| Uncertain market for exporters and investors |
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Taking an active approach to the management of all foreign exchange market exposures is critical in limiting adverse impact on Irish exporters and investors, according to Simon Barry.
Barry writes, 'the magnitude and speed of the moves seen on the fx markets over the past year is truly staggering and is a reminder of just how abrupt moves in financial markets can be when there is a pronounced shift in sentiment.' |
Within the euro area, Ireland is unique in that it carries out more of our trade with the UK and US than any other economy in the zone. Over one third of all Irish goods exports went to either the UK or US last year. Thus, developments in those economies as well as changes in the value of the euro versus both sterling and the dollar matter a great deal from an Irish perspective. Moreover, Irish exposure to overseas developments is by no means confined to trade flows alone. Recent years have seen a surge in Irish investment in overseas property, for example. While there are no official statistics on the scale of or trends in such flows, estimates suggest that Irish investment in foreign property in 2007 alone totalled over €10 billion, with about half of that, or €5 billion going to the UK and close to 10 per cent, or €1 billion, going to the US. | | Simon Barry |
Looking at incoming information, there is little doubt that the overseas economic and investment climates have deteriorated notably in recent months, with the severe dislocations in financial markets of late adding massively to downside risks. Growth estimates for our trading partners for this year have been taken down markedly. Notably, UK economic prospects have dimmed sharply, reflecting the impact of the dual shocks of higher commodity prices and the pronounced tightening of credit conditions. Growth this year will do well to reach 1 per cent and could turn negative next year, an outcome that would represent the weakest two-year period for the UK economy since the recession in the early 1990s. While there have been some tentative signs of a stabilisation in US housing, overall activity there is too set remain very weak in the period ahead. Growth forecasts for next year have been slashed from some 2.7 per cent in January to below 1 per cent and the US faces its weakest two-year period since the last US recession in 2001.
A review of recent trends in overseas asset markets also makes for some discomfort from an Irish perspective given the large outflows into those markets as noted above. House prices in the UK are now falling at an annual rate of over 10%, the weakest performance since the housing crash of the early 90s. Even greater weakness is evident in UK commercial property, where returns are down 17 per cent in the year to August. Turning to the US, the weakness of the housing market there has been very well documented, with prices on some measures down over 15 per cent over the past year as a glut of oversupply, tighter credit and sliding confidence have combined to weigh heavily on the market. And the news isn’t much better if we switch the focus to the performance of international equity markets with both the US (S&P 500) and UK (FTSE 100) stock markets, for example, showing losses of around 35 per cent over the past year.
An unfavourable economic environment
So Irish exporters and investors alike are being exposed to exceptionally unfavourable economic and asset market trends in the current environment. However, the story has been even more problematic when one takes account of the fact that for a large part of the past year the euro has been rising sharply against both the dollar and sterling.
Dollar weakness has been a hugely prominent theme in world financial markets for much of the past decade. But the dollar’s weakening trend accelerated sharply earlier this year as a Fed in hyper-cutting mode and an ECB steadfastly committed to asserting its inflation-fighting credentials provided major support for the euro versus the dollar. The result was that EUR/USD made a succession of new all-time highs over the summer, the ultimate high-point being a reading of over $1.60 in mid-July shortly after the ECB rate hike.
But since then, there has been a major shift in the dynamic between the two currencies, with EUR/USD moving from its record high to as low as $1.33 at one point (trading at around $1.36 at time of writing). A number of drivers of the move can be identified, including growing concerns about the state of and prospects for the euro zone economy. Furthermore, stress has now clearly spread to the financial system on this side of the Atlantic, as well as the economy here, with a host of institutions requiring bailouts or rescue packages of various sorts of late. There is also the perception that the authorities in the US have been more pro-active and quicker to respond to the various challenges in the current environment than their euro zone counterparts. European governments initially struggled to put together a co-ordinated response, with policy-makers in individual member states focused on introducing somewhat ad-hoc measures at a national level. While the special summit called by President Sarkozy on the same weekend as the October G7 meeting did result in a more coherent and co-ordinated framework across the eurozone, the recent intensification of the crisis did expose the flaws in the institutional framework surrounding EMU: in particular, that while there may be a single monetary authority (ie. the ECB), there is no pan-European governmental structure, with the appropriate fiscal authority, making a swift and decisive response to any crisis situation difficult to effect.
Furthermore, a major pull-back in oil and other commodity prices – a response to a spread of US economic weakness to other regions – has reversed one previously-important source of downward pressure on the greenback. Brent crude, for example, has gone from $147pb to below $80pb in three months. In addition, in a bigger-picture sense, there was the perception that a Eur/USD rate of $1.60 represented a significant overshoot relative to long-run equilibrium levels. In any case, these recent moves provide some extremely welcome relief for Irish exporters to the US and indeed other markets in which pricing is invoiced
in dollars.
