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The month of November had its challenges for financial markets, with equities mixed and some foreign currencies showing moderate gains after staging a rally late in the month. The key event was the U.S. Presidential election, which took place early in November. President Barack Obama was re-elected to a second four-year term, while Democrats retained control of the Senate and Republicans retained control of the House. While that result was not a particular surprise, investors quickly turned their attention to the looming fiscal cliff, with U.S. political leaders needing to come to agreement on
taxation and spending policies soon. In the absence of any deal, current
legislation would see a sharp fiscal adjustment begin to take effect
from early 2013. While early rhetoric by U.S. political leaders has been
encouraging, the budget talks are nonetheless contributing to an
unsettled backdrop, and both global equities and foreign currencies have
come under pressure at times. Japanese politics has also been a factor,
with the impending December election leading to some decline in the
On the equity front, the S&P 500 is down around 0.5% in the past month, but European equities staged a late recovery to register a 2% gain over the same period. For the currency markets, the yen dropped 3%, while the pound and euro were broadly steady, with the latter recovering losses from earlier in November as European debt strains eased slightly. Emerging currencies were also mixed, reflecting an uneven news flow. The zloty, won and ruble managed gains of more than 1% versus the greenback, while the rand, rupee and real all fell by 2% or more.
Finally, the other theme of note during November was the ongoing evolution of the Eurozone’s debt crisis. Much of the month was focused on when and whether Greece would receive further financial assistance from its European partners, uncertainty that contributed to broader European market jitters and a temporary rise in Spanish and Italian government bond yields. Late in November, Eurozone finance ministers agreed to the release of a further E34 billion in funding for Greece in December, with further funding next if Greece meets the terms and conditions of its aid agreement. The temporary resolution to Greece’s financing difficulties could help Europe’s bond markets to stabilize in the coming weeks.
Americas Recent economic figures pointed to modest pick-up in growth ahead of the impact from Hurricane Sandy that hit the Northeast in late October. Q3 GDP growth firmed to a 2% q/q annualized pace, while October nonfarm payrolls rose by 171,000 and the jobless rate edged up to 7.9%. Survey data remains consistent with slow but steady growth, as the October ISM manufacturing index rose to 51.7 and the ISM services index eased to 54.2. October retail and manufacturing figures were softer, perhaps reflecting some early evidence of Sandy’s impact.
In Canada, activity remains subdued and inflation benign. October employment rose by just 1,800 and the jobless rate was steady at 7.4%. September manufacturing sales rose by 0.4% m/m and retail sales rose by 0.5% m/m, while the October core CPI was steady at 1.3% y/y. Mexican data has eased slightly in recent weeks, including a slowing in Q3 GDP growth to 3.3% y/y, softer retail and industrial activity in September, and a dip in October CPI inflation to 4.6% y/y. The Bank of Mexico held its overnight rate steady at 4.50% at its late October meeting, but warned that it could tighten monetary policy “soon” if price pressures persisted. Brazilian figures were mixed – September industrial output fell 3.8% y/y and retail sales slowed to 8.5% y/y, while the October CPI quickened to 5.45% y/y. The Brazilian currency has underperformed over the past month, falling by 2.4% against the greenback. Chile’s economy has remained sturdy, with Q3 GDP growth unchanged at 5.7% y/y and the central bank holding its overnight rate steady at 5.00% at its November meeting.
Europe In the Eurozone, economic indicators are consistent with an ongoing contraction. Q3 GDP fell by 0.1% q/q and 0.6% y/y, while the quarter ended on a particularly soft note with a 2.5% m/m drop in industrial output. In subsequent survey data, the Eurozone manufacturing and services PMIs printed at 46.2 and 45.7 respectively, still well in contraction territory, although Germany’s November IFO confidence index did rise to 101.4. The European Central Bank made no change to its monetary policy stance at its early November meeting. Recent U.K. figures hint at modest improvement – or at least stabilization – for the British economy. Q3 GDP jumped by 1% q/q, a result that was nonetheless boosted by temporary factors, most notably the London Olympics. October retail sales fell 0.8% m/m and September industrial output fell some 1.7% m/m. Inflation moved higher in October with the CPI rising by 2.7% y/y. In fact, inflation was high enough and the economy has improved enough for the Bank of England to pause its quantitative easing policy at its November meeting.
