Before we dive into this week’s missive, this will be our last commentary before Christmas. We may try and write a short commentary between Christmas and New Year if market movements warrant one. We wish all our readers a wonderful Christmas and a very happy New Year. The commentary below covers a somewhat US Dollar centric view, but one that we think is important in understanding how the world works, perhaps more so than ever. Perhaps a little bit arcane for some at this time of year, but extremely important nonetheless.
A couple of weeks ago in “Oil and dollar dominate thoughts as we wait for Italy to decide” (See the report on 3rd December) we discussed the concept of how important it is for the US to “export” Dollars to the rest of the world. With a huge amount of global trade still conducted in US Dollars, in order to continuing growing their economies, the rest of the world needs an ever increasing stash of Dollars. In that report, we showed the chart below (courtesy of our friends at MI2 Partners) to illustrate how the US current account deficit was effectively the source of Dollars prior to the crisis. The chart also illustrates how the Fed’s balance sheet expansion helped bridge the gap when the US current account deficit failed to increase during the post crisis recovery.
Chart 1 – US Current Account and Global GDP
We have been thinking about this broad subject a lot since then, and the recent output from central bank meetings gives an opportunity to update some of our thinking. A week or so ago, the ECB tinkered with its stimulus programme. As we all know, they extended their QE programme from March 2017 to December 2017, but at a rate of EUR60 billion per month (down from EUR80 billion). Draghi was relatively dovish and hinted strongly that QE would continue into 2018, albeit at a rate to be determined at or nearer the end of next year. Overall, it is a tapering of monthly purchases, however, the pedal is still firmly pressed to the floor.
Onto the US Federal Reserve, where a second rate rise in 12 months was widely expected last week, and they did not disappoint. Frankly, we were somewhat concerned about being aggressively bullish on the US Dollar into the Fed meeting, as the last two years’ worth of meetings had been a series of policy disappointments followed by dovish diatribes from chair Yellen. In the event, the Fed’s forecasts and the Yellen commentary were on the hawkish side, and we quickly had to buy Dollars again. But short term trading aside, there is an obvious policy divergence again between Fed policy and that of all other developed economy central banks, one that should be very supportive of the Dollar in the months ahead.
The significance is that not only does the Fed supply the world with Dollars via QE but it also controls the price of those Dollars directly via interest rates and indirectly insofar as their policies strengthen or weaken the Dollar. As we have explained before, with offshore Dollar debt having increased from roughly US$6 trillion to US$10 trillion in the post crisis period (a huge slug of that being Chinese borrowers), a strong Dollar alone makes servicing this debt more expensive. A strong Dollar combined
+with rising rates is a double whammy to both US$ borrowers in the offshore world and also those that need to finance trade in Dollars.
Chart 2 below is similar to chart 1 except we have taken out the Fed’s balance sheet, and inserted a measure for Global FX Reserves and also the Broad Trade Weighted Dollar. As can be seen, in the years before the economic and financial crisis in 2008, global FX Reserves rose alongside the Global economy whilst the US Dollar weakened and the US’ current account deficit grew (both the Dollar and current account are inverted in this chart). Between 2009 and 2011, the US Dollar remained weak as Fed policy remained very accommodative and before the European crisis erupted; the 2009 to 2011 was the period of fastest economic growth. Post 2011, with a strong Dollar, slower growth in global FX reserves and a broadly static US current account deficit, global economic growth measured in US Dollars has struggled to gain any real momentum, actually declining in 2015.
Chart 2 – The Global Economy with US current account, US Dollar and Global FX Reserves
Certainly, a strong Dollar and static current account deficit has acted as a bit of a headwind to global growth since 2012. But what of Global FX Reserves? The usual mechanism of reserve accumulation is that a country’s monetary authority intervenes to buy US Dollars and prints local currency to pay for this intervention (this is a bit simplistic, but serves as an illustration). By printing local currency, the non US monetary authorities increase their domestic money supply, which is of course stimulus.
In terms of the Dollar side of the equation, the non US monetary authorities buy US$ denominated assets with the Dollars they have bought, quite often US Treasuries. With global FX reserves having increased by nearly US$10 trillion between 20013 and 2014, that’s an awful lot of non US monetary stimulus going on. Furthermore, the continuous purchase of US Treasuries will surely have supressed US interest rates to some degree.
As an aside, it is mostly this $10 trillion increase in FX reserves that is alluded to when the likes of Bernanke and Yellen talk about a global savings glut. We would contend that it is not in fact a savings glut, but the result of years of massive intervention on the part of several countries (China the biggest culprit) leading to massive stimulus in non US economies and a suppression of US rates. The so-called savings glut certainly helped the global economy both before the crisis and during the recovery cycle. It also helped asset prices.
If we were to look at global FX reserves in isolation, something clearly changed in 2014, since which time reserves have dropped by well over US$1 trillion. With this reduction much greater than during the 2008 crisis, should we not have expected both the global economy and financial markets to be suffering again? Furthermore, with the US current account deficit pretty static in the last couple of years, and the US Dollar strengthening by some 20%+ over the same period, surely both the global economy and financial markets should be in turmoil?
Enter two new actors. As noted above, as the European crisis erupted into 2011/12, the ECB tepidly increased its balance sheet (via liquidity as opposed to outright QE initially) followed in 2013 by the Bank of Japan. Now, apologies for the next chart which is getting a bit messy, but we think it is important to try and understand. Chart 3 below incorporates most of chart 2’s components, except we have removed Global GDP and added back in the Fed’s balance sheet and also an index showing the combined balance sheet of the ECB and Bank of Japan measured in US Dollars. We have also put in a dashed vertical line at the point in 2014 when things changed.
