Tag: DXY

Humble Pie, US Credit Standards, General Electric and More

 

“I don’t enjoy eating humble pie; it never tastes good. But I do appreciate it when it happens.” – Simon Sinek

“I have more respect for a man who lets me know where he stands, even if he’s wrong, than the one who comes up like an angel and is nothing but a devil.” – Malcolm X

 

Humble Pie

 

Last week we wrote about our bullish view on oil prices. A few days later oil prices dropped by more than 7 per cent in one trading session, leaving us to eat a large portion of humble pie. Capital markets are tough and, on occasion, very cruel.

Following the sharp drop in oil prices this week, we were left scratching our heads and have since tried to understand what transpired. One of the best explanations we have found comes from the Macro Tourist blog. Rather than commenting on the piece, we provide the link here and urge you to read the analysis.

There is also an article from Bloomberg that presents Goldman Sachs’s reasoning for the recent drop in oil prices. We quote from the article:

 

Goldman analysts blamed the rout on a combination of momentum trading strategies, and selling from financial institutions which had helped arrange hedges on behalf of oil producers. Goldman is itself one of Wall Street’s top commodity banks.

“Increased selling of crude oil futures by swap dealers as they manage the risk incurred from existing producer hedging programs” was a key contributor to the rout, analysts including Jeff Currie said in a note.

Producers often lock in their price exposure by buying put options from banks. As prices fall toward the level where the options pay out, the banks are then forced to sell ever greater numbers of futures to hedge their own risk.”

 

Both articles point to technical as opposed to fundamental factors being behind the recent drop in oil prices. At the risk of becoming victims to confirmation bias, we tend to agree and continue to maintain our fundamental view.

As one of our former colleagues and dear friends often reminds us, market participants with an information advantage can only express themselves through the markets, ipso facto technicals, in such circumstances, front run fundamentals. If oil prices continue to drop from current levels we will have to accept that something that we do not know or understand is afoot in the oil market and close our long position in $XLE.

 

 

Fed’s Senior Loan Officer Opinion Survey on Bank Lending Practices

 

The Fed published the most recent edition of its quarterly “Senior Loan Officer Opinion Survey on Bank Lending Practices”. We quote from the Fed’s commentary on the key findings from the survey:

 

“Regarding loans to business borrowers, banks indicated that they eased their standards and terms for commercial and industrial (C&I) loans while experiencing weaker demand for such loans on balance. At the same time, banks reportedly left their standards unchanged on most categories of commercial real estate (CRE) loans, while demand reportedly weakened for most categories of such loans.

For loans to households, banks reported easing their standards on most categories of residential real estate (RRE) loans while experiencing weaker demand for such loans on balance. In contrast, banks reportedly left their standards on auto and credit card loans about unchanged, while demand for such loans also remained unchanged.”

 

The latest survey showed US banks continue to loosen lending standards for commercial and industrial loans as opposed to tightening them. Notably, the survey data suggests that banks are facing declining loan demand. Reasons for declining demand for credit include (i) increases in companies’ internally generated funds, (ii) reduced investment, and (iii) borrowers shifting their borrowing to new lenders.

One of the primary reasons we have remained bullish on the prospects of the US market, particularly since the ‘volmaggedon’ driven sell-off in February, is that we have seen little evidence of a meaningful tightening in either the availability of credit or credit standards in the US. The loan officer survey confirms as much.

Credit standards have been reliable leading indicators for commercial and industrial loan demand over the coming six to twelve months. It might well be that loosening credit standards stimulate demand for credit; or it may be that business prospects are bright enough to warrant a loosening of standards. With increases in companies’ internally generated funds being cited as one of the reasons for the softness in credit demand, it suggests strong business prospects are contributing to a loosening of standards.

 

General Electric Fears

 

Uneasiness around General Electric’s US dollars 114 billion in debt has been growing since October, when Standard & Poor’s downgraded the company’s credit rating to BBB+, just three notches above junk. In Novembers, Moody’s and Fitch Ratings followed suit, pushing the company’s bonds to new all-time lows. Making matters worse, newly appointed chief executive Larry Culp expressed in an interview that General Electric urgently needed to cut its debt and sell assets in order to do so – the company’s share price fell 10 per cent price drop in response.

With the Fed continuing to raise interest rates, we are not surprised to see a company with a weak balance sheet and poor business prospects suffering from the ills of excessive debt. General Electric is unlikely to be the last of such cases that we read about before the Fed is done raising rates.

For now, however, with credit standards remaining loose and corporate yields spreads remaining tight (despite the slight widening in recent weeks), we do not consider the fallout from the likes of General Electric to be systemic. Nonetheless, we would avoid allocating capital to high yield credit at this stage of the business cycle.

 

 

Paul Krugman on the Tax Cuts and Jobs Act and the Balance of Payments

 

In the Fed loan officer opinion survey one of the reasons highlighted for soft credit demand is reduced investment. This is somewhat perplexing when we consider the incentives provided by the Trump Tax Plan, or the Tax Cuts and Jobs Act (TCJA), for US corporations to repatriate capital back onshore and use it for capital investments.

Paul Krugman, the Nobel Prize winning economist, has an excellent piece titled “The Tax Cut and the Balance of Payments (Wonkish)” in the New York Times that provides some explanation and evidence for why the TCJA has not resulted in increased capital investment in the US. While urging you to go and read the piece yourself, we quote from the article to highlight some of the critical points Professor Krugman makes (emphasis added):

 

“What tax-cut advocates argued was that the rate of return in the U.S., net of taxes, is set by global forces. Suppose that there is a global rate of return r*; then the U.S. will have to offer r*/(1-t), where t is the corporate tax rate.

Now imagine cutting t; the figure shows a complete elimination of corporate taxes, but the logic is the same for simply reducing the rate. This should lead to inflows of capital from abroad, increasing the capital stock, which both raises GDP and reduces the rate of return. In the end the after-tax return on capital should be back where it started, with all of the tax cut passed through to wages instead.

The crucial point, however, is that for this to happen you have to have a large increase in the physical stock of capital – it’s not an immaculate financial transaction. This in turn means that those inflows of capital have to enable a massive wave of real investment in plant and equipment.”