In Switzerland, the October manufacturing PMI improved to 46.1 and the KOF leading index was broadly steady at 1.67, while the rate of CPI deflation eased to 0.2% y/y in October. We still expect a steady policy stance by the Swiss National Bank at its December meeting, in terms of its zero interest rate target and continuing to cap the value of the Swiss franc versus the euro. In Sweden, September industrial output slumped 4.1% m/m and recent confidence surveys have been subdued, suggesting that further central bank monetary easing may be forthcoming. In Norway, the outlook is for steady policy interest rates. Recent economic figures have been somewhat mixed, although Q3 mainland GDP did grow by 0.7% q/q. In the region’s emerging economies, GDP contracted in both Hungary and the Czech Republic during the third quarter. The past month has also been an active one for the region’s central banks with rate cuts in recent weeks from Poland (25bp), Hungary (25bp), the Czech Republic (20bp, taking the benchmark rate effectively to zero) and Israel (25bp).
Asia Recent events have contributed to a less supportive backdrop for the Japanese currency. Japan’s Q3 GDP contracted at a 3.5% q/q annualized pace, while September industrial output fell by some 4.1% m/m. With deflation persisting, the Bank of Japan eased monetary policy further in late October, expanding its asset purchase target by 11 trillion yen. Political jitters have also contributed to yen weakness, with general elections called for 16 December. Opposition party leader Abe, who appears likely to win those elections based on political polls, has called for aggressive monetary easing from Japan’s central bank. In contrast, Chinese data continue to suggest some improvement in that country’s economy. The October trade surplus rose to US$32.0B with exports firming to 11.6% y/y. October retail sales firmed further to 14.5% y/y as did October industrial output, to 9.6% y/y. On the political front, Xi Jinping was named as head of the Chinese Communist Party at the 18th Party Congress, and will become Chinese President in March 2013. In other central bank activity across Asia, the Philippine central bank cut its overnight borrowing rate by 25bp to 3.50% in late October.
Down under, Australian activity data has been mildly soft overall. October employment was steady with a job gain of 10,700 and an unchanged unemployment rate of 5.4%. However, Q3 real retail sales dipped by 0.1% q/q and business sentiment softened in October. The Reserve Bank of Australia held its Cash Rate at 3.25% in early October, but the minutes of the meeting indicated that the central bank remains open to the idea of further monetary easing. New Zealand economic figures have been noticeably soft in tone. Q3 employment dropped by 0.4% q/q and the jobless rate rose to 7.3%, while Q3 real retail sales unexpectedly fell by 0.4% q/q.
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This month, Risks & Rewards welcomes guest columnist Ramon Espinosa, Head of FX Analytics for Wells Fargo Foreign Exchange, who addresses the traditional economic subject of Purchasing Power Parity and its application to foreign exchange risk management.
Purchasing Power Parity In mid-November, after Shinzo Abe—the head of Japan’s opposition Liberal Democratic Party and a favorite to become Prime Minister after the country’s December 16, 2012 parliamentary elections—called for ‘unlimited’
Risks & Rewards With Dave Napalo — featuring Ramon Espinosa
Head of FX Analytics Wells Fargo Foreign Exchange
by the Bank of Japan, the Japanese yen experienced its largest two-day
decline against the US dollar in more than a year. Among other
measures, Abe suggested that the Bank boost its inflation target to as
much as 3% from 1%, a level last breached in 2008 (and before then in
1998). This relationship between (expected) inflation and the value of
the yen reminds us of the theory of Purchasing Power Parity (PPP). In
light of this, we take this opportunity to review PPP and its
implications for foreign currency risk and risk management.
What is PPP? Purchasing Power Party comes in two forms: Absolute PPP and Relative PPP. Absolute PPP derives from the so-called Law of One Price, which holds that an item that trades in integrated markets should trade at a common price (abstracting from transportation and transaction costs). Accordingly, if a good trades freely across two regions that use different currencies to measure value, then the rate of exchange between the two currencies in a pure currency transaction should correspond to the ratio of the good’s price in each currency, because otherwise it will be possible to earn profits by arbitraging the difference. As an example, say that good X trades freely across regions A and B, in region A the ‘Stage’ is used as currency and the price of X is 5 Stages, and in B the ‘Coach’ serves as the currency and the price of X is 100 Coaches, then Absolute PPP asserts that the appropriate rate of exchange between the two currencies is 20 Coaches per Stage (i.e., STA/COA PPP = Price of X in B/Price of X in A = 100/5 = 20).
A well known example of PPP exchange rates is The Big Mac Index, published by the Economist magazine. This index measures the relative price of the McDonald’s Corporation’s Big Mac hamburgers in some 40 countries versus its price in the US.
Fundamentally, therefore, the PPP exchange rate measures the relative value of local currency prices. Put differently, it represents the exchange rate that equalizes the two prices, when they are expressed in a common currency. Because it ‘equalizes’ prices, the PPP exchange rate for the currency of a country with ‘relatively high’ prices will imply a weak or depreciated value of that currency, and the PPP rate for the currency of a country with ‘relatively low’ prices will convey a strong value of that currency.
