Dollar, Debt, and Politics

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Like a rock tumbling down hill, oil prices have broken 40 dollars per barrel and sustained their downward momentum. Bearish reports ranging from the outcome of the OPEC meeting in Vienna over a week ago to supply outlooks from the International Energy Agency continue to weigh on the global crude market and have further dampening effects on global financial markets. Particularly equity markets look troubled with the notion of a diminishing global growth picture, and the prospects of a global recession come 2016. Not just limited to the aforementioned reasons, but markets remain on a jittery footing heading into the Fed meeting this week. It is remarkable how much can change in one short week as market participants exhibit signs of discontent with what’s in the pipe for the year ahead.

The greater probability though is not so much a fear for how North American markets will react to Fed actions next week, but instead what will result in the world’s emerging markets. South Africa reminded us this week that there are greater fears for emerging market (EM) investors than simply the price of the US dollar and commodity markets. Simply put, the commodity markets slump has put downward pressure on some of the world’s EM’s as returns are depleted and pressure mounts on government revenues. A strong US dollar also inflates the burden of US dollar denominated debt many of the countries and residing corporations have issued to finance themselves. But with the pressure of inflated interest payments and depleted revenues comes political risk.

With South Africa as the example, the Treasury and the Central Bank have long been viewed as stable and independent institutions. The benefit of an independent treasury is that it is an added pressure to government to restrain their finances and keep government debt in check. This all changed for the Republic of South Africa this week when the President Jacob Zuma fired his finance minister and replaced him with an unknown party insider. The Economist Magazine actually cited a spike in Google searches of the man’s name as people were unfamiliar with who would be taking the helm of the country’s finances. As the fear is this was a politically motivated decision, the rand, South Africa’s currency, in a swift reaction sold off 5 per cent against the US dollar despite sitting on multi year lows.

This is a critical time for emerging market economies. Also, given the demand from EM’s for precious metals, it has direct implications for the gold market. At the beginning of December Fitch Rating Agency downgraded South Africa’s debt to one notch above junk status. This is as Debt-to-GDP rose from 2009 until present time from under 30 per cent to just above 45 per cent. Political risks, whether from South Africa or any other nation, become more prevalent for investors and can change the dynamic of global markets.

This will likely reinforce a theme for the beginning of 2016 that the dollar, if not for investment opportunity in US markets, will be attractive for its safe haven and even more so liquidity status. It’s a challenge for commodity markets to counter trend a strong US dollar and as long as the outlook for EM’s is bleak, a strong dollar may persist. The global economy will be challenged in 2016, and objectively, remains one of the bearish factors weighing on the gold market.

Divergence and the Dollar

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This past week in the markets set the scene for a diverging picture in terms of monetary policy in the United States versus the reset of the world. Through speeches and congressional testimony, US Fed Chair Janet Yellen made clear that a December rate hike remains on the table as the US Federal Reserve looks to lift off of rock bottom interest rates on December the 16th. This would be the first rate hike by the Fed in ten years. On the other side of the Atlantic, Mario Draghi and the ECB perhaps fell short of investor’s expectations Thursday, but nonetheless remain in an accommodative stance as they extend the duration of their bond purchasing program and cut key policy rates. The path of rate hikes by the US Fed and how their policy diverges from their fellow G7 nations continues to be heavily debated and will be one of the foremost important themes for the global economy in 2016.

There is no question the decision makers at US Fed sit between a rock and hard place. A report out of the Financial Times at the end of last week revealed more than a trillion dollars in US corporate debt has been downgraded so far this year. This represents a 72 per cent jump in the total value of US debt that was downgraded in the first 11 months of 2014. Much of the story is related to the energy picture and US companies that face declining revenues with weaker commodity prices, but also linked is the fear and pressure created from higher interest rates from the path of Fed rate hikes.

Fitting in the commodity story is another very relevant question. The old adage use to be the cure for lower oil prices is lower oil prices. This current down period in energy markets is certainly putting pressure on that theory. As OPEC meetings finalized in Vienna this week, there is only more excess supply uncertainty for the market with the cartel opting not to constrain output and abandon a production target until their next meeting. Relating to the dollar story, it’s not only higher interest rates in the US prompting a strong dollar trade, but also a continued outlook for weak commodity markets.

Tying this together speaks to investor caution of whether the credit cycle seen in global bond markets is nearing its end. Eight of the largest US banks were downgraded by rating agency Standard and Poor’s this week and four of them including Bank of America, Citigroup, Goldman Sachs, and Morgan Stanley were stripped of their coveted A ratings. Only 3 US corporations now have AAA rated credit (and potentially soon to be 2 as one is ExxonMobil) whereas five years ago that number was over 20. In broad terms, as creditworthiness declines and risk increases, investors must look for preservation and return of their capital.

It was interesting to see gold Friday surge over 25 dollars an ounce against the backdrop of fundamentals that would otherwise be bearish for the precious metal. By no means am I attempting to call a bottom in gold prices, but as commodity markets got hammered Friday with the OPEC news and the dollar strengthened with Fed rate hike anticipation, gold as well traded higher in tandem. This rare occurrence when gold and the dollar strengthen together can often signal investors are in search of a safe haven at a time of heightened uncertainty. Whether gold has bottomed is to be determined, but with limited opportunity from relatively stretched credit markets, and an uninspiring equity market backdrop, diversification to gold is worth examining in 2016.