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Bein’ Green
“It’s not easy being green.”
—lyrics sung by Kermit the Frog, written by Joe Raposo
October 2014
“Bein’ Green” (1970) is a song
written by Joe Raposo. It was
performed first by Jim Henson
as Kermit the Frog on “Sesame
Street” and “The Muppet Show.”
Later the song was widely
covered by such famous artists
as Ray Charles, Frank Sinatra,
Van Morrison, Tony Bennett, and
Diana Ross among others. The
song is a melancholy reflection
on wanting to be something
other than one is (that is, green)
but later accepting and
embracing that quality.
E. William Stone, CFA®, CMT
Managing Director, Investment and
Portfolio Strategy
Chief Investment Strategist
Marsella Martino
Senior Investment Strategist
Rebekah M. McCahan
Investment Strategist
Nicholas M. Srmag, CFA®
Fixed Income Strategist
Ryan Whidden
Senior Portfolio Strategist
Paul J. White, PhD, CAIA®
Director of Portfolio Strategy
Michael Zoller
Investment Strategist
pnc.com
Executive Summary
Diverging global growth, geopolitical tensions, and changing expectations for
major central banks’ monetary policies have notably caused skittishness in the
markets and unease among investors. It is easy to get lost in the shuffle and hard
to keep track of the moving parts. Over the past few months in our Investment
Outlooks, we have tackled some of the big issues affecting global markets.
Importantly, central banks around the world are paying attention to these issues.
One interesting reaction in 2014 has been the movement of major currencies,
particularly the dollar. In some cases, moves have been in a different direction
than had been forecast.
This month’s title, Bein’ Green, is a reference to the term “greenback.”
Greenbacks were paper currency printed in green ink issued by the United
States during the Civil War. While the greenbacks are no longer in use, the term
“greenback” is still used casually to refer to paper dollars.
In this month’s Investment Outlook we look at what has moved currencies. It is
our view that currency moves in this particularly noisy global market
environment are indicative of both country and global growth dynamics. A
discussion of currencies would be incomplete without a discussion of central
bank policies, which we consider, as well as the outlook for the regions. For this
discussion we are focused on the developed markets. We discuss:
 the dollar and the Federal Reserve (Fed);
 the euro and the European Central Bank (ECB);
 the sterling and the Bank of England (BOE);
 the yen and the Bank of Japan (BOJ); and
 market considerations.
Geopolitical concerns remain on the radar as the biggest risks to markets; also
prominent is the fragility of the Eurozone and Japanese economies. We expect
that the risk of recessions is likely to cause central banks to respond, particularly
in the Eurozone.
Our outlook for the United States for the rest of 2014 is for continued economic
expansion, with several helpful tailwinds, including less fiscal drag and political
turmoil, strong corporate profits, low inflation, and rising asset prices, among
other things. For 2014, PNC expects economic growth of 2.2% year over year,
accelerating to 2.9% in 2015.
Investment Outlook
Banks and Money
It is easy to get lost in the shuffle of financial and economic news that goes on around
the world. Lately, concerns about global growth, changing outlooks by region,
geopolitical tensions, and so on have caused noticeable skittishness in the markets
and unease in investors. Over the past few months in our Investment Outlooks, we
have addressed some of the big issues:
 the fragility of the Eurozone economy (Eurozone Then and Now, July 2014);
 the inflation outlook (Nation’s Inflation Conversation, August 2014); and
 the strength of the U.S. economic recovery and related market reactions (Old
Man Economy: Timing the Shifts of an Economic Expansion, September
2014).
Central banks around the world are paying close attention to these topics and others
in the global sphere, and many are largely focused on being accommodative.
Globally, commodities and oil are less expensive, and the dollar has traded stronger
versus the euro and the yen. Cheaper oil, which is disinflationary, is typically viewed
positively; however, with differing regional economic scenarios, central banks may
step in, making the outlook a bit trickier. With rising concerns that the Fed will
tighten, some central banks, such as the ECB, have eased.
We wrote more than a year ago, in our May 2013 Investment Outlook, Undeclared
Currency Wars, of the challenges in forecasting currency moves and, more
importantly, how global growth and central bank action around the world were
affecting currency. Currency moves in 2014 have in some cases surprised and are
reflective of global economic and market views. This month, we discuss some of the
major global currencies. We also highlight changing central bank policies in the
major developed markets.