 

…

 

“[P]romoting capital inflows was at the heart of the halfway reasonable argument for the tax cut. So far, that argument appears to be not totally stupid, but also, as it happens, quite wrong.”

 

…

 

“On its face, a corporate tax cut looks like a big giveaway to stockholders. Proponents of the TCJA claimed that this was misleading, because large capital inflows would ensure that the cut went to workers instead. But there’s no sign of those big inflows, so what looks like a big giveaway to stockholders is, in fact, a big giveaway to stockholders.

And about 35 percent of that giveaway is to foreigners, so the tax cut makes America as a whole poorer.”

 

What Professor Krugman presents invalidates one of the key strong US dollar / offshore US dollar shortage arguments out there: the repatriation of offshore US dollar holdings into the US by US corporations. As Professor Krugman puts it, repatriation by US corporations might just be an accounting gimmick that does not require cash to move between jurisdictions. If, in fact he is correct in his diagnosis, there are plenty of reasons to be optimistic about the prospects of non-US markets heading into 2019.

 

We have for several weeks been working on better understanding the offshore US dollar market, the monetary transmission mechanisms being utilised by the Fed in a post-QE world and what it means for the prospects of the US dollar and non-US markets. We hope to have our work completed to share with you in the coming few weeks.

 

 

 

 

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

Continued Strength in the US Dollar | China’s Line in the Sand | Germany Between a Rock and a Hard Place

 

“One benefit of summer was that each day we had more light to read by” – Jeanette Walls, American author and journalist

 

“The best of us must sometimes eat our words.” – J. K. Rowling

 

“Increasingly, the Chinese will own a lot more of the world because they will be converting their dollar reserves and U.S. government bonds into real assets.” – George Soros

 

We have a mixed bag here for you this week folks with commentary on:

  • The strength in the US dollar
  • China’s response to Trump’s latest threats to escalate the trade war
  • Germany’s energy needs placing it between a rock and a hard place

 

Continued strength in the US dollar

A number of you have messaged us about the recent strength in the US dollar and our take on it. For the benefit of all readers, we briefly wanted to touch upon where we stand after the latest move higher by the greenback.

Back in March – Currency Markets: “You can’t put the toothpaste back in the tube” – we wrote:

 

The major central banks of the world are now in a competitive game. While markets may enter an interim phase where the Fed’s hawkish posturing leads to a strengthening dollar, this phase, in our opinion, is likely to be short-lived.

 

The line in the sand beyond which we would consider our view to be invalidated is a sustained move above 96 on the US dollar index.

 

At the time we wrote the above, we were unaware of how or why the 96 level was going to prove to be a significant level for the US dollar. However, we felt that psychologically it was a critical level for market participants. The dramatic plunge in the Turkish lira today, the sentiment being displayed across key media outlets and the general tone on Twitter all seem to validate that around 96 on the DXY is indeed an important level.

For now all we would add is that we are in wait and see mode. If the US dollar continues to move higher or remains above the 96 for a prolonged period (6 to 8 weeks), we would have to accept that our bearish view on the US dollar was wrong. If, however, the greenback fails to sustain above 96 we would likely look to put on carry trades in emerging market currencies and go long the euro and Japanese yen.

Until we have more clarity we will remain on the side lines.

 

China’s Line in the Sand

Last week, the People’s Bank of China (PBoC) imposed a reserve requirement of 20 per cent on some trading of foreign-exchange forward contracts, effectively increasing the cost of shorting the Chinese yuan. The move has offset some of the pressure from President Trump’s threats to further escalate the trade war and has brought stability to the currency.

Official statements indicate that the PBoC made the move to reduce both “macro financial risks” and the volatility in foreign exchange markets.  To us the move by the PBoC, however, suggests that China is not yet ready to trigger a sharp devaluation of its currency in the trade war with the US.

What is more confounding, however, is figuring out what China can do to respond to the threats of further escalation of the trade war by the Trump Administration. Initially China tried to appease Mr Trump by:

  • Lavishly hosting him in China;
  • Offering to increase imports from the US to reduce its trade surplus;
  • Proposing to gradually opening its local markets to US corporations; and even
  • Engaging in commercial dealings in favours of Mr Trump’s family;

Failing at that, China has tried to respond by:

However, China’s retaliatory efforts have not swayed Mr Trump either.

The problem, as we described in Trade Wars: Lessons from History, is one of creed:

 

President Trump and his band of trade warriors are hell-bent on stopping the Chinese from moving up the manufacturing value chain.

 

Alexander Hamilton understood that America’s long-term stability hinged upon its transition from an agrarian to industrial society, the Chinese leadership deeply appreciates the need to transition its economy from being the toll manufacturer of global industry to playing a leading role in the high-tech industries of tomorrow.

 

The only way we see the Trump Administration relenting in its push to corner the Chinese is if Trump the “dealmaker” takes control of proceedings. That is, in his desire to make a deal and claim victory, President Trump tells his band of trade warriors and security hawks to take a backseat and instead strikes a deal with China that involves a combination of China buying more from the US and opening up its markets to more foreign ownership (something we suspect China wants to do any way, but on its own terms).

 

Germany: Stuck Between a Rock and a Hard Place

President Trump began his visit to the annual summit of NATO allies in June this year by breaking from diplomatic protocol and verbally attacking Germany:

 

“We’re supposed to protect you from Russia, but Germany is making pipeline deals with Russia. You tell me if that’s appropriate. Explain that.”

 

In May 2011 Germany decided to abandon nuclear power in favour of greener sources of energy such as wind and solar. Nuclear power accounted for almost a fifth of Germany’s national electricity supply at the time Chancellor Angela Merkel announced plans to mothball the country’s 17 nuclear power stations by 2022 following the Fukushima Daiichi nuclear disaster in 2011.

Germany, however, failed in its attempt at adequately fulfilling a greater proportion of its energy needs through alternative sources of renewable energy. And the direct consequence of Chancellor Merkel’s decision to drop nuclear power has been that Germany has become increasingly dependent on Russia’s plentiful natural gas supplies.

Germany has a difficult decision to make. Does it choose to maintain its geopolitical alliance with the US and abstain from Russian gas or does it choose cheap gas and re-align itself geopolitically?

