A Dollar Tug of War

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A little over a year ago when the world was discussing the realms of currency wars and central banks purposely imposing policy in order to devalue their exchange rates with trading partners, it was the policy makers that argued that their approach was directed domestically, and a weaker currency was simply an indirect consequence. As long as the policy intent was not, for example to weaken their currency, or to better the country’s respective terms of trade by cheapening their exports, it was deemed acceptable.

Today, however, we are seeing the other side of that coin as western central bankers once again look out for their respective countries best interest, and in an uncoordinated approach adjust their monetary policy and stimulus. And it’s the worlds emerging economies, who were the engine of growth for the global economy as it climbed back from the worst recession since the Great Depression, that are feeling the pain.

It was only by coincidence, not by design, that central bankers around the world coordinated policy in order to spur economic growth. It prompted fears of currency wars or a “race to the bottom” in terms of devaluing their exchange rate. I think it’s clear now that did not yet happen. But if the tremors we are witnessing in currency markets over the last few days have illustrated anything, it’s that nothing destabilizes risk assets like the boisterous equity markets of 2013, more than uncertainty and instability in foreign exchange markets. And that’s exactly what’s to come as the world’s central banks once again operate in this unilateral non-structured fashion.

Over the course of the last week we saw action from central banks all over the world in attempts to stabilize their financial sectors. As the markets perceive the United States and the US Federal Reserve to be tightening their policy by altering their stimulus and decreasing their bond purchases by a successive $10 billion per month, the emerging market economies have no choice but to follow suit. It’s simply a stronger dollar attracting capital and foreign investment back towards the US, and other advanced economies. In the last week, countries like Turkey have had to raise their key policy interest rate from 7.75 percent to 12 percent in an emergency meeting. Although not as drastic, South Africa and India raised their rates also. And this doesn’t discredit that the home grown problems some of these countries already face may be the root cause of their suffering; moreover, a strengthening US dollar only acts to exacerbate their problems.

It’s almost paradoxical though how emerging economies through the efforts of the G20 were relied upon to fuel a recovery for the industrialized nations of the world. Many countries saw their exchange rates significantly strengthen against the US dollar, with Brazil being the textbook example as the Real appreciated by as much as 48 percent. No questions this strangled their export sector, especially given they represent resource based open economies which thrive on strong international markets. But now, a rift if being created as no consideration is yet to be given from the western world. A dollar tug of war is creating a global imbalance. And what’s surprising is that with a strengthening dollar, we are seeing the rebirth of the safe haven characteristics of gold.

Only in periods of extreme turmoil do we see gold and the US dollar trade higher in tandem. And that’s not to suggest that we have entered a period of extreme turmoil, but it certainly shows the potential for gold. To some extent it’s argued the industrialised nations can immune themselves from an emerging market crisis; nonetheless, periods of economic uncertainty have always been favourable for gold. That’s when insurance is needed more than ever. Alternatively, a weak US dollar also bodes well for the yellow metal. I don’t want to attempt to forecast a crisis, but this tug of war, juggling act, or whatever we want to call it is what will see gold bottom in 2014.

A Bumpy Road Forward

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“The experience of the market place of this past week will be indicative of this entire year; I think we are going to be in a world of much greater volatility. That doesn’t mean we end up in a bad place. . . but there will be quite a bit of disruption”

-Blackrock CEO Larry Fink speaking at the World Economic Forum in Davos, Switzerland

 

It was quite the ending to a week that was nothing short of a meltdown in the world’s emerging market economies. What represented the world’s engine of growth a few years back with the likes of relatively larger nations like China, South Africa, Russia, India, and Brazil has quickly shifted to a point of fragility for financial markets everywhere. Perhaps, now we are witnessing the correction in equity markets, particularly in the United States, which many had been calling for, but we cannot discredit the impact of the demand for US dollars at the result of funds that are departing emerging economies.

In the last few weeks, its fear and contagion spreading though these markets that have caused their respective currencies to lose significant ground against the US dollar. And it is at the direct effect of investors selling their foreign assets, and the currency used to purchase them in order to return to the US. Just to look at a few examples, the Russian Ruble and the South African Rand are at their lowest levels since the 2008 financial crisis. The Turkish Lira was down four percent on the week and that was with the world’s central banks stepping up in support and purchasing a billion pounds worth of lira.

But the most intriguing story has to be the Argentinian peso, the biggest loser of them all, seeing its lowest level in 12 years as their government abandoned a policy that had required their citizens to save only in their domestic peso, instead of US dollars. By the end of the week, the Argentinian currency was trading around 8 pesos to a dollar, but due restrictions and lack of availability of greenbacks, reports of black market transactions had the peso at 13 to a US dollar.

