Newton’s Third Law states that for every action there is an equal and opposite reaction. Economics is certainly not science so the application of Newton’s law would seem inappropriate for analyzing the global economy, but in today’s world I think it is apt; more growth here means less growth there, a zero sum game of aggregate demand ping pong. It was almost 5 years ago that Brazil’s finance minister, Guido Mantega, declared the existence of a global currency war, complaining that the Federal Reserve’s quantitative easing program was pushing the Real higher and damaging the Brazilian economy. It is safe to say that Brazil’s politicians needed no help in damaging the Brazilian economy but Mantega’s comments have proved at least somewhat prophetic. It is also safe to say that Brazil would certainly welcome some of the capital inflows it was decrying just a few short years ago. Mantega wanted a cheaper currency and he got in spades, proving once again that one should be careful what one wishes for.
Now five years later, it is the US that is on the receiving end of those capital inflows with the dollar the currency world’s current darling. With the end of the Fed’s QE program, the divergence between US and international monetary policy has pushed the dollar index up 20% since the middle of last year. The price of oil has dropped over 50%, largely a response to the rising dollar. The consequences of that drop are still being reckoned and while the long term impact is most certainly positive, the short term may be a different story. For evidence, one need look no further than last week’s economic reports.
There were three regional Fed manufacturing surveys released last week and the Chicago PMI. The Fed surveys all came in less than expected with the Dallas Fed – right in the middle of oil country – reporting the biggest slide from an already negative 4.4 to a nasty -11.2. Further contraction was not unexpected; the magnitude was. The Richmond and Kansas City reports were not as bad at 0 and 1 respectively but were less than expected and falling from much higher levels. The Chicago PMI was a disastrous 45.8 (with 50 representing expansion) but there are some caveats to the report. First of all the Chicago PMI includes services as well as manufacturing. Second, it was cold in Chicago which is not exactly news but probably had some impact. Third is that the port strike on the West Coast has probably had some impact on all regions of the country.
What’s important about these numbers is that they confirm other data that is pointing to an industrial/manufacturing slowdown in the US. It is interesting that, at the same time, Japan and Europe appear to be firming. It is more than tempting to point to a cheaper Yen and Euro as at least a partial cause of the shift. There is in economics a phenomenon called the J curve that says that after a devaluation, a country’s trade deficit will first get worse before getting better. Certainly Japan saw that effect but their trade numbers have recently been improving, mostly in Yen terms but increasingly in volume terms as well. Is that the effect of a cheaper Yen? As for Europe, the Eurozone countries reported a record trade surplus in 2014 and the Euro didn’t even start falling until the second half of the year.
I am reluctant to attribute this emerging shift in manufacturing strength – and maybe economic growth overall – all to the devaluation of the Yen and Euro but certainly the currency movements have had an impact. It appears that the Fed’s initiation of the currency war with repeated rounds of quantitative easing has come full circle with the rising dollar negatively affecting the US economy, mostly through the impact of lower oil prices on the energy industry. I have said previously that I don’t know whether the slowdown in capital spending by US energy companies will be sufficient to push the US into recession and I have no further insight today. If anything it appears the effect so far has been rather muted but that Dallas Fed survey and a pretty big rise in jobless claims last week may mean that is starting to change. In any case, the US economy is largely service based and that sector so far seems to be little affected so we might avoid an outright recession.
The long dollar trade is probably the most crowded trade on the planet right now. Whether one measures its value versus a barrel of crude oil or against the world’s other fiat currencies the dollar is strong and well loved by global investors. Emerging market currencies – including Mr. Mantega’s Real – have been weak for far longer than just the last few months and it is perhaps a contrarian signal that the WSJ just noticed. And we all know what has happened with the Yen and Euro but I would just point out that both appear to be trying to stabilize at current levels. If growth expectations do start to equalize, whether because the US is slowing or the rest of the world is improving – or both – both currencies should start to find a bid. Will the BOJ and ECB allow their currencies to rise from here? While they may not want stronger currencies right now, I suspect that if the long dollar trade starts to unwind there is little they can do about it.
The actions of US monetary policymakers after the crisis of 2008 held the dollar down and pushed foreign currencies higher. In a world of slow growth the fraction of demand that gets shifted around the world on the tide of floating currencies has become much more important. Just as in the 1930s version of the currency wars, the country that devalues first appears to gain a – slight – first mover advantage. Also like the 1930s the actions of one central bank create a reaction from other central banks, not exactly Newton’s Third Law but close enough for the pseudoscientific economics profession. Ironic too that having lectured Brazil that QE was our policy but their problem, the Fed can now hardly complain about the impact of the policy easing in other countries that has accelerated this year. I’ve lost count now of how many times monetary policy has been eased around the world so far this year but the list got longer this weekend as China eased for the second time in four months.
If global growth is about to undergo another of the periodic shifts we’ve seen since the crisis, the US would appear to be the loser in this round. That doesn’t necessarily mean recession here – and a recession here would likely derail growth in other parts of the world – but a growth slowdown may mean that investors need to shift away from the recent winning trades. US stocks and bonds have obviously benefitted from the capital inflows while international markets have suffered. That isn’t true universally obviously, but a glance at any valuation metric will tell you that US stocks are pretty popular right now.
The US generates roughly 22% of global GDP but our stocks represent almost 38% of total global market cap. The current ratio of US market cap to global GDP has only been higher one time since 1960 and that was during the insanity that was the dot com bubble of the late 90s. While we could be on our way to that level of over valuation, betting on that outcome would seem to fall well outside the mandate of a prudent investor. With generally lower valuations outside the US and what appears to be the beginning of a shift in the global balance of growth, a better option is probably to start shifting one’s investment focus away from the US markets.
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