German Foreign Minister Heiko Maas’ interview on 9 August suggests that Germany may well be leaning towards the latter (emphasis added):

 

“Yes, in future we Europeans will have to look out for ourselves more. We’re working on it. The European Union has to finally get itself ready for a common foreign policy. The principle of unanimity in line with which the European Union makes its foreign policy decisions renders us incapable of taking action on many issues. We’re in the process of transforming the European Union into a genuine security and defence union. We remain convinced that we need more and not less Europe at this time.”

 

Russia is under US sanctions. China is under pressure from the US. And now Germany – in no small part due to its massive trade surplus with the US – finds itself in the cross-hairs.

What if Russia, China and Germany were to form an economic, and dare we ask political, alliance? Something that would have seemed far-fetched less than a year ago, does not seem to sound so crazy anymore.

 

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. 

Trade Wars: Lessons from History

 

“There is nothing new in the world except the history you do not know.” – Harry Truman

 

“Give us a protective tariff and we will have the greatest nation on earth” – Abraham Lincoln

 

“If a nation expects to be ignorant and free, in a state of civilisation, it expects what never was and never will be.” – Thomas Jefferson

 

At the Luzhniki Stadium in Moscow last week, France defeated Croatia in the final of 2018 FIFA World Cup. As the French toasted their second FIFA World Cup triumph, pundit upon pundit and football fan after football fan debated the manner of France’s victory and the controversial decisions that went France’s way. Our small group of friends and colleagues also got caught up in a debate on whether the referee rightly or wrongly rewarded the penalty that led to France’s second goal. Our debate was not limited to those of us that watched the match together but rather extended to our WhatsApp groups and roped in friends from all over the world.

It is often said that it is human nature to see what we want to see and ignore that which goes against our expectations.

As our arguments for and against the penalty went round and round in circles, we decided to watch replays of the incident from the match to try and settle which side of the debate had more merit. The funny thing is as we watched the replays the conviction levels on either side of the debate became even stronger. By some means what each of us saw, or at least thought we saw, reaffirmed our predisposition.

Of course, whether it was a penalty or not (it wasn’t) does not really matter. The record books will show that the French defeated the Croats by four goals to two. There will be no asterisk next to the record to note that arm chair fan Joe Schmoe disputed the validity of France’s victory due to the award of a dubious penalty.

Reflecting upon the harmless nature of our argument, we think of the oft quoted words of Winston Churchill:

“Those who fail to learn from history are doomed to repeat it.”

Powerful statements can often hide as much as they reveal.

Can we learn what actually happened from studying history? Unlike the final score of a football match, the record of any past event that cannot be definitively quantified is likely to be clouded by the prejudices of historians and distorted by our individual partisanship.  And if we do not truly know what happened, can we really be doomed to repeat it?

Reality or not, below we examine the recorded history of American protectionism, reflect upon the successful adoption of the ‘American System’ by China and consider the possible outcomes of the rising trade-related tensions between the US and China.

 

American Independence and British Retaliation

On 18 April 1775, a clash between the British redcoats and the local militia at Lexington, Massachusetts, led to the fighting that began the American War of Independence.

Fifteen months after fighting began the American colonists claimed independence from the British and Thomas Jefferson drafted the Declaration of Independence.

The British did not take the colonists’ declaration lying down and made attempts to forcibly regain control over America. Economic warfare was one of the tools used by the British to inflict pain upon the Americans.

Britain closed off its markets to American trade by raising tariffs on American manufactured goods. US exports to England and its colonies fell from an estimated 75 per cent of total exports prior to the Declaration of Independence to around 10 per cent after it. The sharp fall in trade brought on an economic depression in the US.

Britain did not stop at just tariffs. It wanted to halt the US’s transformation from its agrarian roots to an industrialised nation and in this pursuit it went as far as outlawing skilled craftsmen from overseas travel and banning the export of patented machinery.

 

The American System

The American System, also known as the American School of Economics, is an economic plan based on the ideas of Alexander Hamilton, the first Secretary of the Treasury of the United States, which guided the US national economic policy from first half of the 19th century till the early 1970s. The system is widely credited as having underpinned the US’s transformation from an agrarian frontier society to global economic powerhouse.

The American System is rooted in the mercantilist principles presented by Alexander Hamilton to Congress in December 1791 in the Report on the Subject of Manufactures. The three basic guiding economic principles of the system demanded the US Government to:

  1. Promote and protect American industries by selectively imposing high import tariffs and / or subsidising American manufacturers;
  2. Create a national bank to oversee monetary policy, stabilise the currency and regulate the issuance of credit by state and local banks; and
  3. Make internal improvements by investing in public infrastructure – including but not limited to roads, canals, public schools, scientific research, and sea ports – to facilitate domestic commerce and economic development.

These guiding principles are based on Alexander Hamilton’s insight that long-term American prosperity could not be achieved with an economy dependent purely on the financial and resource extraction sectors. And that economic self-sufficiency hinged upon the US Government intervening to protect and to support the development of captive manufacturing capabilities.

Alexander Hamilton’s ideas were not immediately accepted by Congress – Congress was dominated by Southern planters, many of whom favoured free trade. One Thomas Jefferson, in particular, vehemently opposed Hamilton’s protectionist proposals.

Congress and Jefferson became much more receptive to Hamilton’s ideas in the aftermath of the Anglo-American War of 1812, during which the British burnt down the White House. The government’s need for revenue and a surge in anti-British fervour, in no small part, made favouring Hamilton’s proposals politically expedient for Congress.

In 1816 Congress passed an import tariff, known as the Dallas Tariff, with the explicit objective of protecting American manufacturers and making European imported goods more expensive. The legislation placed import duties of 25 per cent on cotton and wool textiles and manufactured iron; 30 per cent on paper and leather goods and hats; and 15 per cent on most other imported products. Two years later, and in response to predatory dumping of goods by the British, Congress further increased import duties.

American industry blossomed after the imposition of tariffs and vested interests lobbied to keep or even increase import duties. With the public strongly in support, Congress continued raising tariffs and American import duties rose to around 40 per cent on average by 1820.

