August 2012 The EUR outlook after the ECB Economics Research We revisit the Eight Issues that will likely determine the fate of the Euro. Changes relate to the ECB announcement and Spanish bailout. Overall we see a very narrow advantage for EUR positive news. We also look screen cyclical vulnerabilities of the key currencies. Several high beta currencies seem particularly at risk currently. We have used last month s Eight Issues for the EUR as the benchmark to assess the latest developments in the Euro area. Overall, we conclude that positive developments narrowly outweigh negatives. The ECB announcement of a conditional SMP program has the potential to become a watershed decision for the Eurozone crisis, though we have not seen any detail yet. Still, the idea of combining potentially unlimited ECB funding for countries in fiscal trouble with strong conditionality for reforms appears to substantially improve the long-term viability of the Eurozone. Outside the Eurozone issues, we also summarise quickly the latest changes in cyclical momentum for key currencies. A number of high beta currencies with large current account deficits and comparably marked slowing in activity appear particularly vulnerable. We have not made any forecast changes in this abbreviated version of our FX Monthly. Thomas Stolper +44(20)7774-5183 thomas.stolper@gs.com Goldman Sachs International Robin Brooks (212) 902-8763 robin.brooks@gs.com Goldman, Sachs & Co. Themistoklis Fiotakis +44(20)7552-2901 themistoklis.fiotakis@gs.com Goldman, Sachs & Co. Fiona Lake +852-2978-6088 fiona.lake@gs.com Goldman Sachs (Asia) L.L.C. George Cole +44(20)7552-3779 george.cole@gs.com Goldman Sachs International The Evolution of EUR/$ Since Early June 1.28 1.27 1.26 1.25 1.24 1.23 1.22 1.21 EUR/$ Publication of the last FX Monthly 1.2 01-Jun-12 01-Jul-12 01-Aug-12 Source: GS Global ECS Research Investors should consider this report as only a single factor in making their investment decision. For Reg AC certification and other important disclosures, see the Disclosure Appendix, or go to www.gs.com/research/hedge.html. The Goldman Sachs Group, Inc. Goldman Sachs
1. Eight Key Issues for the Euro Revisited after the ECB announcement In the July issue of the FX Monthly we enumerated the eight key issues, which could determine the fate of the Euro. It was only about four weeks ago that we published the list, but a lot has happened since. A quick reality check therefore seems appropriate. To assess if we have made overall progress or not, we will use an Olympic medal count for Euro Bull and Euro Bears. If there is no change in the assessment or no additional information, then we will award no medal at all. Issue 1: Spanish Bank Bailout Silver for Euro Bears The only reason we have not awarded a gold medal for Euro Bears is because there is still some small hope that the bank bailout will ultimately help the Spanish Government access the bond market again. However the market reaction so far was pretty clear. The selective demand for bank recapitalisation funds has not been enough to break the feedback loop between government funding, bank funding, credit contraction and slower growth. Market participants understood that ultimately the Spanish government remains the guarantor for the bailout funds, regardless of who actually receives the EFSF/ESM payment. Moreover, markets also understood that the narrow conditionality in the MOU only focuses on the banking sector. Of course, we expect additional structural reforms to be implemented in the context of the Euro area s Macroeconomic Imbalances Procedure (MIP), but the lack of related specific conditionality in the MOU has reduced the confidence building impact of the Spanish bank bailout plan so far. To be clear, the bank recapitalisation with EFSF/ESM funding remains a helpful development, but so far it has been insufficient to materially reduce risk premia Silver for the Euro Bears. Issue 2: Stabilising Growth in Greece and Italy Bronze for Euro Bears As we discussed in July, given the high debt levels of these countries, clearly positive GDP growth numbers are a necessary pre-condition for any hope of debt sustainability. Since we have published the list, consensus growth projections have been revised down for both Greece and Italy. Mid-July consensus expectations now assume annual 2013 growth of -2.6% for Greece and -0.3% for Italy. Overall this suggests markets are getting more skeptical about debt sustainability, at least at the margin. Goldman Sachs Global Economics, Commodities and Strategy Research 2
