“There are decades where nothing happens; and there are weeks where decades happen.” – Vladimir Lenin
“There cannot be a crisis next week. My schedule is already full.” – Henry Kissinger
“When written in Chinese, the word ‘crisis’ is composed of two characters. One represents danger and the other represents opportunity.” – John F. Kennedy
“The crisis of today is the joke of tomorrow.” – H. G. Wells
On Tuesday President Donald Trump met with North Korean leader Kim Jong-un in Singapore and offered a significant concession: to halt the “tremendously expensive” joint US-South Korean military exercises. The North Korean leader in turn committed to the “complete denuclearisation of the Korean Peninsula”. While we think the meeting is a positive step towards reducing tensions in the Korean Peninsula, we remain sceptical – after all the US just recently did an about turn on the Iran nuclear deal and announced fresh sanctions on the Persian state. We suspect, with the possibility of US military action against North Korea diminished, that China and South Korea are the only parties truly satisfied with the outcome of the Trump-Kim summit.
On Wednesday the Federal Reserve raised the Fed funds target rate by 25 basis points to a range between 1.75 per cent and 2 per cent. At the same time it also increased the interest rate on excess reserves (IOER) – the interest the Fed pays on money placed by commercial banks with the central bank – by 20 basis points to 1.95 per cent. Finally, the Federal Open Market Committee (FOMC) raised its median 2018 policy rate projection from 3 hikes to 4.
The change in the policy rate projection from 3 to 4 hikes is not as significant as the headlines may suggest – the increase is due to one policymaker moving their dot from 3 or below to 4 or above. In fact, the mean 2018 rate increase is only 5 basis points. The median number of 2019 rate hikes remains at 3, while for 2020 one rate hike was removed and the median projection is now at 2 hikes.
On Thursday the European Central Bank (ECB) after holding a two-day Governing Council session in Riga announced its decision to halve the size of monthly asset purchases to €15 billion after September and end its asset purchase program by the end of the year. As a reminder, the ECB had already started implementing a step-by-step exit from its bond buying as follows:
- First, in December 2016, the ECB announced that its monthly purchases would decline from €80 billion to €60 billion as of April 2017 until yearend.
- Second, in October 2017, the ECB announced that the monthly purchases would fall to €30 billion as of April 2018 until at least September of this year.
- Third, in March 2018, removed its easing bias by omitting in its statement a reference to the possibility of bigger bond purchases.
The ECB did not tighten monetary policy, however, and is committing to keeping interest rates at record lows for another year by adding that it expected rates to “remain at their present levels at least through the summer of 2019.”
Lastly ahead of the small matter of the FIFA World Cup kicking off in Russia on Thursday with the host nation playing against Saudi Arabia, Messrs Vladimir Putin of Russia and Mohammed bin Salman of Saudi Arabia had a meeting. The state of the oil market was unsurprisingly a key talking point during the meeting, what with the OPEC meeting in Vienna next week and Trump demanding concessions on OPEC-NOPEC supply constraints.
The events of this week may have brought about much for market participants to digest and could well shape the way markets play out over the remainder of the year. For now and in terms of prospects of global equity markets and the US dollar we, however, think that the events of this week only matter at the margin and that the prevailing trends remain intact.
Investment Perspective
As is the financial media’s wont, Fed and ECB pronouncements are followed by a flurry of commentary and analysis on the ramifications of the central bankers’ statements. In the flood of digital ink commentaries warning of either (1) a stock market crash that is surely to follow due to the major central banks shrinking their balance sheets, or (2) a US dollar shortage that will undoubtedly squeeze emerging markets, have become almost customary.
We address the concerns of tightening monetary policy leading to a stock market crash with some historical context. In 1928, the Fed started raising interest rates, taking them from 3.5 per cent in January to 5 per cent by July. Concurrently, the FOMC proceeded to drain excess reserves from the US banking system.
Instead of the stock market crashing, the Dow Jones Industrial Stock Price Index proceeded to increase by 82 per cent between 1 January 1928 and 1 September 1929. To further contextualise the performance of the stock market, the index had already increased by 160 per cent between 1 January 1918 and 1 January 1 1928, excluding dividends.
Dow Jones Industrial Stock Price Index
Source: Federal Reserve Bank of St. Louis
Reiterating our message from The Bull Market is Not Dead from earlier this year, we consider the equity market sell-off in the first quarter of this year to be a correction and not the end the of the bull market. Adding to that, we think it is not the recent actions of the Federal Reserve or the ECB that will bring this bull market to an end, instead it will be a speculative over extension of the market driven by excessive optimism and greed that will lead to the eventual market crash. For now we maintain our expectation that the US equity markets will record significantly higher new highs before the party is over.
Stay long US equities.
The issue of a US dollar shortage is a little more complex. It is something both the IMF and the Bank for International Settlements (BIS) have repeatedly warned about. The warnings have been prompted by the Fed undertaking quantitative tightening and the Trump Tax Plan, which removes the tax loophole corporations exploited by keeping US dollar abroad. The argument goes that these two US-centric developments will result in US dollars fleeing from international markets and into the US. This analysis is not wrong, data from the Institute of International Finance shows that investors pulled out more than US dollar 12 billion out of emerging debt and equity markets in May this year.
While we acknowledge that short-term risks can arise due to US dollar shortages, we consider the risk of a broad based US dollar funding shortage to be technical not endemic in nature. And technical risks by design can be fixed by a few strokes of the pen. Again, we turn to history for some context. In October 2008, at the height of the global financial crisis, the Fed authorised temporary arrangements extending US dollar 45 billion in liquidity to New Zealand, Brazil, Mexico, South Korea and Singapore. Around the same time, the IMF launched a short-term financing fund to help emerging market economies weather the global credit crisis.
If there truly is a US dollar funding crisis, the Fed will find a technical solution to a technical problem. For now, we agree with the Fed in that there are no major concerns around US dollar funding in international markets. We quote from the minutes of FOMC’s meeting in May this year (emphasis added):
“While term LIBOR (London interbank offered rates) had widened relative to comparable maturity OIS (overnight index swap) rates in recent months, the cost of dollar funding through the foreign exchange swap market had not risen to the same degree. Recent usage of standing U.S. dollar liquidity swap lines had been low, consistent with a view that the recent widening in LIBOR–OIS spreads did not reflect increased funding pressures or rising concerns about the condition of financial institutions.”
Do not short emerging market currencies. Short the US dollar instead.
If you have questions about this post or generally on our views, feel free to email us or message us on Twitter at any time.
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.