Also in 1816, Congress created the “The President, Directors, and Company, of the Bank of the United States”, commonly referred to as the Second Bank of the United States, and President James Madison gave it a 20-year charter to handle all fiscal transactions for the US Government, regulate the public credit issued by private banking institutions, and to establish a sound and stable national currency.

The third and final tenet of the American System, federally funded internal improvements, was never fully adopted. Nonetheless, the US Government did end up using a part of the revenues generated from the import duties and the sale of public lands in the west to subsidise the construction of roads, canals and other public infrastructure.

Abraham Lincoln, Theodore Roosevelt, and many of the other great leaders from American history supported the American System. That is, they were all protectionists. Republican protectionist instincts used to be so ingrained that even if there was the slightest liberalisation of trade made by the Democrats, it would be reversed as soon as the Republican regained power. For instance the Revenue Act of 1913, passed during the early days of President Woodrow Wilson’s administration, which lowered basic tariff rates from 40 to 25 per cent, was almost entirely reversed after Republicans regained power following World War I.

It is only as recently as 1952, upon the election of Dwight D. Eisenhower, do we find a notable Republican leader that favoured free trade over protectionism.

Coincidentally, or not, President Eisenhower’s willingness to betray the Republican protectionist heritage in favour of free trade policies just so happened to be around the same time funding of the Marshall Plan ended. By 1952, the economy of every participant state in the Marshall Plan had surpassed pre-war levels; economic output in 1951 of each and every participant exceeded their respective output in 1938 by at least 35 per cent.

Happenstance or not, the economic recovery of Western Europe and its growing alliance with the US, created powerful inducements to free trade and overall wealth creation.

 

China’s Adoption of The American System

In 1978, China initiated the transformation of its economy towards a more liberal and market-based regime. The reforms, as it would become glaringly apparent over the following decades, were predicated on promoting exports over imports by adopting a combination of mercantilist and protectionist policies. The government supported exporters by waiving duties on materials imported for export purposes, creating dedicated export-processing zones, and granting favourably priced loans for capital investment. At the same time, the government supported the creation of national champions and industry leaders by limiting (or altogether prohibiting) foreign participation in strategic industries. These steps were in adherence with the first tenet of the American System.

The Chinese government also tightly managed monetary policy and kept its currency artificially undervalued through the combination of capital controls and intervention, driving capital exports and the build-up of trade surpluses – the second tenet.

A significant portion of government directed investment in China, especially since the early 1990s, has been in increasing the amount and improving the quality of public infrastructure. Investment was directed into all forms of public infrastructure including but not limited to developing power and telecommunications networks, public buildings, dams, rural road networks, manufacturing facilities, and academic institutions – the third tenet.

Much as the US economy flourished under the mercantilist tenets of the American System, China too has flourished over the last four decades by adopting the very same system.

Just as the Republicans in America were willing to make a turn toward free trade as the global economic environment became conducive to a US led global order, the Chinese leadership is beginning to espouse the virtues of free trade as its version of the Marshall Plan, the Belt and Road Initiative, gathers steam.

The Chinese leadership has guided its economy to such great heights based on, we suspect, their acute understanding of American economic history. It is China’s demonstrated adherence to the American System, which leads us to believe that just as Alexander Hamilton understood that America’s long-term stability hinged upon its transition from an agrarian to industrial society, the Chinese leadership deeply appreciates the need to transition its economy from being the toll manufacturer of global industry to playing a leading role in the high-tech industries of tomorrow.

 

Investment Perspective

 

Chinese Premier Li Keqiang and his cabinet unveiled the “Made in China 2025” strategic plan in May 2015. The plan lays out a roadmap for China take leadership role in 12 strategic high-tech industries and to move up the manufacturing value chain. The Council on Foreign Relations believes Made in China 2025 is a “real existential threat to US technological leadership”.

Just as the British insisted upon the US remaining an agrarian society in the 18th century, President Trump and his band of trade warriors are hell-bent on stopping the Chinese from moving up the manufacturing value chain. Short of going to war, the Trump Administration is even following the same playbook by imposing tariffs, blocking technology transfer and withholding intellectual property.

President Trump, however, appears ready to go further and even upend the global trade system and call into question the US dollar’s global reserve currency status. Mr Trump’s stated objective is to revive the US’s industrial base. This objective, however, is unachievable in a global trade system in which the US dollar is the world’s reserve currency. The privilege of having the world’s reserve currency comes with the responsibility of consistently running current account deficits and providing liquidity to the rest of the world.

 

Imposition of Tariffs

Unlike any other currency, the global reserve currency cannot be easily devalued. As we discussed in Don’t wait for the US Dollar Rally, its Already Happened, as the US dollar weakens international demand for the greenback increases. For this reason, it is probably easier for the US to pursue alternative means that have the same effect as a devaluation of its currency.

The imposition of tariffs, from foreign manufacturers’ perspective, is the equivalent of a devaluation of the US dollar. For US based buyers and consumers, tariffs lower the relative prices of US manufactured goods with respect to foreign manufactured goods. Tariffs, however, are only effective if their imposition does not result in an equivalent relative increase in the price of the US dollar. It is perhaps no coincidence then that the Chinese yuan started to tumble as soon as the US moved to impose tariffs on Chinese goods. And in response Mr Trump is turning on the Fed and its tightening of monetary policy.

 

The Nuclear Option

Mr Trump always has the nuclear option in his bid to revive industry in the US. He can attempt to overturn the global trade system and the status of US dollar as the world’s reserve currency by limiting the amount of US dollar available to the rest of the world – pseudo-capital controls. If this were to happen, any and every foreign entity or nation that is short US dollars (has borrowed in US dollars) will suffer from an almighty short squeeze. In response, China specifically would have to take one of two paths:

  1. Open up its economy to foreign investment and sell assets to US corporations to raise US dollars.
  2. Loosen capital controls to allow the settlement of trade in yuan.

 

A G2 Compromise

The final, and in our minds the most painless, alternative to the above scenarios is that of a G2 compromise i.e. China and the US come to an agreement of sorts that results in China making significant concessions in return for the US maintaining the current global trade system.

What such a compromise will look like we do not know but it most definitely involves a weakening of the US dollar.