The Dollar Strengthens
This year, the dollar began trading by bouncing around, yet it was little changed by
the half-year mark. The return for the first six months was -0.7%. However, after
hitting a low, on July 1, 2014, the dollar has appreciated markedly. From July 1
through September 19, 2014, the Trade Weighted U.S. Dollar Index is up more than
5% (Chart 1). The dollar has risen in the third quarter against all major currencies.
Chart 1
Trade Weighted U.S. Dollar Index
Source: Federal Reserve, PNC
2
Except during the rally following the 2008 financial crisis,
the dollar has not traded this strongly since 2000. The
Trade Weighted U.S. Dollar Index is up more than 12%
since mid-2011. The strong dollar is indicative of the
recovery and the companies’ earnings outlook. Also,
currencies trading relative to other countries supports a
view of a stronger U.S. economy versus other developed
economies. And diverging monetary policies are affecting
currency trade, as is the Fed move toward normalizing
while other economies look to ease.
Currency moves often catch investors by surprise
(Table 1, page 3). In 2004, for example, many forecasters
called for the dollar to fall; but the dollar surprised on the
upside in 2005 as the Fed aggressively raised interest rates
from 2.5% to 4.25%. The currency impact to the EAFE
was largest in 2005.
October 2014
Bein’ Green
At the time of our May 2013 Investment Outlook we wrote
that the dollar acted as a safe-haven currency but then
began to pull back, driven by disappointing growth and
monetary relaxation outside the United States. We also
noted the mixed outlook for the dollar, stating that some
viewed the dollar as declining over the long term. This
year that has not proved to be the case, reinforcing our
conclusion currencies often surprise.
For investors, it is important to bear in mind exchange
rates, particularly considering international investments. A
stronger dollar could negatively affect earnings for
multinational firms, something to be mindful of as the
third-quarter 2014 earnings season begins.
Table 1
MSCI EAFE Performance
EAFE
Currency
Local Dollar Impact
Negative Currency Impact
1981-84
18.8%
1996-2001
6.9%
Positive Currency Impact
1985-87
2002-07
7.2%
2.0%
-11.6%
-4.9%
21.4% 48.7%
8.1% 14.8%
27.3%
6.7%
Source: Bloomberg L.P., PNC
Chart 2 illustrates the impact of the dollar—rising or falling—on returns from 2000
through September 17, 2014. In the early 1980s the strong dollar significantly cut the
EAFE return to U.S. investors. After devaluing the dollar in 1985, the EAFE return
was dramatically higher in dollar terms. In most of the years of the bull market in the
late 1990s the strong dollar caused performance to be weaker than in local currency
terms. In 2013 and year to date, the S&P 500® is outperforming the EAFE in both
dollar and local currency terms.
Chart 2
S&P 500 and International Returns
YTD through 9/17/14
Source: Bloomberg L.P., PNC
Table 2
Global Stock Market Returns
Year-to-Date Return
Local
Stock Market
Currency Dollars Difference
OMX Stockholm 30 Index
5.3%
-5.5% -10.8%
IBEX 35 Index
8.6
1.2
-7.4
FTSE MIB Index
8.1
0.6
-7.5
AEX-Index
4.3
-2.8
-7.1
Euro Stoxx 50 Pr
3.5
-3.5
-7.1
DAX Index
0.6
-6.4
-6.9
CAC 50 Index
2.0
-5.0
-7.0
Swiss Market Index
7.1
1.1
-6.0
S&P/TSX Composite Index 11.0
6.5
-4.6
Nikkei 225
-0.8
-4.0
-3.2
Brazil Ibovespa Index
9.8
7.7
-2.1
Mexico IPC Index
5.4
3.8
-1.6
FTSE 100 Index
-1.1
-2.1
-0.9
S&P/ASX 200 Index
0.4
0.0
-0.5
Table 2 illustrates the impact of the dollar on U.S.
Source: Cornerstone Macro, PNC
investors invested in foreign markets. Clearly the dollar
rising hurts returns to U.S. investors. Conversely, it is supportive of domestic
equities, which become more attractive to U.S. investors.