News of the world’s faltering emerging economies is not to outstrip the potential for global growth in 2014. There is still very much a level of cautious optimism (which seems to be the key word) for global growth going forward, but it has become no question that the emerging markets are what will unsettle this picture. Some seem to suggest that the US Federal Reserve tapering their bond-purchasing program is the direct cause of the run from emerging markets, but as Larry Fink (quoted above) goes on to suggest, that takes a too simple approach to the problem.

The fact of the matter is not all these different markets can be painted with the same brush. However, they often are because when there is turmoil they all sell off together; however, it’s important to understand the shortfalls in some of their fiscal policies that contribute to this disruption. For example, overreliance on a strong China as a trading partner or failing to implement policy that acts to curtail what has been rampant levels of inflation, with the most extreme scenario being Argentina at an inflation rate close to 25 percent.

The bond market and the US dollar were the benefactors of a resurgent level of volatility in the markets these last few days. In addition to this, we also witnessed gold trading higher reaffirming its safe haven characteristics. We should let this volatility comes as bit of a sobering reminder for how correlated the world’s financial markets remain, and how disorder in Buenos Aires leads to trepidation in New York and beyond.

Pricing the Taper

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According to the Bank for International Settlements, the total of public and private debt in the G20 Nations is 30 percent higher than it was before the Great Recession of 2008 and 2009. And when you think of a crisis as a period for deleveraging, or starting to reign in and payback debt, that hasn’t been the case across the world’s 20 largest and emerging market economies, and policies like ultralow interest rates and quantitative easing have only acted to encourage and exacerbate the issue.

The concern stems from the stimulus driven policies of the world’s central banks that have allowed consumers to go out and make big ticket purchases at relatively low financing costs. Buying that new car or managing mortgage payments were made significantly more achievable because of how longer term interest rates were and are being suppressed. But as the Fed enters this period of altering their form of stimulus which they provide to the market by shifting away from an exhausted bond purchase program towards enhanced forward guidance on record low policy rates, the market still conceals a lot of uncertainty that becomes difficult to price in.

We like to believe in the efficiency of markets and that the price of an asset reflects all the current available information to any level of investor. And that encompasses the fact that expectations of future events are priced into the market as well. Hence the episode back in May of 2013 when Chairman Bernanke hinted at the idea of paring back bond purchases, the effect on financial markets was significant because easy money policies from the Fed provided fuel for risky assets. But now that the markets have seemed to have digested the idea of a taper from the US Federal Reserve and the realization that Quantitative Easing (QE) can come to an end, some analysts suggest that this is then realized in the price of financial assets.

But the uncertainty still remains, and unfortunately I think it’s more prevalent than ever. Beyond the fact the G20 Nations are more levered than they were before the crisis, the biggest risk to 2014 is that the market has mispriced the effect of tapering QE. As we know, the monetary efforts employed by the US Fed were experimental policies that have previously never been experienced. It’s very difficult to price something into the markets that we have never seen before.

The McKinsey Global Institute published a challenging paper back in November of last year stating the effects of ultra-low interest rates and a stimulus policy on financial markets is inconclusive. That could suggest the withdrawal of stimulus might not impact asset prices, but this paper has been refuted quite logically by many leading thinkers as it assumes that stimulus level rates had no effect on the real economy. It essentially ignores the fact that businesses were able to finance new projects and lock in record low borrowing rates (which they have), or make those investments in an easy-money environment. The markets are forward looking (and given strong annual returns, economic growth numbers are beginning to echo that), but the uncertainty questions whether the natural players in the market can pick up the slack created by the US Fed’s diminished presence.

Whether this market can sustain its momentum once the US Fed no longer plays an as active role in the longer term debt markets is the unknown for 2014. Its without doubt the Fed will remain in its accommodative stance with their forward guidance and projections while maintaining a rock bottom Fed Funds Rate, but the question will be with regards to how the economy will fare one to two years down the road.

Premium for Excellence

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To suggest that the Canadian Federal Government is pushing a weak dollar policy must then imply that in years past they too were opting for a stronger Canadian dollar. At the least the price of the Canadian dollar would suggest that, but unfortunately its nonsense. The Canadian dollar is and has been subject to the market forces of foreign investors who wish to hold the currency. Given the Great Recession that destabilized the global economy in 2008, Canada was by far the least dirty shirt. The Canadian economy, given the relative strength of the domestic economy as a result of sound fiscal policy, was a haven for capital. And many economists around the world echoed that tune for all the months that the currency traded around par with its US counterpart, particularly giving tribute to the financial system. But probably the most vocal was Bank of Montreal’s Douglas Porter who estimated a 15 cent premium in the dollar.

And given the tremendous strength seen in the greenback since May of last year when the US Federal Reserve began to float the idea of altering their monetary stimulus, it’s no surprise the shine has come off the Loonie. Perhaps what is a surprise, however, is the drastic pace at which the Loonie has fallen. But at this time, investors don’t necessarily need to pay a premium for excellence, like they would have for the stability of the Canadian dollar during periods of uncertainty. Moreover, that is why it’s unfortunate to suggest the federal government is operating this weaker dollar policy, just because the price of the Loonie is deteriorating.