Turning to those with exposure to sterling receipts, the UK currency has also been very much out of favour on the fx markets for some time now. Relative interest rates have been an important part of the story here too. The Bank of England was quick to cut UK rates in the early stages of the crisis a year ago, in contrast to the ECB’s much more hawkish stance (up to recently at least). Fears about the UK economy, property markets, the stability of the financial system and the effectiveness of the UK policy framework have added to sterling’s downside with a highly uncertain political climate also doing little to help sterling’s cause.
The result was a sharp weakening of sterling from 70p a year ago to a new all-time low of close to 82p in early September. While recent euro weakness has taken some of the pressure off sterling lately (trading at around 78p at time of writing), this was a move that has caught many Irish corporates off guard, partly due to the fact that for much of the previous 4 years EUR/Stg had been in an extremely narrow range of around 66-70p.
Currency outlook
What of the outlook for the euro versus the dollar and sterling in the period ahead? The speed and extent of the move from $1.60 to the mid $1.30s in EUR/USD has been phenomenal. We note that movements in some standard fundamentals such as relative market interest rates can’t fully explain the full extent of the recent bout of dollar strength. Rather, it seems as if large-scale repatriation of capital by increasingly risk-averse US investors and safe-haven buying of US treasury securities look to have been offering considerable support to the greenback.
One note of caution for the short-term is that speculative traders now own close to record amounts of dollars versus the euro. This suggests that buying dollar versus euros has become a crowded trade and thus points to the risk of a positioning-led correction if short-term traders decide to sell dollars to realise profits from recent moves. Therefore, we wouldn’t be surprised to see a pull-back at some point in the coming weeks/months, possibly back to the low $1.40s. Irish importers of dollar-priced goods or services who may have been caught off guard by the speed of the summer move should use any such move as an opportunity to buy dollars in our view. But in strategic terms, we believe that the era of mega-cheap dollars is over. The ECB clearly softened its tone at its October press conference and this was soon followed by the co-ordinated 0.50 per cent rate cut announced by the major central banks including the ECB on October 8th. While the Fed also cut by 0.50 per cent at that stage and it looks as if it will now have to move US rates lower still, there is more scope for large-scale policy easing in the euro zone where the prevailing policy rate is 3.75 per cent vs. 1.5 per cent in the US. Some of this interest rate scenario is already in the price, however, and recent moves in Eur/USD have taken us to the kind of target levels we had been forecasting previously, albeit over a multi-quarter time horizon.
Turning to sterling, it has managed to move off its recent low of around 82p to trade at around 78p.
It seems as if sterling is benefiting from a ‘bailout bounce’ in sentiment. The market looks to be rewarding the leadership shown by the UK authorities in devising its comprehensive plan to support the banking system, a framework which is now being rolled out elsewhere. On a related point, UK Prime Minister Brown is looking a more authoritative figure in the current environment, so perhaps sterling is also benefiting from a perception that the UK political environment is looking somewhat more stable, in the near-term at least. However, we believe the UK currency remains vulnerable to further selling pressure. The Bank of England also took part in the recent co-ordinated rate cut and with UK base rates at 4.50 per cent there is scope for a further aggressive loosening of monetary policy in the UK.
Recent rhetoric from the Bank of England has shown a clear shift in emphasis from concerns about above-target inflation in the short term to concerns about inflation undershooting the target in the medium-term, given the pronounced weakness in UK growth prospects. UK rates are coming from a higher level, and the BoE has repeatedly shown itself to be more pre-emptive and pro-active than the ECB. So while we expect both central banks to lower rates in the coming months, UK rates have further to fall (to 3.5 per cent or lower).
This is an environment which is likely to be associated with another spell of sterling weakness in our view. We target a return to 80p or higher in EUR/Stg in the weeks and months ahead. In addition, we believe that there is scope for sterling to recoup some of its losses of the past 12 months given that its fall has been so large and rapid in historic terms. On a trade-weighted basis, for example, sterling’s recent decline has been its largest and swiftest since it collapsed following its exit from the ERM in 1992. Thus, viewed from a longer-term perspective, we regard some of its weakness against the euro as being somewhat overdone, and we target 76p by the second half of next year.
Overall, the magnitude and speed of the moves seen on the fx markets over the past year is truly staggering and is a reminder of just how abrupt moves in financial markets can be when there is a pronounced shift in sentiment. There is little any Irish exporting firm or investor can do to influence the performance of the underlying markets to which they have exposure. But, an active approach to the management of all foreign exchange market exposures is critical in limiting the adverse impact of large and sudden currency moves, which if left unmanaged can significantly affect firm and investor performance. |
Simon Barry is senior economist with Ulster Bank Capital Markets.
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