In the post-Lehman-collapse world, the dollar traded as a reflection of the risk-on/
risk-off trade before stabilizing somewhat as the recovery progressed. In other words,
the dollar acted as a safe-haven currency, strengthening at signs of financial market
turmoil. Uncertainty in other developed markets has benefited the dollar recently,
reflecting a flight to safety.
The outlook for the dollar, at least in the near term, can be viewed as more of the
same. Global uncertainty plus continued strength in the U.S. economy are positives.
3
Investment Outlook
But once again, we recommend caution on investing in the
dollar specifically, because history shows that predicting
currency moves is most difficult.
Chart 3
The Dollar and Oil
Also, from a global perspective the dollar is inversely
correlated with oil prices (Chart 3, page 4). Thus, the
stronger the dollar is, the lower oil prices go, adding a
disinflationary global impact. Inflation in the United
States remains low, not only because of declining gasoline
prices. However, lower gasoline prices are a strong
positive for consumer confidence, and low oil prices are
also a plus for the U.S. consumer. Declining energy prices
are an offset to geopolitical tensions, particularly in light
of Russia’s position as an energy resource.
The Fed
Source: Bloomberg L.P., PNC
The outcome of the September 17, 2014, Federal Open
Market Committee (FOMC) meeting has several
implications. As expected, the Fed kept interest rates
unchanged and reduced its quantitative easing (QE3) monthly purchases of assets to
$15 billion per month. The Fed statement indicated that, barring any changes in the
current economic forecast, it expects to complete tapering this program by its
October 29, 2014, meeting. The tapering has been an effect of the Fed’s view of a
stronger U.S. economy in the green sprout stages, a stated requirement by the Fed for
it to begin to normalize monetary policy.
While there were no major changes to language, Fed Chair Janet Yellen provided
some interesting commentary in her postmeeting conference call. Still “significant
underutilization of labor resources” and “considerable time” language was kept with
regard to not making any increases in the federal funds target rate after the tapering is
complete and in particular if inflation continues to run below the committee’s 2%
target. The growth forecast was adjusted a bit lower. Inflation is little changed.
Ms. Yellen hedged a bit in her conference call, still sounding cautious.
The Fed statement was slightly more positive than the one following the prior
meeting, noting a somewhat further improvement in labor markets. Importantly, the
vote was not unanimous, with Philadelphia Fed President
Charles Plosser and Dallas Fed President Richard Fischer
both dissenting, preferring to move toward tightening.
Chart 4
Target Federal Funds Rate at Year End
Source: Bloomberg L.P., PNC
4
The FOMC Dot Plot moved up a bit, with the end date
now 2017 (Chart 4). The median view has the federal
funds rate at 1.375% by the end of 2015, higher than the
1.13% in June, with both the hawks and Ms. Yellen
moving up the median. The market appears to be pricing
in the same terminal rate as the Fed, 3.75%, but gets there
later than the Fed does, in 2017. If markets catch up to the
Fed, rates would go up across the board. It will be
important to watch the October and December FOMC
meetings for further guidance. PNC expects the first
increase in the federal funds rate to come in July 2015.
The dot plot comparative to yields suggests to us that the
market will need to adjust if the market view approaches
the Fed’s view (Table 3, page 5). There is still time for
markets to adjust or there could be changes to the dots or
October 2014
Bein’ Green
there could be a combination of the two eventualities.
Through this year, markets will be cautiously watching.
Table 3
Interest Rate Expectations on Treasuries
From an inflation perspective, the dollar is helping keep
inflation pressures low. This keeps the Fed focused on the
Current Yield
wage portion of the equation. For more information, please
Implied by FOMC Projections
see our September 2014 Topical Commentary, Wages,
Difference
Inflation, and Central Bank Policy, in which we examine
Source: Cornerstone Macro, PNC
wage growth and its effect on central banks and monetary
policy. We note that changing views on monetary policy—the Fed possibly moving
to tighten while other central banks move to ease—is supportive to the dollar.
