity programs. This possibility of worsening debt dynamics will make markets even more wary about the current efforts to deal with the European crisis. Indeed, widening French, Italian and Spanish spreads already highlight the dangers of indecisive action and political turbulence.

Bottom line: The looming recession makes it ever more pressing for euro area policymakers to bolster their efforts, but also limits their ability to rely on fiscal belt-tightening to restore confidence. We maintain that growth oriented policy changes and more aggressive action by the ECB are required to resolve Europe’s crisis.

Making A Separation

Stock markets seem to have been trying to separate the euro zone crisis from economic fundamentals elsewhere in the world.

Back in August, financial markets were grappling with three big risks: a double-dip recession in the U.S., a total implosion in the European banking system and a hard landing in the Chinese economy. Events since the shakeout suggest that the market was too pessimistic about the outlook and has come to terms with the fact that the European crisis has not driven the U.S. into a recession.

Our Global Investment Strategy service argues that the U.S. economy is probably gravitating toward its trend growth of 2.5%. The possibility of even stronger growth should not be dismissed. The large accumulation of liquid assets on corporate balance sheets suggests that companies have much “dry powder” to increase capital outlays. Of course, political and policy uncertainty is a roadblock, but solid profits are also a powerful incentive for companies to invest.

As for China, financial markets have slowly realized that the slowdown in growth is cyclical in nature and the government is well equipped to navigate a “soft landing”. Nevertheless, lingering concerns still exist and many analysts continue to predict that the economy could soon hit a brick wall. The improving picture for the U.S. and Chinese economies has probably put a floor beneath stock prices, especially the S&P 500.

Nevertheless, it will take a decisive solution to the euro zone crisis for risky assets to make a significant breakthrough on the upside.

The Fed: Impotent But Not Giving Up

BCA Research, The Fed: Impotent But Not Giving Up

The Fed has largely exhausted its policy options and is divided about what to do next. Talk (aka communications) rather than monetary stimulus is now the preferred strategy.

The Fed’s extreme policy activism may have prevented economic disaster, but it has failed to deliver decent growth and sharply falling unemployment. This is because the level of long-term interest rates or the size of the Fed’s balance sheet do not deal with what ails the economy. Thus, additional quantitative easing would likely have little economic impact, even though the Fed has not ruled it out. Moreover, the case against more QE is supported by the fact that inflation expectations are holding up at a relatively high level and unemployment claims have stabilized. The key problems are that businesses lack the confidence to hire and spend aggressively and consumers are still trying to deleverage. There is not much that monetary policy can do to change this picture, but don’t expect the Fed to simply give up. The Fed is now considering how to send out the message that policy will stay highly accommodative until economic activity returns to more acceptable levels.

Bottom Line: Low rates clearly will be around for a very long time.