While the application of the Law of One Price to goods traded internationally provides motivation for PPP exchange rates, PPP rates can be based on the comparative prices of any ‘basket’ of goods and services. And as international comparisons of interest often involve broad concepts, such as GDP, that are comprised of traded and non-traded items, PPP estimates are often based on such broad price comparisons. The Organization of Economic Cooperation and Development (OECD), for instance, prepares annual estimates for roughly forty countries based on comparisons of price measures for GDP and its components (see chart below). The World Bank generates similar PPP estimates for some 180 countries (given the broader country coverage, detailed ‘benchmark’ estimates are updated less frequently than the OECD’s annual estimates).
The estimates above illustrate the relative-price nature of PPP estimates. For instance, in the case of the estimates for Germany, Greece, and Italy, because the latter two countries have lower costs of living than Germany their PPP rates compensate by conveying stronger values for the EUR than the German rates. Similarly, as an offset to the inflationary consequences of the upward drift in commodity prices over much of the past decade, Australia’s 2003-2011 PPP rates register depreciation for the country’s currency. And in the case of Japan, which for more than a decade has struggled with deflation rather than inflation, the 2003-2011 PPP rates compensate by indicating progressive appreciation of the country’s currency.
The second version of Purchasing Power Parity, Relative PPP, asserts that the currencies of countries with relatively high inflation will tend to depreciate relative to those of countries with relatively low inflation. The recent relationship between (the call for) higher Japanese inflation and the subsequent depreciation of the yen is consistent with Relative PPP. Similarly, the upward drift to the points in the scatter plot below suggests a positive relationship between inflation and currency depreciation, as predicted by Relative PPP.
Are Currency Moves Consistent With PPP? The table above also contrasts current spot levels to the currencies’ 2011 PPP estimates, and in nine of ten cases the spot level indicates overvaluation of the currency relative to its PPP rate and for six of the currencies the degree of overvaluation is significant. Given these observed deviations between spot and PPP rates, it seems natural to ask whether the PPP rates represent equilibrium levels, towards which currencies can be expected to revert over the long term. The evidence in support of this, however, is mixed at best. Deviations between spot rates and PPP exchange rates can be large and persistent; in fact, there appears to be modest positive correlation between a country’s per capita income and the tendency for its currency to trade at levels stronger than those suggested by PPP; and, as suggested by the scatter plot above, the positive relationship between relative inflation and currency depreciation tends not to be strong or consistent.
Quite likely, the mixed evidence in support of PPP reflects a number of factors. First, recall that the PPP estimates shown above are based on the prices of broad baskets that include both traded and non-traded items, and the inclusion of the latter items dampens the significance of the Law of One Price and its associated PPP effects. Similarly, the ability of firms to ‘price-to-market’ (i.e., price discriminate, by charging different mark-ups to consumers in different markets) further impedes the operation of the Law of One Price. Lastly, economic growth is often fueled by rapid productivity growth in export industries, which results in higher wages and prices but, by its nature, requires little currency depreciation to maintain competitiveness; and that complex of price movements may also account for persistent deviations between actual currency values and their relative-price based PPP rates.
PPP and FX Risk Management Without doubt, PPP is alluring. It seems natural to think of prices and currencies as sharing a close relationship. When confronted with a need for long term currency projections, it is tempting to rely on the short-cut method of projecting inflation rates and then applying PPP. And if PPP ‘holds’ (i.e., if spot rates revert quickly to their PPP levels), then currency fluctuations can be expected to have only minimal effects on a firm’s financial performance, as currency and price effects offset each other, reducing the need for hedging. For instance, an exporting firm operating in a high inflation environment would experience pressure on its margin due to rising wages and other costs, but that pressure would be mitigated by the effects of a depreciating local currency on revenues from overseas sales.
Given mixed evidence for PPP, however, we urge caution in its use. In some circumstances, for example, a country beset by persistent high inflation, a long term currency projection based on PPP-style relationships may be appropriate; in many others, however, it seems more appropriate to tie long-term currency values to equilibrium estimates based on other, broader methodologies (e.g., Fundamental Equilibrium Exchange Rates and Behavioral Equilibrium Exchange Rates). And finally, risk managers should not presume that inter-related currency and price moves will protect firm performance from currency risks. Instead, they would be better served by monitoring individual sources of risk, evaluating their effects on financial performance individually and collectively under varying correlation scenarios, and then using derivatives to mitigate material risks. For additional discussion of this topic and information on hedging currency risk, please contact your Wells Fargo FX specialist.