2 Year 5 Year 10 Year
0.57% 1.83% 2.6%
0.85
2.45
3.1
0.28
0.62
0.5
The Euro on Sale
This year, the euro has traded almost inversely to the dollar. Also flat through the
first half of the year—from July 1, 2014, forward—the euro has fallen from $1.36 to
$1.28, a more-than-5% move lower (Chart 5). PNC Economics forecasts the
exchange rate at $1.32 per euro at year-end 2014 and $1.31 per euro at year-end
2015.
Growth in the Eurozone appears to be stalling. We wrote about the fragility of the
region’s economy in our July 2014 Investment Outlook, Eurozone: Then and Now.
Since, PMI continues to temper, consumer confidence has fallen, as has the ZEW
Economic Sentiment Indicator (Chart 6).
ECB President Mario Draghi has warned of the threat of falling prices and of
households postponing spending. In his speech to the European Parliament’s
Economic and Monetary Affairs Committee on September 22, Mr. Draghi said, “The
Governing Council remains fully determined to counter the risks to the medium-term
outlook for inflation. Therefore we stand ready to use additional unconventional
instruments within our mandate and alter the size and/or the composition of our
unconventional interventions should it become necessary to further address risks of a
too prolonged period of too low inflation.” Mr. Draghi expects inflation to remain
low in the next few months before rising gradually in 2015 and 2016.
The Eurosystem staff economists lowered their 2014 GDP growth outlook for the
Eurozone to 0.9% from 1.0%, and to 1.6% for 2015 from 1.7%. ECB economists
lowered their forecast for 2014 to 0.6% from 0.7%.
Chart 5
The Euro Exchange Rate
Chart 6
Manufacturing PMI
Source: Bloomberg L.P., PNC
Source: Bloomberg L.P., PNC
5
Investment Outlook
Table 4
MSCI Weights by
Country
United Kingdom 21.6%
France
9.8
Switzerland
9.1
Germany
8.8
Spain
3.6
Sweden
3.0
Netherlands
2.7
Italy
2.5
Denmark
1.5
Norway
0.9
Finland
0.9
Ireland
0.3
Austria
0.2
Portugal
0.2
Europe
66.2
Europe excl. U.K. 44.6
Japan
20.4
Australia
8.2
Hong Kong
3.0
Singapore
1.5
Israel
0.5
New Zealand
0.1
Total
100.0%
Returns of several major European indexes are positive this year. However, in dollar
terms, many have negative returns. Euro moves are particularly notable in aggregate
to international funds and can greatly affect performance. Of note, the MSCI EAFE
weight for Europe (excluding the United Kingdom) is 44.6% (Table 4).
The ECB
In early September, the ECB opted to further slash rates, even though in his
August 22 speech at Jackson Hole, Mr. Draghi had stated the ECB expected to keep
rates as they were “for an extended period of time.” Reducing rates by 10 basis points
takes the main refinancing operation (MRO) rate to 0.05%, the marginal lending
facility to 0.30%, and the deposit facility to -0.20% (Chart 7). The negative deposit
rate by the ECB can be viewed as a tax on banks, which they could avoid by moving
assets to the United States. This would be a negative for the Eurozone.
In addition, the ECB has stated its intent to buy asset-backed securities, which was
somewhat of a surprise. It will announce the purchases after its next Governing
Council meeting on October 2, 2014. This is in addition to the targeted longer-term
refinancing operations (TLTRO) announced in June, which offer up to €400 billion in
four-year loans to Eurozone commercial banks at an interest rate of the MRO rate
plus 0.1 percentage point. The ECB’s balance sheet has actually shrunk; banks have
paid back a good portion of long-term refinancing operations (LTRO) (Chart 8). For
the balance sheet to expand, the TLTROs would need to be successful or asset
purchases would have to assist.
The targeted loan program, aimed at trying to kickstart lending, was a disappointment
the first time around. The take-up at auction was a mere €83 billion. The ECB has a
total of eight auctions scheduled through 2016. The initial response may be a sign
that banks do not need, or are reluctant to take on, the funding. Also, there is
criticism that this may not be the right answer, with banks reluctant to take funding at
an almost unheard of 15-basis-point rate.
The outcome also provides further evidence that Mr. Draghi will need to do more. In
the earlier-referenced speech on September 22, 2014, he stated that the ECB stood
ready to do so. The next TLTRO scheduled for December will be telling; it likely
will be significant if there is a repeat of the response to the initial auction. Banks may
be waiting for the outcome of stress tests or details of the ECB’s asset-backed
securities purchase program before deciding whether to participate in the TLTRO.