 

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

 

 

Don’t wait for the US Dollar Rally, its Already Happened

 

“Don’t cry because it’s over. Smile because it happened.” – Dr Seuss

 

“Republicans are for both the man and the dollar, but in case of conflict the man before the dollar.” – Abraham Lincoln

 

“Dark economic clouds are dissipating into an emerging blue sky of opportunity.” – Rick Perry

 

According to the minutes of the Fed’s June meeting, released on Thursday, some companies indicated they had already “scaled back or postponed” plans for capital spending due to “uncertainty over trade policy”. The minutes added: “Contacts in the steel and aluminum industries expected higher prices as a result of the tariffs on these products but had not planned any new investments to increase capacity. Conditions in the agricultural sector reportedly improved somewhat, but contacts were concerned about the effect of potentially higher tariffs on their exports.”

Despite the concerns around tariffs, the minutes also revealed that the Fed remained committed to its policy of gradual rate hikes and raising the fed funds rate to its long-run estimate (or even higher): “Participants generally judged that…it would likely to be appropriate to continue gradually raising the target rate for the federal-funds rate to a setting that was at or somewhat above their estimates of its longer-run level by 2019 or 2020”.

The somewhat hawkish monetary policy stance of the Fed combined with (i) expectations of continued portfolio flows into the US due to the interest rate differentials between the US and non-US developed markets, (ii) fears of the Trump Administration’s trade policies causing an emerging markets crisis, and (iii) the somewhat esoteric risk of ‘dollar shortage’ have led many to conclude that the US dollar is headed higher, much higher.

Of all the arguments for the US dollar bull case we consider the portfolio flows into the US to be the most pertinent to the direction of the greenback.

According to analysis conducted by the Council of Foreign Relations (CFR) “all net foreign demand for ‘safe’ US assets from 1990 to 2014 came from the world’s central banks”. And that “For most of the past 25 years, net foreign demand for long-term U.S. debt securities has increased in line with the growth in global dollar reserves.”  What the CFR has described are quite simply the symptoms of the petrodollar system that has been in existence since 1974.

Cumulative US Current Account Deficit vs. Global Foreign Exchange Holdings1aSources: Council on Foreign Relations, International Monetary Fund, Bureau of Economic Analysis

 

In recent years, however, global US dollar reserves have declined – driven by the drop in the price of oil in late 2014 which forced the likes of Norges Bank, the Saudi Arabian Monetary Agency, and the Abu Dhabi Investment Authority to draw down on reserves to make up for the shortfall in state oil revenues – yet the portfolio flows into the US continued unabated.

Using US Treasury data on major foreign holders of Treasury securities as a proxy for foreign central banks’ US Treasury holdings and comparing it to the cumulative US Treasury securities issuance (net), it is evident that in recent years foreign central banks have been either unable or unwilling to finance the US external deficit.

Cumulative US Marketable Treasury Issuance (Net) vs. US Treasury Major Foreign Holdings1Sources: US Treasury, Securities Industry and Financial Markets Association

 

Instead, the US has been able to fund its external deficit through the sale of assets (such as Treasuries, corporate bonds and agency debt) to large, yield-starved institutional investors (mainly pension funds and life insurers) in Europe, Japan and other parts of Asia. The growing participation of foreign institutional investors can be seen through the growing gap between total foreign Treasury holdings versus the holdings of foreign central banks.

US Treasury Total Foreign Holdings vs. US Treasury Major Foreign Holdings2Source: US Treasury

 

Before going ahead and outlining our bearish US dollar thesis, we want to take a step back to understand how and why the US was able to finance its external deficit, particularly between 2015 and 2017, despite the absence of inflows from its traditional sources of funding and without a significant increase in its cost of financing. This understanding is the key to the framework that shapes our expectations for the US dollar going forward.

We start with Japan. In April 2013, the Bank of Japan (BoJ) unveiled a radical monetary stimulus package to inject approximately US dollars 1.4 trillion into the Japanese economy in less than two years. The aim of the massive burst of stimulus was to almost double the monetary base and to lift inflation expectations.

In October 2014, Governor Haruhiko Kuroda shocked financial markets once again by announcing that the BoJ would be increasing its monthly purchases of Japanese government bonds from yen 50 trillion to yen 80 trillion. And just for good measure the BoJ also decided to triple its monthly purchases of exchange traded funds (ETFs) and real estate investment trusts (REITs).

Staying true to form and unwilling to admit defeat in the fight for inflation the BoJ also went as far as introducing negative interest rates. Effective February 2016, the BoJ started charging 0.1 per cent on excess reserves.

Next, we turn to Europe. In June 2014, Señor Mario Draghi announced that the European Central Bank (ECB) had taken the decision to cut the interest rate on the deposit facility to -0.1 per cent. By March 2016, the ECB had cut its deposit facility rate three more times to take it to -0.4 per cent. In March 2015, the ECB also began purchasing euro 60 billion of bonds under quantitative easing. The bond purchases were increased to euro 80 billion in March 2016.

In response to the unconventional measures taken by the BoJ and the ECB, long-term interest rates in Japan and Europe proceeded to fall to historically low levels, which prompted Japanese and European purchases of foreign bonds to accelerate. It is estimated that from 2014 through 2017 Japanese and Eurozone institutional investors and financial institutions purchased approximately US dollar 2 trillion in foreign bonds (net). During the same period, selling of European fixed income by foreigners also picked up.

As the US dollar index ($DXY) is heavily skewed by movements in EURUSD and USDJPY, the outflows from Japan and Europe into the US were, in our opinion, the primary drivers of the US dollar rally that started in mid-2014.

US Dollar Index3Source: Bloomberg

 

In 2014 with Japanese and European outflows accelerating and oil prices still high, the US benefited from petrodollar, European and Japanese inflows simultaneously. These flows combined pushed US Treasury yields lower and the US dollar sharply higher. The strong flows into the US represented an untenable situation and something had to give – the global economy under the prevailing petrodollar system is simply not structured to withstand a strong US dollar and high oil prices concurrently. In this instance, with the ECB and BoJ staunchly committed to their unorthodox monetary policies, oil prices crashed and the petrodollar flows into the US quickly started to reverse.

Notably, the US dollar rally stalled and Treasury yields formed a local minimum soon after the drop in oil prices.