The Wells Fargo stagecoach makes its London debut at the Lord Mayor’s Show
“Yee-haw! Cowboys have arrived in London!”
What's Hot: The Wells Fargo stagecoach
“Look! There’s a stagecoach! What company is that?”
These exclamations rippled through the thousands of people who braved the cold November weather to watch the Lord Mayor’s Show on Saturday, November 10, 2012. The Lord Mayor’s Show dates back more than 800 years, when the elected Lord Mayor of London had to travel to Westminster with his procession to swear loyalty to the crown. While one of the longest-established and best-known events in London, there was a new twist this year—the debut of the Wells Fargo stagecoach.
The parade route boasts some of the best sights of London. The stagecoach and parade volunteers set-up near St. Paul’s Cathedraland joined the main procession at The Bank of England. After passing many of the traditional guild houses (many of which are still in operation today), the stagecoach traveled through historic parts of the financial district and completed the the procession in front of the Royal Courts of Justice.
The stagecoach rides past St. Paul's Cathedral.
On the route, parade goers stared in awe—shouts of “there’s a cowboy” and “yee-haw” could be overheard as the stagecoach passed. Besides what they have seen in American films and television, Londoners are not often exposed to the culture of the old-West, so seeing the iconic Wells Fargo stagecoach in London was definitely a thrill for those lining the parade route.
Thousands of parade goers lined the streets to watch the parade procession.
The stagecoach made two more appearances in London. It travelled with London team members to the Bishop Challoner Catholic Collegiate School, where Wells Fargo presented a $10,000 United Way grant. A number of our team members regularly give up their lunch hour to mentor pupils through our partnership with the school.
Wells Fargo presents a check to the Bishop Challoner Catholic Collegiate School.
Finally, the stagecoach made its way to the Tower of London, where Wells Fargo hosted a private reception for customers and local partners. Attendees had the opportunity to meet EMEA Regional Head Jim Johnston, International Group Head Richard Yorke, and Chief Risk Officer Mike Loughlin.
For more information about our regional Foreign Exchange and Treasury Management solutions please contact your relationship manager or sales consultant, call International Connections at 1-877-593-2468, or email us at email@example.com.
A great reason to bank with Wells Fargo
FX Specialist Atlanta, GA
Featuring: Kim Whelan
People Power had the chance to sit down and talk with Kim Whelan, Foreign Exchange (FX) Specialist, in our Atlanta office. We talked about the time she spent as an exchange student in Madrid, how she came to work in Foreign Exchange, and what she likes to enjoy in her free time.
You currently live and work in Atlanta but where did you grow up? Where did you go to college?
I was born in Connecticut and spent some of my childhood in New Jersey before moving to a suburb of Pittsburgh, PA before 5th grade. I attended Davidson College, near Charlotte, NC where I obtained a degree in Economics. Though I currently live in Atlanta, I consider Pittsburgh my hometown and seem to be in good company based on the number of Steelers, Penguins, and Pirates logos I see around town. How did you come to work for Wells Fargo and the International Group?
I had a summer internship with Wachovia Securities while I was still in college and returned after graduating for a full time position within the Economics Group. A few years later, after the merger, I transitioned to the Wells Fargo International Group working as a Specialist on the Foreign Exchange team. I’ve enjoyed keeping a close watch on the world’s economies and being able to apply my academic background and past experience to the unique real-world situations that our FX clients face. Do you have any international experience such as living abroad or speaking other languages?
I spent a semester living with a host family in Madrid and studying Spanish—I actually minored in Spanish in college. Being an international exchange student was an experience I’ll never forget and am grateful to have had the opportunity. I would love to spend more time abroad in the future—hopefully before my Spanish proficiency completely disappears.
What are some of the factors that influenced your career choice?
Being so close to Charlotte—a major banking center—as an undergraduate certainly influenced my current career path. Classes in international finance also piqued my interest. There are so many different roles to experience in financial services so I was confident that I would always be learning.
What are some of the things you like about working with your clients?
I like the personal interaction and the feeling of solidarity you can have with clients when you are working towards the same goals. I also like that no two clients are exactly the same, and markets are always changing, which allows me the opportunity to work in many different capacities. When you’re not keeping up with what is happening in the world’s economies, what do you enjoy doing with your free time?
I like to be outdoors doing just about anything—exploring city streets, hiking, relaxing at the beach, and playing tennis. I played junior tennis growing up and I can usually tell my age in pictures by some of the fashion choices on display—whether pleated skirts, oversized t-shirts, scrunchies, or not-so-sporty sunglasses. I also like trying new restaurants and recipes. In fact, since moving to Atlanta, tennis and food are responsible for most of my travel around the city.