Wednesday 23 August 2017

Enjoy the export party - but don't suffer a hangover

Irish export boom set to continue but benefit of QE 'lucky break' can't last forever, write Justin Doyle and Philip O'Sullivan of Investec

China, as a small market for Ireland, isn’t a big issue now, but if the world suffers, we face fallout
China, as a small market for Ireland, isn’t a big issue now, but if the world suffers, we face fallout

Robust economic growth across many major export markets and favourable foreign exchange (FX) moves have provided strong tailwinds for Irish exporters. While there are some storm clouds brewing to the East, Ireland should be able to avoid being buffeted by those, although we advise against complacency.

Looking ahead, surveys such as the Investec Irish Manufacturing and Services PMIs show that firms are optimistic on the outlook - we think they are right to be.

Let's start with the data. The CSO's monthly Goods Exports and Imports statistics show that exports were +18.9pc year-on-year and imports +4.8pc year-on-year in H1 2015, producing a 44.8pc year-on-year jump in the trade surplus to €23.1bn. And the data reveals a broad improvement across most export categories. It's a similar picture for imports, where on top of rising purchases of components used by export-oriented firms we note strong growth in items for domestic use.

Transfer pricing effects in the multinational sector often camouflage the effect that FX moves have on the underlying economy.

One way of controlling for this is to look at industrial production data. The CSO provides volume indices of production for what it categorises as the 'Modern' (the multinational-dominated IT and chemicals industries) and 'Traditional' (effectively, everything else) sectors. The latest release shows that Traditional production is rising at its fastest pace since the mid-1990s. FX moves are a key driver (note the US and UK are the destination for c. 21pc and c. 15pc of Irish goods exports respectively), further supported by the (not unrelated) strong growth numbers coming out of those key markets.

There are some concerns at this time about China's slowing economy. The direct effect of this on Ireland should be modest, with China accounting for only c. 2pc of Irish exports. But if the situation worsens, this will hurt Ireland, with every 1 percentage point change in world output estimated to move our GDP by c. 0.9pc. We also note that recent market turbulence should underline the importance for Irish companies to have appropriate hedging policies.

The momentum behind the exporting sectors means that a strong finish to 2015 is likely, which will help to produce another year of impressive growth for the Irish economy.

Looking ahead, the fallout from the troubles in emerging markets will need to be carefully navigated, while for Ireland's core customers, as the Fed and BoE prepare to tighten policy while the ECB remains accommodative, this may lead to further volatility. So, our message is to enjoy the party, but don't overdo it.

With that very volatility in mind, it's worth noting that the overriding FX theme during any period of equity negativity is the sharp exit of the larger, longer term speculative trade that happens to be de rigeur at that time. Back in the early 2000s the speculative FX community had built up a sizeable stake in the 'Carry Trade'. The 'Carry' or yield hunting trade is when an investor/speculator sells or goes overdrawn on a lower yielding (funding) currency in order to buy or 'go in credit' on a higher yielding (Carry) currency. The investor/speculator is primarily hoping to gain on the interest rate differential with one eye on an advantageous FX move.

The Japanese yen, Swiss franc and US dollar had been the favoured, stable, lower yielding/funding currencies while the Australian dollar, New Zealand dollar, South African rand and Norwegian krone were some of the higher yielding (Carry) currencies at that time.

The 'Carry' currencies are usually classified as 'commodity' or 'emerging market' currencies and are historically more volatile in nature. This type of trade tends to fare better in a stable/bullish, pro-risk environment but tends to unfold brutally and rapidly in periods of heightened risk aversion as was the case during the global financial crisis of 2007/09.

In the intervening years the fast FX money has followed the slightly less risky path of Central Bank (CB) stimulus i.e. selling (shorting) the currency of the most accommodative CB at any given time. As such the short US dollar, short Japanese yen and now short euro (in that order) have been the respective FX trades du jour, in essence piggybacking the monstrous money-printing programmes of The Fed, Bank of Japan and, more recently, the ECB.

If one is curious as to what the speculative FX bet is now, just press the rewind button to mid-August. With the Chinese situation becoming ever more precarious and as global risk aversion gathered pace, the standout FX move was the aggressive jump in the value of the single currency and in particular, the nearly 7pc move higher in benchmark euro/US dollar rate from just below $1.10 to just over $1.17 in those few shaky days. The short euro trade is leading the pack with a slightly staler and more fatigued short Japanese yen trailing in the speculative stakes.

As the equity markets have stabilised and pulled back from the precipice so too has the resurgent euro moved closer to its pre-Chinese wobble levels, much in line with our core view.

Most market participants are putting the sharp equity sell-off down to a 'timely correction' after a 'bends' inducing ascent. It appears we can now revert back to concerning ourselves with more mundane issues of diverging monetary policies and upcoming Greek elections but for those parties vested in a cheap euro, the last fortnight has been a wake-up call.

Justin Doyle is Senior Treasury Dealer and Philip O'Sullivan is Chief Economist at Investec

Irish Independent

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