US 10-Year Treasury Yield4Source: Bloomberg

 

Next, we turn to China. On 11 August 2015, China, under pressure from the Chinese stock market turmoil that started in June 2015, declines in the euro and the Japanese yen exchange rates and a slowing economy, carried out the biggest devaluation of its currency in over two decades by fixing the yuan 1.9 per cent lower.  The Chinese move caught capital markets by surprise, sending commodity prices and global equity markets sharply lower and US government bonds higher.

In January 2016, China shocked capital markets once again by setting the official midpoint rate on the yuan 0.5 per cent weaker than the day before, which took the currency to its lowest since March 2011. The move in all likelihood was prompted by the US dollar 108 billion drop in Chinese reserves in December 2015 – the highest monthly drop on record.

In addition to China’s botched attempts of devaluing the yuan, Xi Jinping’s anti-corruption campaign also contributed to private capital fleeing from China and into the US and other so called safe havens.

China Estimated Capital Outflows5Source: Bloomberg

 

The late Walter Wriston, former CEO and Chairman of Citicorp, once said: “Capital goes where it is welcome and stays where it is well treated.” With the trifecta of negative interests in Europe and Japan, China’s botched devaluation effort and the uncertainty created by Brexit, capital became unwelcome in the very largest economies outside the US and fled to the relative safety of the US. And it is this unique combination, we think, that enabled the US to continue funding its external deficit from 2014 through 2017 without a meaningful rise in Treasury yields.

Moreover, in the absence of positive petrodollar flows, we suspect that were it not for the flight to safety driven by fears over China and Brexit, long-term Treasury yields could well have bottomed in early 2015.

 

Investment Perspective

 

  1. Foreign central banks show a higher propensity to buy US assets in a weakening US dollar environment

 

Using US Treasury data on major foreign holders of Treasury securities as a proxy for foreign central banks’ US Treasury holdings, we find that foreign central banks, outside of periods of high levels of economic uncertainty, have shown a higher propensity to buy US Treasury securities during phases of US dollar weakness as compared to during phases of US dollar strength.

Year-over-Year Change in Major Foreign Holdings of Treasury Securities and the US Trade Weighted Broad Dollar Index 6Sources: US Treasury, Bloomberg

 

The bias of foreign central banks, to prefer buying Treasury securities when the US dollar is weakening, is not a difficult one to accept. Nations, especially those with export oriented economies, do not want to see their currencies rise sharply against the US dollar as an appreciating currency reduces their relative competitiveness. Therefore, to limit any appreciation resulting from a declining US dollar, foreign central banks are likely to sell local currency assets to buy US dollar assets. However, in a rising US dollar environment, most foreign central banks also do not want a sharp depreciation of their currency as this could destabilise their local economies and prompt capital outflows. And as such, in a rising US dollar environment, foreign central banks are likely to prefer selling US dollar assets to purchase local currency assets.

 

  1. European and Japanese US treasury Holdings have started to decline

 

European and Japanese US Treasury Holding 7Source: US Treasury

 

The ECB has already scaled back monthly bond purchases to euro 30 billion and has outlined plans to end its massive stimulus program by the end of this year. While BoJ Governor Haruhiko Kuroda in a testimony to the Japanese parliament in April revealed that internal discussions were on going at the BoJ on how to begin to withdraw from its bond buying program.

In anticipation of these developments and the increased possibility of incurring losses on principal due to rising US inflation expectations, it is likely that European and Japanese institutional investors and financial institutions have scaled back purchases of US dollar assets and even started reducing their allocations to US fixed income.

 

  1. Positive correlation between US dollar and oil prices

 

One of the surprises thrown up by the markets this year is the increasingly positive correlation between the US dollar and the price of oil. While the correlation may prove to be fleeting, we think there have been two fundamental shifts in the oil and US dollar dynamic that should see higher oil prices supporting the US dollar, as opposed to the historical relationship of a strengthening US dollar pressuring oil prices.

The first shift is that with WTI prices north of US dollar 65 per barrel, the fiscal health of many of the oil exporting nations improves and some even begin to generate surpluses that they can recycle into US Treasury securities. And as oil prices move higher, a disproportionality higher amount of the proceeds from the sale of oil are likely to be recycled back into US assets. This dynamic appears to have played out to a degree during the first four months of the year with the US Treasury securities holdings of the likes of Saudi Arabia increasing. (It is not easy to track this accurately as a number of the oil exporting nations also use custodial accounts in other jurisdictions to make buy and sell their US Treasury holdings.)

WTI Crude vs. US Dollar Index8Source: Bloomberg

 

The second shift is that the US economy no longer has the same relationship it historically had with oil prices. The rise of shale oil means that higher oil prices now allow a number of US regions to grow quickly and drive US economic growth and job creation. Moreover, the US, on a net basis, spends much less on oil (as a percentage of GDP) than it has done historically. So while the consumers may take a hit from rising oil prices, barring a sharp move higher, the overall US economy is better positioned to handle (and possibly benefit from) gradually rising oil prices.

 

  1. As Trump has upped the trade war rhetoric, current account surpluses are being directed away from reserve accumulation

 

Nations, such as Taiwan and the People’s Republic of Korea, that run significant current account surpluses with the US have started to re-direct surpluses away from reserve accumulation (i.e. buying US assets) in fear of being designated as currency manipulators by the US Treasury. The surpluses are instead being funnelled into pension plans and other entitlement programs.

 

  1. To fund its twin deficits, the US will need a weaker dollar and higher oil prices

 

In recent years, the US current account deficit has ranged from between 2 and 3 per cent of GDP.

US Current Account Balance (% of GDP)9Source: Bloomberg

 

With the successful passing of the Trump tax plan by Congress in December, the US Treasury’s net revenues are estimated to decrease by US dollar 1.5 trillion over the next decade. While the increase in government expenditure agreed in the Bipartisan Budget Act in early February is expected to add a further US dollar 300 billion to the deficit over the next two years. The combined effects of these two packages, based on JP Morgan’s estimates, will result in an increase in the budget deficit from 3.4 per cent in 2017 to 5.4 per cent in 2019. This implies that the US Treasury will have to significantly boost security issuance.