Chart 3 – Central Bank balance sheets with the Dollar, global reserves and the US current account
As we said above, with FX reserves dropping, a static US current account deficit and a rampant Dollar, we would have thought that the global economy and financial markets would have been under severe strain since 2014. Indeed, a couple of times, specifically August 2015 and January 2016 did witness a sharp financial market sell off and worries over economic growth. However, seeming powerful forces came to the rescue both times. Indeed, it is these forces that have continued to encourage risk taking and done enough to keep the economy from keeling over. We would add here that the headwind from FX reserves should continue in the months ahead in our opinion.
As is clear since 2014, whereas the Fed began to taper and finally ended QE in very late 2014, the ECB and BoJ have been running the printing presses pretty hot 24/7. Furthermore, just as the Fed seemed intent on raising interest rates, they eased back in September 2015 (just as the world seemed to be ending) and moved from forecasting four rate rises this year to actually only raising rates once.
What seems clear since 2014 is that central banks have promised to co-ordinate policy on the dovish side. Ok, the Fed did end QE and have nudged rates up a couple of times, but when it really mattered (when markets were on the edge of the abyss), they talked extremely dovishly. And all the while, courtesy of ECB and BoJ QE (with a little help from the Swiss National Bank and close friends), global QE as measured in monthly Dollar totals has never been higher.
So simplistically (and something we all know to be true), global central banks have co-ordinated policy in the last two years at an ultra-accommodative setting and this has prevented any major financial market disturbances and been sufficient to keep the global economy ticking over. Indeed, post the January 2016 market wobble, there was talk of a Shanghai accord at the G20 in February. At the time, policymakers globally were extremely concerned about the strength of the Dollar and co-ordinated policy to weaken it. Namely the Fed rowed back on predictions of four rates rises and the ECB and BoJ stepped up there easing programmes. Without this co-ordination to cap the Dollar’s strength, we think the financial markets could well have suffered much greater losses.
Fast forward to today, and it appears that we are very much back between a rock and a hard place. The Dollar is strengthening (not only because of policy divergence but also because of potential policy changes under the new administration) and this is going to increase strains in the system. Having only just raised expectations for rate rises and confirmed that she does not want to run a “high pressure [economy] as an experiment”, Janet Yellen cannot risk the Fed’s credibility by reversing course again, especially if Trump’s reflationary rhetoric begins to become policy. At the same time, the ECB has only just committed to more QE until December 2017 and the Bank of Japan have recently changed to a new yield curve control policy. Simply put, there is now a new policy divergence between the Fed and the rest of the world that should be very supportive of the Dollar.
Just as in August 2015 and again in January 2016, there comes a point when the Dollar becomes too strong. Not only does it impact global trade growth, it makes funding Dollar debt much more expensive. In fact, with the US economy now more intertwined with the global economy than ever before, and some 40% of S&P 500 corporate revenues coming from overseas economies, a too strong Dollar risks hurting the US at some point as well.
We realise that we have gone into quite a bit of detail today, and we haven’t even had a chance to talk about the impact a strong Dollar would have on commodity prices and therefore the commodity producers particularly in the Emerging Markets. We will tackle some of these related issues another time.
As we sit here and think about the building divergence in central bank policies and the impact this will have on the Dollar and therefore the global economy and financial markets, we are beginning to think it’s a race against time and possibly reality. A race against time in that if the Dollar becomes too strong before Trump’s reflationary policies have a chance to kick in, then a US and global recession becomes a significant risk later 2017. A race against reality in that although Trump’s policies look to be obviously reflationary, we are not at all convinced they will be delivered quickly or even have the desired effect without any negative consequences. Just as with the man himself, there are a lot of uncertainties when it comes to the details of his policy mix, and so we will have to take the evidence as it comes.
As well as a strong Dollar, there are other risks that could easily hit the headlines in 2017. China is struggling to maintain control of both its economy and its currency whilst trying to cool down a red hot property market and deliver some deleveraging at the non-financial corporate level. Can Beijing achieve all this? Probably not. Europe will no doubt grab many a headline next year with elections in Holland, France and Germany and possibly Italy and Greece where problems are deep seated. Geopolitically, Russia and China are clearly trying to strengthen or build out their spheres of influence in Europe and the South China Sea. President Obama has failed to stop Putin and Xi Jingping who clearly view US foreign policy as weak. We doubt that Trump will be any stronger on the foreign policy front.
Assuming that Trumpflation is more of a dream than a reality, then the risks to financial stability next year are a lot higher than markets are currently pricing. At some point, the strong Dollar and rising rates will matter, and matter with a vengeance, although to paraphrase Keynes, markets may not care until after the bears have become insolvent. For our part, we see the best opportunity in bullish US Dollar trades against emerging market and commodity currencies.
Finally, we have been reading some very interesting articles recently on optimal asset allocation in an era of extremely expensive valuations across all major asset classes. We have talked about this before when we have illustrated the likely low single digit nominal returns from both equities and bonds over investment horizons of between say 7 and 12 years. Traditional portfolios populated mostly with equities and bonds have become extremely long duration in recent years and are therefore extremely sensitive to a rising yield environment. There is no simply diversification opportunity in mainstream assets, and so we are thinking that liquid alternatives, which by their nature are short duration assets, are increasingly attractive in a world where realised volatility is likely to be much higher. We will have more to say on this subject in the New Year.
Stewart Richardson
RMG Wealth Management
