AUD.USD

The Winter of Our Discontent     
February 7, 2013
By John R. Taylor, Jr.

The most impressive news out of the United Kingdom this past week involved a parking lot and a dead king.   Most countries bury their kings in more glamorous surroundings, but Richard III was not glamorous at all.  Although his grave started in more dignified and austere surroundings, his reign was so little valued that his resting place was forgotten over the years.  Now that his body has been found and identified through its DNA, and the contorted shape of its spine, we will take this moment to muse on the peculiarities and singularities of British history and how they affect us today.  Almost 528 years after the Battle of Bosworth Field, the insularity of Britain still facilitates a course of economic and social history apart from  that of the rest of Europe.  As the last successful invasion was almost a thousand years ago, the European Union will always be fighting an uphill battle, and despite miserable times, like those that could be seen in the coming few years and during the years of Richard III’s reign, the British can be counted on to protect their shores from all invaders.


Despite many warnings that the policies of austerity followed by the Cameron government would not improve the trajectory of government borrowing, nor develop a strong private sector revival, the British government has continued to follow the Conservatives’ edict as closely as possible.  The debt-to-GDP ratio has almost doubled since 2008, a performance that ranks it below almost all the G10 countries.  It is beating Spain, but not Italy within the EU.  What has made this internal strategy less than it could have been is the slow decline in Britain’s major export market, the European Union.  Although growth has been negligible for the past year or so, employment has actually improved, meaning that  productivity is declining.  Because Britain has become less competitive, a slide in the currency has been desired.  But it did not come. The aggressive QE policy of the Bank of England was supposed to handle this, printing plenty of excess pounds which theoretically would both drive the pound down and stimulate lending at home, keeping the economy growing.  However, the pound did not drop and what borrowing occurred went directly into house buying and the equity market.  With austerity still in the driver’s seat, the only way the UK can grow again, is if the pound drops.  Maybe the economy will be so weak that the pound will fall on its own, but if it does not, a more aggressive QE strategy, perhaps via a new nominal GDP targeting scheme, is very likely in the months ahead.  By year-end, we would bet that the euro has outperformed Sterling even though we are not euro bulls either.


What is really hammering the nails in the UK’s coffin is the cantankerous nature of the relationship between Britain and the continent, especially the Eurozone countries.   The idea that London might lose its place as the financial center of Europe and the world is totally horrifying. Considering that financial services make up something like 15% of the GDP and have a knock-on effect of much more, the departure of the global capital market to Frankfurt would assure a long winter of discontent.  That the Cameron government has threatened a referendum on Britain’s position in Europe seems the utmost of folly, no matter how difficult it has been to square the circle between Anglo-Saxon financial freedom and French-German dirigisme.  One could argue that this tension has been of value to the world and of great importance to the United Kingdom as an economic entity.  London, competing like Zurich for financial clout from outside the Eurozone, and the Midlands selling against Sweden and the Czech Republic will be less vibrant than they are today. The UK without London’s financial weight will become a second tier country surpassed by the larger mid-sized, fast growing Asian economies, without the protection of a strong export base. The Tudors put England back on course after Richard III, and if these careening policies go too much further, the only choice will be accepting this new euro invasion, whether desired or not, or looking for another savior to come along.


The One-speed Economy 
By Jonathan Clark

Approximately six years ago, I was asked to speak at a currency and commodity conference.  An analyst at a leading investment bank made a speech at the time that raised my ire, because she claimed there were benefits to adding commodities to the standard pension fund portfolio of stocks and bonds.  She said that not only did commodities outperform stocks and bonds, and serve as a hedge against inflation, but that they were negatively correlated to the other asset classes, especially during times of financial turmoil.  The large part of her proof was data that started in the early 1970s when commodity prices were extremely low.  The ‘suggested’ weight for commodities in the standard portfolio was 0%.  Many pension funds bought into the argument, although almost none would have overweighted commodities to the extent that the bank suggested.  The results were massive passive investments in commodities and subsequent disappointment with losses over a 5-year period.  During the global financial crisis, commodities declined along with other risk assets so the diversification argument was largely a bust as well and they added a tremendous amount of volatility into the portfolio compared with bonds.


Pension funds, led by CalPERS, are now abandoning these commodity investments.  CalPERS pulled out 55% of its funds in October and we expect more liquidation in the future.  This is very negative for resource producers like Australia where, in August of last year, Resources and Energy Minister Martin Ferguson stated that "the resources boom is over."  Without the tailwind of money flowing into the mining industry, this leaves Australia with a real estate bubble economy, suffering from the ‘Dutch disease’ where a resource boom weakens manufacturing, and an overvalued currency.  The so-called two-speed economy now has only one speed, and it is slow.

If commodity prices fall into midyear as we expect, then export earnings will fall and the RBA will respond with further rate cuts, all of which are negative for the AUD. The Australian dollar broke out of its trading range of the past three months to the downside on Wednesday and this turns the outlook negative for several months.  There is an initial low due at the end of the month or early March.  Our initial target for this downmove is the 1.0075 area.  Following this low, the Aussie should recover for several weeks before resuming its downtrend into the start of April and this overall weakness can persist as long as July.  Our longer-term objective is the .9700 area.  If our negative outlook is correct then the resistance between 1.0440 and 1.0450 will hold. Only a close above this area means we are premature in calling a peak.