Some of the increased security issuance will be mopped by US based institutional investors – especially if long-term yields continue to rise. US pension plans, in particular, have room to increase their bond allocations.

US Pension Fund Asset Allocation Evolution (2007 to 2017) 10Source: Willis Tower Watson

 

Despite the potential demand from US based institutional investors, the US will still require foreign participation in Treasury security auctions and markets to be able to funds its deficits. At a time when European and Japanese flows into US Treasuries are retreating, emerging market nations scrambling to support their currencies by selling US dollar assets is not a scenario conducive to the US attracting foreign capital to its markets. Especially if President Trump and his band of trade warriors keep upping the ante in a bid to level the playing field in global trade.

Our view is that, pre-mid-term election posturing aside, the Trump Administration wants a weaker dollar and higher oil prices so that the petrodollars keep flowing into US dollar assets to be able to follow through on the spending and tax cuts that form part of their ambitious stimulus packages. And we suspect that Mr Trump and his band of the not so merry men will look to talk down the US dollar post the mid-term elections.

 

 

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

Currency Markets: “You can’t put the toothpaste back in the tube.”

“When you strip away the genre differences and the technological complexities, all games share four defining traits: a goal, rules, a feedback system, and voluntary participation.” Reality is Broken: Why Games Make Us Better and How They Can Change the World by Jane McGonigal

 

“The dollar used to be a gold standard currency. And the dollar is really good in the last century, I mean in the 19th century.” – John Forbes Nash Jr.

 

“The thought experiment of Adam Smith correctly takes into account the fact that people rationally pursue their economic interests. Of course they do. But this thought experiment fails to take into account the extent to which people are also guided by noneconomic motivations. And it fails to take into account the extent to which they are irrational or misguided. It ignores the animal spirits.” – Animal Spirits by George A. Akerlof

 

 

When US Treasury Secretary Steven Mnuchin uttered the words “A weaker dollar is good for trade,” at Davos in January, he broke rank and became the first US Treasury Secretary in almost three decades to talk down the US dollar.  And in one fell swoop he ended the cooperative monetary policy game major central banks had been engaged in since the renminbi devaluation scare in January 2016 and transformed it to a competitive game.

Mr Mnuchin’s comments sent President of the European Central Bank (ECB) Mario Draghi and Governor of the Bank of Japan (BOJ) Haruhiko Kuroda into a state of frenzy. Both were quick to react and proceeded to talk down their respective currencies – Mr Draghi hinted at the ECB delaying its exit from monetary easing while Mr Kuroda‘s language became decidedly dovish.

Capital markets, to state the obvious, do not like volatility. Markets like boring. The cooperative monetary policies of the last two years have been exactly that, boring. As central banks sucked volatility out of currency markets, capital markets of all forms became buoyant.  Tech stocks climbed higher. Emerging markets came out of their prolonged slump. Cryptocurrencies soared. Even the much maligned commodity markets rallied. Coincidentally, most markets peaked soon after the détente between global central bank was broken by Mr Mnuchin.

Should we be surprised that a member of the US administration led by President Donald Trump has done away with the niceties of a globally coordinated détente and unleashed competition amongst global central banks? Mr Trump is nothing if not competitive and he is doing his part in stoking global competitive spirits as he did in announcing his plans to impose tariffs on steel and aluminium imports.

One man voluntarily abstaining from the competitive game it seems is newly-appointed Federal Reserve Chairman Jay Powell. Chairman Powell, by striking a hawkish tone during his inaugural testimony on 27 February, extended an olive branch to his fellow central bankers and they gladly obliged. Mr Kuroda this morning suggested that the BOJ could exit from its easy monetary policy as early as next year. The central banks, it seems, want to return to the comfortable climes of a cooperative game world.

The market appears to be giving Messrs Powell and Kuroda due credit with the dollar moving sharply higher after Mr Powell’s hawkish comments and the yen strengthening following Mr Kuroda’s remarks. While the central banks will do their utmost to re-establish a cooperative regime, the reality is “you can’t put the toothpaste back in the tube”. The major central banks of the world are now in a competitive game. While markets may enter an interim phase where the Fed’s hawkish posturing leads to a strengthening dollar, this phase, in our opinion, is likely to be short-lived.

The line in the sand beyond which we would consider our view to be invalidated is a sustained move above 96 on the US dollar index.

 

Investment Perspective

 

One major central bank that has conspicuously remained on the side lines during the recent sharp moves in currency markets is the People’s Bank of China (PBOC). The PBOC rarely, if ever, publicly expresses its desired direction for the renminbi. Its statements are generally limited to reaffirming its commitment to promoting a stable exchange rate regime. The PBOC, however, has been known to actively intervene in markets to influence the direction of its currency – such intervention too has been absent recently.

The PBOC, we think, finds itself at a difficult crossroads with respect to the renminbi. Much like the one the BOJ was at with respect to the yen in the late 1980s. The BOJ, in hindsight, favoured short-termism and opted to keep monetary policy far too easy, which sent Japanese asset prices rocketing higher. The Japanese boom, as well known, was followed by an all-mighty bust. The Chinese Communist Party (CPC), it is said, thinks in decades not years – so one would think that the Chinese will not follow in the footsteps of Japan. Short-termism, however, can afflict anyone and there is, we think, a non-zero probability that China goes down the path of too much easing, which would send Chinese asset prices sharply higher. For this reason we would maintain some allocation to Chinese equity markets.

The more probable scenario, we think, however, is that of the PBOC opting to strike a balance between tightening and opportunistic easing and the PBOC may even let the renminbi strengthen some more – especially if said strengthening is driven by US dollar weakness as opposed to PBOC’s interventions.

As we argued in our piece on China in January, China wants to increase its influence in Asia and that stability is a necessary condition in order to achieve further influence. Therefore, given China’s global ambitions, we think it is unlikely that the PBOC repeats the mistakes the BOJ made in the late 1980s. And if this indeed turns out to be the case, given the current differential in US and Chinese interest rates and bond yields, the Yuan carry trade may be amongst the best trades to put on today.

 

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. 

Beyond the Minsky Moment: The Wisdom of Crowds or the Madness of Mobs?