There are three simple factors that are contributing to a weaker Canadian dollar:

1. A Dovish Bank of Canada

2. US Dollar Strength

3. A Lagging Canadian Economy

The foremost contributor to the downfall in the Canadian dollar has been the change in policy direction from the Bank of Canada. That essentially occurred during the period when Mark Carney was replaced by Stephen Poloz during a period where the bank began to witness a stalling labour market and downward pressure on the rate of inflation. The fact is that it’s the inflation rate the Bank of Canada is concerned with as it ties into the performance of the rest of the economy. Normally, weak inflation indicates an economy that is not expanding.

The strength of the US dollar is as well a major contributor to the weakening Canadian dollar. For starters, the selloffs witnessed in commodity and energy prices (and their strong correlation with the Canadian dollar) as well put downward pressure on the exchange rate. These tie together with the policy of the Fed. Ultimately, as the US Fed begins their period of altering their accommodative policy, and the market perceives it to be tightening their economic stimulus, support comes into the US dollar and US dollar assets.

The final factor impacting the Loonie is the economic data continually revealing the lackluster status of the Canadian economy. In the last week alone, we saw trade numbers that implied the Canadian export sector is showing no growth, and job numbers that illustrated a trending weakness in the labour market. For starters, the trade numbers illustrate that there is slowing demand from foreigners to purchase Canadian goods and services. And the labour market is indicating the private sector is struggling to take over job creation from the public sector, which would have been anticipated at this point in the recovery.

Examining the aforementioned factors alone gives reason for an already beleaguered Canadian dollar. If we wish we can attempt to attribute the story to a political agenda of a central government, but that requires a lot of imagination and omits a period when the Fed stood pat and watched the loonie appreciate only to put a good majority of Canadian manufacturers and exporters in a stranglehold. When investors forget about quality of their assets, there is no premium for excellence, but rest assured that day will return for the Canadian dollar.

The Biggest Question for 2014

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The biggest question for 2014 is not whether the US stock market will be able to perform a repeat of the exuberant gains achieved in 2013. It does, however, relate to whether stocks will be able to repeat their exuberant gains. Ultimately though, that depends on the sentiment of investors and the perception of where capital should flow in the coming months and year ahead. A key contributor to that will be the pace at which the Fed tapers backs their bond purchases versus what the markets expectations will be, which at this point is to see the Fed’s Quantitative Easing (QE) wound down by the end of 2014. Moreover, tapering is associated with the expectation of continued modest improvements in the labour market and broader economy. But the more important investment question for the year ahead looks beyond the recent action in the markets and surrounds the debate of economic growth, the prospects for the US and global economy, and particularly the premises of a return to normalcy versus secular stagnation.

Another way of asking that question, what is it about the general economic growth environment that influencing financial markets?

The most striking fact of 2013 is that companies who make up the S&P 500 will payout or return the greatest amount of funds to investors since 2006. This was done in the form of dividends or stock buybacks, and some final totals sum up to over 500 billion dollars. The even bigger number though is that “Blue Chip” firms, comprising the Dow 30 paid out their highest levels since the late 1990’s. What this could say about the American and global economy is twofold.

On the one hand, American corporations are still finding their share prices relatively cheap. They would opt to repurchase their shares in what has been a rallying market, and seize the opportunity to issue debt at record low interest rates. Obviously, if they are seizing the opportunity to buy back shares at current prices, their outlook is for their share prices to trade higher, if not see some level of stability, but the other major factor of buying back stock means the number of outstanding shares in a company is falling and with the same growth potential share value increases.

That being said, there is also a flipside to firms returning cash to shareholders, and that is that the present value of investment opportunities is less than what shareholders might be able to earn elsewhere. Or simply put, investment in research and development for American companies is becoming exhausted. In this view, there are few and far between opportunities for American business. Instead of employing that extra worker or investing in new equipment, cash is being returned to shareholders. This is something that fits with the hypothesis (hyped by Larry Summers) of secular stagnation, but at the same time, US capital expenditure contradicts this as its highest level in 2013 in November.

Going into the beginning of this year, I think it’s evident that money will continue to flow into equities. It’s trading off the dynamics of central banker’s interference in the economy. And as markets climb a wall of worry, investors will be looking to hedge and limit their downside risk. A hedge, by definition, is an asset that is negatively correlated, or uncorrelated with another asset. Over the last year, the S&P500 gained approximately 30 percent and gold lost that amount. Gold is, and always has been a hedge for risk assets, but as the markets trade higher into 2014 gold will continue to catch bids as investor’s hedge their exposure to equities, and it’s my opinion a bottom will be in place following the first half of this year.