Exhibit 1: Consensus Expectations Have Deteriorated for Italy and Greece Consensus Economics 2013 GDP forecasts 0.3 0.2 0.1 %yoy 2.0 1.0 0 0.0-0.1-0.2-0.3 Italian GDP Growth LHS Greek GDP Growth RHS -1.0-2.0-0.4-3.0 Nov Dec Jan Feb Mar Apr May Jun Jul Aug Source: Consensus Economics Issue 3: Euro area Banking Union Bronze for Euro Bulls Following the latest Euro area summit, it appears plans for Banking Union are progressing faster than initially expected. Several media reports suggest that proposals will be published by mid-september already and the current plans apparently anticipate that the plans will be adopted by the European Parliament and EU governments by a December summit, possibly with the aim of handing over the regulatory authority to the ECB by early next year already. While a positive development, uncertainty persists, hence only a bronze medal for the Euro Bulls. Issue 4: Franco-German Vision for a Political/Fiscal Union Silver for Euro Bulls (with some help from the ECB) The Germans want more control and reforms in the periphery but not necessarily more funding via the ECB. The French are in favour of more funding, in particular via the ECB. The compromise between these two positions has been found by ECB President Draghi, who proposed additional ECB intervention in secondary bond markets but only under the condition that a country applies for EFSF/ESM support and agrees to a MOU. Though it appears on the surface as an ECB initiative, our reading of this proposal is that it goes a long way towards a durable fiscal union. There are elements of debt mutualisation via the ECB balance sheet and obviously via the EFSF/ESM. The ECB potentially acts as unlimited lender of last resort as the central bank of any normal country would. But there are also elements of temporary loss of fiscal sovereignty as necessary during a crisis situation. Full fiscal independence for individual governments would therefore remain restricted to cases where deficits remain moderate, where excessive macro imbalances are avoided and where governments maintain full market access. We need to see more details on the plans, but there have been media reports suggesting that Draghi s ECB proposals have been developed with the participation of key government and central bank representatives from Germany and France. We still need to see if French and German policymakers fully elevate the Draghi plan to something that could be called a common vision. The fiscal challenges Goldman Sachs Global Economics, Commodities and Strategy Research 3
in France remain substantial and could disturb the endorsement of a joint vision. Still, to us it appears that Eurozone tail risks have been substantially reduced already. Silver for the Euro Bulls though some may ask whether the external help from the ECB would justify disqualification. Issue 5: Continued Strong BBoP Position Bronze for Euro Bulls The latest Eurozone balance of payment numbers have been quite positive with the BBoP (=current account +net FDI +net portfolio flows) now clearly back in surplus. The widespread fear that the Eurozone will experience more and more capital leaving the area, has therefore again been disproven. That is not to say that there is no capital flight at all, as a quick look at the SNB balance sheet would testify, however we see no evidence of outflows consistent with a full blown currency crisis. Most of the safe haven flows continue to take place inside the Eurozone. Given the renewed increase in the BBoP surplus Euro Bulls deserve a bronze medal. Exhibit 2: Euro Area BBoP Remains Positive on a Trend Basis 12-month moving average Broad Balance of Payments as % GDP 5% 4% 3% 2% % GDP 12-mma BBoP (Trend) 1% 0% -1% -2% -3% -4% -5% 1998 2000 2002 2004 2006 2008 2010 2012 Source: Goldman Sachs Global ECS Research Issue 6: More Fiscal Tightening Outside the Euro area No Medal As we discussed in the last FX Monthly, this is essentially a 2013 development and the first key event to watch out for is the fiscal cliff in the US. So far there have been no significantly new developments that would warrant a medal for either camp. Issue 7: Monetary Policy Differentials No Medal Since our last FX Monthly, there has been no real change in monetary policy. The ECB refrained from additional rate cuts, credit measures, LTROs or other forms of balance sheet expansion. The same is true for the Fed and the Bank of England and most other key central banks globally. Rate differentials have remained largely unchanged as well. At the Goldman Sachs Global Economics, Commodities and Strategy Research 4
same time they have all signaled that they could do more, including the Conditional SMP plan by the ECB, but that is about all there has been in the last four weeks no medal for either Bulls or Bears. Exhibit 3: Recent EUR Decline has Coincided with Falls in EUR Swap Rates 126 Index % 1.0 124 0.8 122 120 0.6 118 0.4 116 GS EUR Nominal TWI LHS 114 5 year Swap Rate Differential Between EUR and Main Trading Partners 112 Jan-11 Jul-11 Jan-12 Jul-12 0.2 0.0 Source: Goldman Sachs Global ECS Research Issue 8: A Notable Reduction in EUR Short Positions No Medal If there is a notable shift in the other key issues discussed above, we would expect this to be reflected in indicators of speculative positioning as well. This has been the case to some extent, visible in both, IMM positioning and risk reversals. But the move since early June had not been significant enough to warrant a medal in itself. Conclusion: Euro Bulls Win Narrowly by One Bronze Medal Summing up our medal count, Euro Bears won one silver and one bronze medal, narrowly beaten by Euro Bulls with one silver and two bronze. Positive and negative news has been broadly offsetting as has been visible in last month s price action as well. Initially the selloff continued with EUR/$ almost touching 1.20 as Spanish bond markets remained closed, followed by the ECB-induced rebound so far. From a medium term point of view, we would weigh the ECB proposal for a conditional SMP as a very positive medium term development but we also need to see more specifics. Still the prospects of this major backstop becoming operational was already enough to convince us that a temporary bottom may be in place in EUR/$ and that the fiscal risk premium in the Eurozone has scope to compress. We have also expressed this view in last week s tactical recommendation to go long EUR/$. Goldman Sachs Global Economics, Commodities and Strategy Research 5
