The powerful but temporary correction from late Q2 to early Q3 that we warned of in the Q2 editions of Macro Strategy Views appears to be taking place, albeit later than we envisaged. We took this view at the time because of an alarmingly similar fundamental backdrop in early H1-2008 and H1-2011, including soaring food and energy prices, broad US dollar (USD) weakness and a hawkish European Central Bank (ECB). More generally, global asset markets were being inflated by excessive credit and liquidity – in the first case by the credit market, and in the second case by the Federal Reserves QE2 programme, which ended on 30 June 2011. In both cases, once the source of global excess liquidity was removed, the underlying weakness of the global economy was displayed for all to see.
In H2-2008, the massive implosion in the credit markets and the contraction in bank lending across the US and Europe helped to trigger a global recession. For H2-2011, we see good news and bad news; the bad news first. Unlike in H2-2008, G4 – US, euro-area, UK and Japanese – policy makers have few policy levers left to avert renewed recession. In Q4-2008, it has been argued that China saved the world with massive fiscal easing. This time, China could still enact fiscal easing to support growth. However, with CPI inflation at 6.5% y/y, the policy bias is still towards tempering inflation (though we expect this to change sooner rather than later).
More positively, we do not expect the global economy to tip back into recession. To be sure, there are risks aplenty. Moreover, the collapse in equity-market sentiment could yet weigh on real economic activity. However, our base case is a muddle-through economy rather than a recession, for three reasons. First, G4 bank lending, while improving, has remained anaemic compared to pre-global financial crisis levels. As such, there is little room for a sharp contraction in bank lending. Second, the trend in economic data in the US and Japan in particular has been improving. Third, Asia ex-Japan (AXJ) remains a strong source of support for global final demand.
There are similarities between H2-2008 and H2-2011, but there are also major differences. First, as the S&P downgrade of the US reflects, the USD is less of a safe haven than it was in 2008, so one should expect it to be less of a beneficiary of „risk-off moves. Second, EM local bond markets have benefited from a structural reallocation away from G3. The AXJ has seen part of this reallocation, which has in turn changed the flow dynamics for IDR, KRW, SGD and MYR in favour of bonds. Third, FX and equity vols remain well short of 2008 levels.
Given the state of the cycle, with banks continuing to revise down growth estimates, AXJ currencies may remain choppy near-term. In this context, market positioning may play a part, with the likes of the CNY, KRW and IDR underperforming given heavy market positioning. However, the THB and PHP should do better, in our view, due to lighter positioning. Moreover, the SGD is likely to benefit from accelerated reallocation away from the USD in the wake of the US downgrade.
Overall, from late Q3, we expect sovereign debt issues in the US and euro area to lead to accelerated diversification from DM to EM. Within this, AXJ and some Latin American currencies should benefit on stronger fundamentals. Liquidation has been evident in Latam currencies, with the Brazilian real (BRL) and Mexican peso (MXN) down 4.16% and 5.00% in August. Given Mexicos particularly strong ties to the weak US economy, we expect the MXN to underperform. The BRL has also been hit, but Brazil's more closed economy provides more fundamental medium-term support for the currency relative to the MXN.

 

The United States late Friday lost its triple-A debt rating from Standard & Poor’s for the first time in history, with the credit-rating agency saying the political system of the world’s top economy has become less stable and that budget cutting announced earlier this week didn’t go far enough.

Global policymakers held emergency talks Sunday to discuss the first-ever downgrade of the U.S. government’s top-tier credit rating by Standard & Poor’s and the euro-zone debt crisis in Europe, according to media reports. In addition, the European Central Bank reportedly held a meeting Sunday evening to discuss whether to start buying Italian debt in an effort to calm the markets, according to reports.

Stocks plunged around the Middle East on Sunday as most markets in the region opened for a new week of trading following the S&P downgrade. Trading in the Middle East was the first since the downgrade, to be followed in hours by Asian and European markets. Asian markets will be the first on Monday to confront a brave new world - one in which the U.S. government does not have the full faith and confidence of the major ratings agencies. This could make Asian assets look more attractive relative to those of the West, though the immediate fall-out could well be a flight from risk that sends stock markets plunging and bond yields rising around the globe. In particular, emerging markets could face greater scrutiny from institutions and investors with a renewed awareness of danger.

Investors are now looking to the Federal Reserve to adopt further quantitative easing — pumping money into the American economy, but critics argues it will add to make inflationary pressures in the U.S. Investors do feel that if QE3 will be announced, it could be as soon as 25 -27^th Aug 2011

 

CHINA and the World Currency Markets

The reaction of currency markets will be the key focus this week; we believe the dollar is going to continue to get pummelled.

 

China’s official news agency, Xinhua, is certainly not downplaying America’s diminished credit standing. “China, the largest creditor of the world’s sole superpower, has every right now to demand the United States address its structural debt problems and ensure the safety of China’s dollar assets,” Xinhua said. China also urged the United States to apply “common sense” to “cure its addiction to debts” by cutting military and social-welfare expenditure. The reason for the alarmist reaction in China, whose Treasury holdings are estimated at $1.1 trillion, to the S&P downgrade of U.S. credit to AA+ is that it is expected to trigger further dollar weakness. As a weak dollar tends to drag China’s currency down with it due to the loose peg of the yuan to the greenback, this also makes life uncomfortable for Asian exporting economies. We may see more interventions to devalue currencies in the region. China may raise the value of the yuan in its daily fixing, perhaps to a new all-time high against the dollar. Analysts feel that People's Bank of China may set a fixing in the 6.4350-6.4400 range, from Friday's 6.4451.That could be an important benchmark for Asian FX in general, as authorities throughout the region, fearful that rapid appreciation of their own currencies will erode their export competitiveness, keep a close eye on the yuan.

In India, currency traders will definitely watch out from any RBI buying around 43 levels. We do expect rupee to appreciate to 44.10 - 43.80 levels this week.

Indian Equity Markets and Gold

Last week, the Sensex on a weekly basis closed down by 891 points or -4.9%, to close at 17305.87 levels whereas the Nifty closed down by 270 points, or -4.9%, to close at 5211.25 levels. In the coming week, volatility is likely to stay higher for at least couple of sessions before index finds its ground. Going forward, Nifty has an important support in the range of 5070-5000 levels. Meaningful recovery could be expected only if index manages to close above 5350 levels. On the rallies, 5300-5330 is likely to act as stiff resistance. We recommend that investors could now pick few A List stocks which are now available at good valuation from a a long term investment perspective. Indian equities could see a return of around 15 - 20% from these levels in next 12 month time. For short term investors, we would suggest that if Nifty falls by another 150 points, then cover your shorts and wait and watch the market, it will be messy for a couple of weeks and risky trades should be avoided.

We believe that a weakening USD might cause gold to rise in USD terms, but with INR appreciation, the impact on gold in rupee could be limited. Still as investors we believe that you remain invested in gold with every dip acting as buying opportunity.