If the secret to happiness lies in maintaining low expectations, traders are nearing nirvana this morning. The euro is in full retreat and the commodity complex is on the defensive, as markets worry that this week's European Union summit will do little to reverse the world's economic slide.
The Canadian dollar is floating near the 1.03 handle, and West Texas tea is trading hands well below the $80 threshold. The bears are buying dollars and yen to store in their caves, causing exchange rates to rise in value, but are leaving gold to trade almost unchanged around $1,560 an ounce.
Greece on the Defensive
In a match rich with economic irony and rhetorical potential, the German national team defeated the Hellenic side 4-2 in the European football championships on Friday. Soon afterward, the drama moved to the economic playing field, when the Bild am Sonntag newspaper published a survey showing that 78% of German citizens want Greece to leave the euro area. Support eroded elsewhere as well, with 65% of the French and almost 50% of Italians and Spaniards also favouring a Greek exit. Overwhelming majorities in all four countries believe that rescue funds will never be repaid.
In an interview after the results, Finance Minister Wolfgang Schaeuble said that the Greeks had severely damaged their credibility within the euro area, making it less likely that they will succeed in extracting substantial concessions when renegotiating rescue package terms in the coming months. He stated that "the ball is now in Greece's court. It's in their hands to win back the confidence of Europe. They're only going to accomplish that with concrete actions and deeds."
He also appeared to slam the door shut on socializing debt across the euro area, saying "anyone who has the chance to spend someone else's money will do that. You'd do that, and so would I. The markets know that. And so from that point of view, they wouldn't be convinced by euro bonds."
He may have ascribed more rationality to the markets than they actually possess.
Margaret Thatcher once said that "the trouble with socialism is that you eventually run out of other people's money"; but investors, pundits, and the media have largely ignored this principle since the day that the common currency area was founded.
Germany is finding itself isolated, arguing that while jointly-backed debt would unquestionably boost market sentiment in the short term, it would only lay the foundations for economic and political strife in the long term.
This stance leaves Merkel and Schauble almost alone in playing defense against a determined set of forwards, most of whom are seeking to please the crowd by scoring against Germany's balance sheet. Of course, many of these strikers are prone to scoring own goals, meaning that this match may go on for far longer than expected - and be far more entertaining (read volatile) than expected.
*In a side note, a Greek football fan commented on the Greek-German divide in the New York Times weekend edition, saying "They make beer -- and we drink it. That's why they don't like us."
Pundits have written millions of of words about the euro area's inherent problems, but I don't think any have been so explanatory, or eloquent. Beer and profundity go together after all...
Submerging Markets
The weekend brought a sobering warning from the Bank for International Settlements, which suggested that the emerging markets are facing their own version of the boom and bust cycle that brought the developed world to its knees three years ago.
As we have observed, many developing countries benefitted from substantial foreign capital flows in recent years, as exports soared and overseas investment poured in. Emerging markets as disparate as Turkey, Thailand, Brazil, Indonesia, Argentina, and China saw credit balances expand more quickly than gross domestic product.
In its annual report, the BIS highlighted the fact that this has left many sectors vulnerable to a change in external financing conditions, and elevated the risk of a widespread emerging market bust.
In a sense, the Bank's warning may have come too late.
Over the past year, many emerging markets began to sink beneath the waves. Growth rapidly decelerated as exports fell and rich-world investors withdrew their capital -- putting borrowers and financial systems under severe stress.
The real, ruble, and rupee are all among the world's worst-performing currencies this year, and the yuan has also weakened.
Sentiment on the emerging markets has soured, and bulls have lost enormous amounts of money in the process.
However, it is important to note that many governments built extensive defenses after the Asian currency crisis in the late 90s, and are now better prepared to weather changes in global economic conditions. With direct control of lending institutions and access to vast foreign exchange reserves, they are positioned to pump money back into the system -- and offset capital flight.
These defenses are not impregnable, but they should ensure that the Bank's worst fears go unrealized.
Further weakness in the emerging markets is very likely: expectations and investment flows have simply been too high for too many years. Disappointment was inevitable, and substantial risks still exist.
Some of the most important risks lie in the commodity currencies. We may be seeing the end of the hard commodity supercycle that has dominated market activity over the last decade. Without accelerating emerging market growth to underpin speculative bets, the case for further upside has been materially weakened. Currencies like the Canadian dollar and the Aussie have room to slide.
Interestingly, soft commodities face a more complex outlook. As the flow of money into the emerging world slows, and households take the reins from credit-fueled businesses, appetites will change -- literally. We may be seeing the emergence of a longer term soft commodity supercycle.
If so, the implications for currency valuations will be significant. Watch this space.
Have a great week!
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