2. Potential FX Underperformers Linked to Cyclical Underperformance The last couple of months have seen a notable deceleration in global activity, with the latest business surveys number from early August suggesting that PMI-implied global growth now only tracks at 2.1% yoy annualised, as highlighted by Kamakshya Trivedi and George Cole in a recent Global Markets Daily. At the same time there are some tentative signs that policymakers may provide a backstop with additional easing expected in a number of countries. From an open economy point of view, slowing activity and easier monetary policy is typically a combination that leads to currency weakness. However, during a global slowdown, not every currency can weaken against every other currency. So it becomes a question of figuring out which currencies face the strongest depreciation pressures and which ones face the weakest depreciation pressures. The latter group may well end up appreciating, in this inverted beauty contest. As a simplified approach, currencies of countries with the fastest deceleration of growth may well depreciate most. This logic also underlies our FX Growth Current, which typically performs well when currencies of accelerating economies appreciate and countries with weaker activity see currency depreciation. The Growth Current has posted solid total returns this year so far already suggesting that currency markets remain sensitive to incremental changes in activity levels. Exhibit 4: Strong Performance of FX Growth Current Points to Growth Sensitivity in FX Markets 112 Index 111 110 109 GS FX Growth Current 108 Jan Feb Mar Apr May Jun Jul Aug Source: Goldman Sachs Global ECS Research From a less generic point of view, we looked at the currencies facing the fastest deceleration in PMI readings in recent months. These currencies are particularly vulnerable if they face large current account deficits in addition. This is based on the idea that beyond interest rate differentials, capital flows are the other transmission channel from weaker growth into a weaker currency. However, weakening capital flow may be a particular challenge in countries where a large current account deficit needs to be funded in addition. Goldman Sachs Global Economics, Commodities and Strategy Research 6
Combining these thoughts, we have simply plotted the most recent changes in the PMI readings over a 3- and 6-month window against the projected 2012 current account position. Exhibit 5: Currencies with Current Account Deficits and Weakening PMIs More Vulnerable Current Account Balances versus 3-month change in Manufacturing PMIs 6 4 3m PMI change HUF 2 CHF 0 PLN CZK SEK ILS CNY SGD BRL RUB -2 EUR ZAR INR MXN JPY -4 TRY AUD TWD NOK USD KRW GBP -6 CA % GDP -8-4 0 4 8 12 16 Source: Haver Analytics, Goldman Sachs Global ECS Research Exhibit 6: Currencies with Current Account Deficits and Weakening PMIs More Vulnerable Current Account Balances versus 3-month change in Manufacturing PMIs 4 2 0-2 -4-6 -8 6m PMI change TRY PLN ZAR BRL USD INR CZK ILS GBP MXN EUR HUF CNY KRW JPY RUB SEK TWD CHF SGD NOK -10 AUD CA % GDP -12-8 -4 0 4 8 12 16 Source: Haver Analytics, Goldman Sachs Global ECS Research As can be seen in the charts a number of high beta currencies look fairly vulnerable in the bottom left quadrant. TRY, AUD, ZAR, BRL and INR can all be found in that zone. But the USD and GBP are also in a potentially difficult position. Goldman Sachs Global Economics, Commodities and Strategy Research 7
On the other hand, a number of Asian currencies, including the CNY and SGD look better positioned. And outside Asia we find the CHF, SEK, RUB and even the HUF, which is a very interesting result. It is possible that cyclical underperformers soon rebound strongly. Central banks globally are looking to respond to the recent cyclical weakness. There has been some relief from lower commodity prices. And even economic surprise indicators show some tentative improvement. On the other hand, in case of renewed disappointment from cyclical data during the Summer lull, or in case policymakers fail to deliver on the expectation of additional easing, the bottom left quadrant in our charts is worth some careful monitoring. 3. No Forecast Changes in this Summer FX Monthly This month we have not made any forecast changes and only publish an abbreviated FX Monthly without the table section at the end of the publication. Our FX Monthly with all country pages and the data section will be produced as usual from September onwards. Goldman Sachs Global Economics, Commodities and Strategy Research 8
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