A Retrospective on 2007: Another Weak Dollar Year

This has been an extraordinary year. While we were cyclically bearish on the dollar, we grossly underestimated the magnitude of the dollar descent, particularly the move in EUR/USD from 1.36 to 1.49 in late summer. Further, we did not foresee the severity of the dislocations in the credit and money markets, although we, along with most analysts and investors, understood that the credit markets stood out at the start of the year as being mispriced, in contrast to equities or bonds. In short, we misjudged the intensity of the market violence.

Our calls: the good and the bad

Let’s first assess the quality of our calls this year:

The dollar would weaken for cyclical reasons, but an improving US C/A deficit would temper the USD’s descent. The showdown in the US housing sector would be only a source of irritation. In other words, we were looking for a mid-cycle soft landing in the US, not a cycle-terminating shock. Our “Dollar Smile” framework suggested the dollar would be in a vulnerable position, ironically because a slowdown in the US would not be severe.

AXJ and other EM currencies would appreciate. Less “pushed” than “pulled,” the world’s capital would be attracted by opportunities in the emerging market (EM) space and the dollar should weaken against the AXJ currencies.

Risky assets (global equities) would perform well, rising enthusiastically and falling grudgingly. Bonds and equities were out of synch and a P/E expansion would make sense. A general shortage of tradable assets would provide persistent support for risky assets.

The global economy would be extremely buoyant. The effective halving of the global capital-to-labour (K/L) ratio meant that the world would/should embark on a wholesale expansion of capital expenditures, to renormalise the ratio between the world’s capital stock and effective labour supply.

Carry trades would remain important. Specifically, cash yield differentials would dictate the trends in exchange rates.

Sovereign wealth funds would be the most important new category of investors in recent times. We began highlighting the prospective emergence of SWFs in September 2006, and kept writing about their importance to risky assets, the general asset management business, financial protectionism, and other issues. We highlighted the importance of China’s and Russia’s SWFs, and argued that Japan should have its own SWF. We argued that these SWFs would probably favour financials, resources, high-tech, and infrastructure.

Accelerated decline in the ‘home bias’ of Asia and EM in general. JPY would continue to experience headwinds because Japan’s home bias was still too high and secular divestment by Japanese retail investors from JPY assets would make sense. Similarly, the private sector in China and other EM economies would likely experience a broad-based divestment from their home assets.

In retrospect, most of the above themes and calls were correct, and many will likely carry over to drive the markets in 2008 (particularly in 2H). However, we underestimated the power of reserve diversification, which likely occurred at a rapid pace by Middle East sovereign funds and other large reserve holders. The rise of EM may also have led to a decline in demand for the dollar.

Second, the loss of confidence in the dollar was swift and prevalent, which we did not anticipate. The dollar’s hegemonic status is being challenged by the EUR, as the GCC countries contemplate de-pegging from the dollar. Though we quickly recognised factors fuelling inflationary pressures ― the impact of high oil prices, a Fed policy increasingly inconsistent with the GCC’s objectives, and the weakening dollar ― we did not recognise this at the beginning of the year as a key pressure point.

Third, we were more bullish on risky assets and dismissive of sell-offs in equities during the February/March and July/August sell-offs. In a way, we captured the strong recoveries in equities very well, but may have missed the first part of the correction in the JPY crosses.

Lessons learned and thoughts for 2008

Aside from our market calls, several themes/lessons will be important for 2008:

Lesson 1. This is more than a sub-prime crisis. The financial crisis we face goes beyond housing and sub-prime. In the past, the extraordinarily low volatility environment, with a healthy gap between the return on capital and the cost of capital, led to excess leverage in some sectors. The money markets froze up, reflecting not only the sub-prime crisis, but also a general “bank run” on capital markets in developed countries.

Lesson 2. Central banks are potent, but the private sector is critical, too. In our view, recent co-ordinated liquidity action by various central banks yesterday was important, and potentially positive for financial markets and the global economy. The Fed effectively introduced a lower-cost, anonymous, variable-rate auction version of the discount window aimed at providing liquidity beyond the cash market. To the extent that this enhances general confidence, the term interest rates in the interbank market should start to decline. The corporate bond and money markets’ initial reaction has been remarkably muted, and the reaction of the global equity markets has been outright negative. But it is perhaps correct to assume that, if this variable rate tender proves to be too modest, the Fed will raise the amount auctioned and/or introduce other tools to achieve its objective. In short, the willingness of the Fed to go to the extreme should not be in question, even though its ability to close the LIBOR-OIS spread requires a change in the behaviour/psychology of the private sector.

Lesson 3. Extraordinary powers of globalisation. The rise of the emerging powers has become quite clear this year. Their ability to withstand multiple sell-offs in the global financial markets has been remarkable. Further, this structural rise of the real economies of EM within a fundamentally asymmetric arrangement between capitalists in the West and labourers in the East is quickly evolving into a more symmetric arrangement: EM is now a source of capital flows, not just a destination of FDI from the West. This, in our view, is a watershed in the balance of world economic power.

Lesson 4. The rise of sovereign wealth funds. SWFs have indeed turned out to be a powerful driver of risky asset prices. At fire-sale prices, SWFs have been particularly active with financial institutions in the developed world, which they broadly consider as strategically important. In our view, this is not a fad but the beginning of a long-term trend, as the SWF will form the most powerful new category of investors in the world, with Japan likely the next new member.

By Stephen Jen London
Morgan Stanley
December 16, 2007