6
Chart 7
ECB Policy Rates
Chart 8
ECB Balance Sheet
Source: European Central Bank, PNC
Source: European Central Bank, PNC
October 2014
Bein’ Green
Announced actions by the ECB reflect an economic outlook for the Eurozone that is
weaker than it was earlier in the summer. The surprising nature of its plans seems to
suggest a change in the Governing Council’s strategy, reacting to worsening data
rather than using a long deliberate decision-making process. The complex and fragile
Eurozone economy is also affected by the situation in Russia, notably in terms of
Russia as a supplier of energy and trade sanctions against Russia (see our Market
Update, From Russia, with No Love).
The Yen Drops
Recent data from Japan have been mixed to modestly disappointing. Consumer
confidence has declined. Japan reported -7.1% growth in the second quarter,
primarily due to the value-added tax increase on April 1.
These point to reasons the Bank of Japan has indicated it is considering additional
stimulus, which may have helped push down the yen. It is reported by a number of
news outlets that in an interview on September 19, Kazumasa Iwata, a former deputy
governor at the BOJ, said that Japan is at risk for falling into recession. The weak yen
is seen as reducing purchasing power of households and negatively affecting
corporations.
The yen has declined, and is trading near six-year lows versus the dollar (Chart 9).
This has been welcomed by BOJ Governor Haruhiko Kuroda, who has pledged more
help in the form of stimulus if necessary. A weaker currency helps to inflate import
prices, supporting exports and thus corporate profits. A weaker yen therefore benefits
the Nikkei. Year to date, the Nikkei is down 0.8% in local currency terms and almost
4% in dollar terms (Chart 10).
Chart 9
Dollar to Yen Spot Exchange Rate
Chart 10
Nikkei versus the S&P 500
Source: Bloomberg L.P., PNC
YTD through 9/17/14
Source: Bloomberg L.P., PNC
Bank of Japan
Is Abenomics working? This is a question that remains unanswered. The BOJ, under
Mr. Kuroda’s leadership, introduced stimulus supportive of Prime Minister Shinzo
Abe’s plans to re-flate the economy. Currently, with uncertainties surrounding the
economics picture, we believe the government or the BOJ will wait and see before
taking any additional measures. According to the Japan Times, Mr. Abe appears to
7
Investment Outlook
be waiting for third-quarter indicators in order to decide whether to implement a
second sales tax hike to 10%.
In its September meeting, the BOJ indicated the economy was more or less in line
with expectations and made no changes to its qualitative and quantitative easing
program. The BOJ expects demand will resume after the impact of the initial tax hike
has been absorbed.
The British Pound Rebound
The pound had weakened in early September to a low of $1.61 per pound prior to the
Scotland referendum on independence. The pound rallied after the referendum was
rejected, with 55% voting against and 45% voting for (Chart 11). PNC Economics
expects the exchange rate to average approximately $1.67 per pound in 2015 and
2016.
Chart 11
Pound to Dollar Spot Exchange Rate
Chart 12
Rate Hike Probabilities
Source: Bloomberg L.P., PNC
Source: Strategas, PNC
Bank of England
Despite low wage growth, BOE Governor Mark Carney has signaled a plan to raise
interest rates next spring. Second-quarter GDP growth accelerated to 3.2%. Inflation
remains at 1.5%, below the BOE’s target of 2%. The International Labor
Organization unemployment rate improved to 6.2%. Wage growth was a muted 0.6%
in July. The BOE expects real wages to begin to grow in mid-2015. On September 9,
Mr. Carney told the Trades Union Congress, “You can expect interest rates to begin
to increase.” In our view, this does not indicate a promise; it is dependent on the
economy continuing along its recovery path.
Probabilities indicate that a rate hike in 2014 is less likely and appears to be forecast
for early 2015 (Chart 12).
Market Considerations
In September, the Organisation for Economic Co-operation and Development
(OECD) revised its global growth outlook lower and reduced the forecasts for most
major economies, with the exception of China. The OECD’s global growth forecast
is 3.4% for 2014 and 3.9% for 2015. The forecast for the United States for 2014 is
8
October 2014
Bein’ Green
2.1%. Geopolitical risks remain at the forefront, including the Russia/Ukraine
conflict and tensions in the Middle East.