 

“I must say a word about fear. It is life’s only true opponent. Only fear can defeat life. It is a clever, treacherous adversary, how well I know. It has no decency, respects no law or convention, shows no mercy. It goes for your weakest spot, which it finds with unnerving ease. It begins in your mind, always … so you must fight hard to express it. You must fight hard to shine the light of words upon it. Because if you don’t, if your fear becomes a wordless darkness that you avoid, perhaps even manage to forget, you open yourself to further attacks of fear because you never truly fought the opponent who defeated you.”

– Excerpt from Life of Pi by Yann Martel

 

Doctor: You do not fear death. You think this makes you strong. It makes you weak.

Bruce: Why?

Doctor: How can you move faster than possible, fight longer than possible, without the most powerful impulse of the spirit? The fear of death.

Bruce: I do fear death. I fear dying in here while my city burns. And there’s no one there to save it.

Doctor: Then make the climb.

Bruce: How?

Doctor: As the child did – without the rope. Then fear will find you again.

― The Dark Knight Rises (2012)

 

The Minsky Moment – a term coined by Paul McCulley of PIMCO that refers to the central concept underlying American economist Hyman Minsky’s  theory on the inherent instability of financial markets – has been ubiquitously quoted by just about every major research publication and financial periodical in the aftermath of the Global Financial Crisis.  Based on yesterday’s market action, we may have just witnessed another Minsky Moment. And it was not pleasant. Many of you will have experienced fear – we certainly did – and felt your neurologically programmed fight or flight reflex kick-in. While fight or flight responses have their benefits, such responses tend not to be helpful at times of stock market crashes. We overrode our urges to react, turned off our screens, silenced our Twitter feed and spent the rest of the day reading – everything and anything except the financial news.

As we immersed ourselves, once again, into the frantic and frenzied world of financial markets this morning some of the reactions from the media, sell-side, FinTwit and the like have been predictable, the usual suspects – risk parity funds, the Fed, Goldman Sachs, the US government and algorithmic traders – have all been blamed in one form or another. The question, for market participants, however, is not whose fault it is but what, if anything, should we be doing with our portfolios at this juncture.

In the process of portfolio construction we, as analysts, make, in effect, choices amongst several different competing hypotheses. Analysis of competing hypotheses involves:

 

  • identifying the evidence and assumptions with diagnostic value in assessing the likelihood of each hypothesis; and

 

  • outlining future milestones that may indicate whether events are following the expected path or not.

 

In our opinion, one’s view on the medium-term direction of the US dollar is central to the type of portfolio that one constructs today. So the hypothesis and its alternative in this case are:

  • Hypothesis: We are in a structural lower US dollar environment

 

  • Alternative hypothesis: The US dollar has bottomed and is headed higher

 

Over the last few months we have written about or initiated trade ideas related to a number of themes, most notably Europe’s domestic recovery, the potential for a strong rally in agriculture commodities, rising inflation in the US and higher oil prices. Central to all of these investment themes is the view that we are in a structurally lower US dollar environment. This view is predicated on a number of factors, including but not limited to:

 

  1. The US faces a public pension funding gap estimated to be USD 3.85 trillion. This funding gap may never be filled but it certainly will not be filled if we have a strong US dollar and declining equity markets. History has shown time and again that elected officials and unelected rulers, alike, have long understood the benefits of tampering with the value of their currency. Given the choices available we expect President Trump to be an advocate of a weak dollar policy. A weaker dollar improves the profitability of US large caps, which in turn should be supportive of equity markets.

 

  1. The weakening of the US dollar over the course of 2017 suggests that both US growth and higher short-term interest rates had been priced in; the market, however, did not fully appreciate the economic recovery underway in the rest of the world. The surprise was amplified by the prospects of earlier than anticipated tightening of monetary policy by the ECB.

 

  1. The US budget deficit is forecast to exceed USD 1 trillion in 2019 and the Congressional Budget Office expects US budget deficits to continue to grow.

 

The US dollar is very much in a bear market at the moment. As with any bear market we should expect bear market rallies, which can be sharp and painful – especially when positioning is stretched in one direction. For our weak dollar hypothesis to be nullified we would need to see at least one of the following:

 

  • continued strength in the US dollar from now till the end of summer i.e. a period of at least six months;

 

  • a reversal in US fiscal policy; or

 

  • a sharp acceleration in monetary policy tightening by the Fed.

 

At this stage and given the sharp decline in the US dollar, cyclical rallies are par for the course. The recently enacted tax reform is likely to increase the flow of capital into the US and at the same time boost capital spending and the profitability of US companies. Moreover, if the Republicans are able to consolidate power in the mid-term elections, this too should temporarily strengthen the US dollar – somewhat counter intuitively we think a consolidation of power would strengthen the case of a weaker US dollar as President Trump would have more leeway in increasing fiscal deficits.

 

Investment Perspective

 

The question then is what type of portfolio should one have under a structurally weak US dollar environment. In broad strokes, our thinking is as follows:

 

  1. US bonds have more value than other developed market bonds. Any bond allocation should be tilted towards the US with a bias towards shorter duration instruments.

 

  1. International equities have more value than US equities. Use periods of intermittent US dollar strength to build positions in mid-cap equities in Europe and add to our exposure to Japan.

 

  1. Within US equity markets, give preference to large caps over small- and mid-caps. A weaker dollar has an outsized impact on the profitability of large caps relative to domestically focused small and mid-cap businesses.

 

  1. Commodity and commodity producers should benefit from a weaker dollar and, as previously discussed, higher capital spending arising both from the US and from China’s Belt and Road Initiative.

 

  1. Oil, after speculative positioning re-adjusts to less frothy levels, should benefit from a lower US dollar and robust global demand.

 

  1. Emerging markets to outperform developed markets.

 

In the final analysis, we consider the recent surge in market volatility as a signal for the shift in momentum as opposed to the start of a bear market. The analogue of the fifteen year US dollar cycle best captures our thinking:

Dollar Index Analogue – 15 Year Cycle (Normalised)DXY normalisedSource: Bloomberg

Similarly, consider the fifteen year cycle analogue of the ratio of the MSCI Emerging Market Index to the S&P 500 Index.

 MSCI EM Index to S&P 500 Analogue – 15 Year Cycle (Normalised)MXEF SPXSource: Bloomberg

 

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.