As the U.S. economy normalizes, there is less of a need for extraordinary interest rate
policy. Looking back at the impact of prior tightening cycles, specifically in 1994 and
2004, we note markets tend to sell off following tightening but recover over time
(Table 5).
Table 5
Fed Tightening Cycles
Change
Yield
S&P 500
10-Year
2-Year
1994--First Rate Rise 2/4/94
9 Months before
3 Months before
3 Months after
9 Months after
6.7%
2.7
-4.0
0.5
0 bps
25
123
213
67 bps
29
147
258
2004--First Rate Rise 6/30/2004
9 Months before
3 Months before
3 Months after
9 Months after
14.5
1.3
-2.3
3.5
68
72
-50
-6
125
109
-11
113
Payrolls
Unemployment
(average mo/mo)
Rate
January 6.6%
0.2%
7.1%
0.3
6.6
0.3
6.4
0.3
5.8
0.1
0.2
0.1
0.1
January 5.6%
6.0%
5.6
5.4
5.2
Source: Strategas Research Partners, PNC
With the market having been on such a strong bull run, we
Table 6
wrote about the normalcy of corrections and the
S&P 500 Market Days without a Correction
relationship between economic growth and the market in
January 3, 1928 to September 24, 2014
our September 2014 Investment Outlook, Old Man
Decline
5%
10%
20%
Economy: Timing the Shifts of an Economic Expansion.
Current Case
163
749
1,398
Markets tend to correct (Table 6), which can cause and be
Average
50
161
635
caused by investor unease. Typically, corrections occur in
Multiple
of
Average
3.3
4.7
2.2
response to a market-moving condition. Depending on the
nature of the event, market conditions can be perceived as
Source: Ned Davis Research, PNC
a tell-tale sign of investor unease. Because markets do not
run in straight lines, investors should be mindful of the
likelihood of corrections when planning long-term investment goals.
Investors sometimes look to market corrections as a sign of economic conditions. Our
research has shown this is not the case. Our research shows that stock price declines
do not do a good job of predicting recessions.
Central bank decisions can typically have a significant impact on financial markets.
We have previously discussed how markets react to increases in Fed policy rates
(please see our August 2014 Topical Commentary, Federal Open Market Committee
Rates Watch for details). Though this analysis is based only on U.S. markets, we
believe the inferences can still be used to gain insight into how international markets
might react.
Bonds and stocks react differently to rate increases (Table 7, page 10). Historically,
the bond market has moved first. The stock market tends to react a few weeks after
that. This makes intuitive sense to us. Bond prices are far more sensitive to interestrate changes, which comprise the bulk of the underlying value of the investment. In
contrast, interest rates are only one of many drivers in the stock market.
9
Investment Outlook
Table 7
Market Reaction to Past Fed Tightening
1986
1988
1994
1999
2-Year Treasury
Reaction Started (weeks before first rate hike)
One-Month Change (basis points)
Two-Month Change (basis points)
3
8
10
7
11
31
1
49
119
11
30
70
S&P 500
Reaction Started (weeks before first rate hike)
Peak to Trough (change)
Duration of Decline (weeks)
Trough to End of Tightening (change)
2
-1.9%
5
27.8%
2
-6.7%
9
14.2%
0
-7.5%
21
13.1%
11
-5.4%
27
15.6%
2004
15
47
102
9
-6.7%
15
20.2%
Average
7
28
66
5
-5.6%
15
18.2%
Source: Cornerstone Macro, PNC
As noted throughout this discussion, central bank policy potentially moves exchange
rates. Those countries in which policy rates are increased first (market consensus
right now believes the United Kingdom and the United States will lead) become
relatively more attractive for investing. Capital may flow into these first-mover
economies, boosting their currencies at the expense of others. Typically, developing
economies can expect to see greater shifts in their exchange rates relative to
developed economies.
The dollar specifically has risen not just versus the euro but also against most major
currencies, reflecting the improved economic outlook for the United States, in
addition to being relatively more attractive from an interest-rate perspective.
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