Is the strong US dollar merely the Emperor’s new clothes?

One noteworthy feature of financial markets this month has been the rush to buy the US dollar. This has me puzzled.

At times of economic and fiscal stress and uncertainty, investors shift from demanding a return ON capital to demanding a return OF capital. Yet, they are rushing to buy US dollars, hoping for a return OF capital! If the US dollar is so strong despite such poor US fiscal, economic, social and political outlooks in a post-coronavirus environment, how bad is the rest of the world?

Prior to the outbreak of COVID-19, the risk-reward balance of the US economy favoured the reward.

  • The US was reporting economic growth (as measured by GDP) and offered interest rates higher than other main economies, except for China; the US is the world’s largest economy;
  • the US dollar is the world’s main reserve currency at a macro level (government, trade and debt) and micro level (it is estimated that more than 40% of US cash on issue is outside the US, fuelling the global black market);
  • almost all commodities are traded in US dollars;
  • the US is on track for an eye-watering USD1 trillion deficit this fiscal year (before any emergency fiscal packages);
  • the US Government is the world’s largest borrower; and
  • US companies have geared up their balance sheets in recent years to take advantage of ‘cheap’ debt (so, there’s lots of securities for investors).

The latter three highlight the US’ main risk and vulnerability, more so if you consider the implications for the substantial increased supply of US debt and US dollars. The US federal government (as well as state governments and municipalities) will have to issue more debt to fund their stimulus packages. There is no urgency for investors to buy US debt (both public and private sector). They can hang back and wait for higher interest rates.

To help fund the increased US government debt, the Federal Reserve has indicated that it will undertake more quantitative easing, i.e. it will print money to buy the government’s debt, thereby increasing the supply of US dollars. All things being equal, more US dollars in circulation will lower its relative value.

The US’ response to the coronavirus threat (at federal and state levels) has lacked a cohesive plan. With on or two exceptions at state and local levels, officials seem reluctant to adopt the hard-line public health measures that have been adopted elsewhere (e.g. China, Italy, France, UK, Singapore, South Korea, Australia and New Zealand). As a consequence, the US has fallen behind its major trading partners in addressing the health threat and economic fallout from COVID-19. Furthermore, the US can only fund any fiscal support by issuing even more debt, which puts it under even more obligation to investors and shifts the risk-reward balance towards risk.

Many US companies have increased their debt levels and overall leverage in recent years by taking advantage of low interest rates and easy credit conditions but that has made them vulnerable to the sort of dire economic outcome that many see in a post-coronavirus US. The recent, dramatic fall in US stockmarkets is an understandable adjustment to the risk-reward balance given many companies’ prospects for reduced future earnings and the need to feed higher gearing.

Again, I ask – why buy US dollars?

I expect that the recent rush into US dollars has been defensive – to acquire USD cash for future US dollar denominated spending and debt commitments. Some of those buying US dollars internationally are US based investors, such as mutual funds and those who manage the retirement and other savings of the ordinary US residents. However, many are foreign nationals investing through their central banks or sovereign wealth funds whose natural investment is not the US dollar.

Looking at this another way – the US is the Emperor and financial markets are its tailors who need to keep supplying the Emperor with new clothes even though all that the tailors have left are rags and their silver tongues. Eventually, the world will see the harsh reality of the Emperor’s new clothes, or lack thereof. Market prices (specifically, companies’ share prices, yields on US government and corporate bonds, corporate credit margins and the value of the US dollar) will then adjust for the US’ increased risk and savers will want their funds returned to the safety of home.

A country’s exchange rate against those of the main global currencies and its main trading partners is a major indicator of expectations for that country’s economic, fiscal, social and political performances, much the same way as a company’s share price is the major indicator of its activity, profitability and long term health. So, can someone please enlighten me as to why the US dollar has strengthened, why so many see the US dollar as a safe haven and why so many market economists and commentators are confidently predicting further US dollar strength?

Is Italy too big to fail?

In 2008, the US Government and the Federal Reserve decided that the investment banks Bear Stearns and Merrill Lynch were ‘too big to fail’ and pressured, and then assisted other banks to buy them. That is where Federal authorities drew the line defining which US banks were ‘too big to fail’ stopped. As a result, the next troubled investment bank (Lehman Brothers) went into bankruptcy on 15 September 2008, mainly because its problems were seen to be self-inflicted, which triggered panic in global financial markets and resulted in more than USD1 trillion direct US government spending by way of bond, asset and share purchases and emergency loans.

The European Union (EU), European Central Bank (ECB) and European governments are now faced with deciding where to draw their ‘too big to fail’ line. Italy, already in economic recession, has gone into lockdown and will undoubtedly face economic contraction (negative GDP) in many, if not all quarters, of 2020.

The Italian government has announced fiscal support and is promising more, which will exacerbate Italy’s already burdensome fiscal deficit and debt positions and cause it to break the EU’s budget deficit rules. EU and ECB policymakers will have a very important decision to make about which side of the ‘too big to fail’ line Italy sits.

Do they change the EU’s fiscal rules to give troubled all EU nations greater deficit and borrowing capacities?

Do they increase the ECB’s asset purchase (bond buying) programme, and head down the same path as the Bank of Japan, Federal Reserve or Bank of England?

Do they decide that Italy is ‘too big to fail’ and offer a bail out (with possible IMF help) subject to Italy first undertaking fiscal austerity measures, like they did with Greece in 2010? In that case, where do they draw the line on bail outs?

Italy is much bigger than Greece. The consequences of making the wrong choice are potentially enormously dire. Even the long term right choice might have dramatic consequences in the short term. If the Italian government was to default on its debt, just as Lebanon has done this month, the impact on global bond markets and the euro would be devastating.

Italy is the third largest government bond issuer, behind the US and Japan. Yields on Italian government bonds have risen this month, contrary to all other industrialised nations’ government bond yields that have fallen dramatically. Most industrialised nations have two market levers (or circuit breaks) – the exchange rate and domestic interest rates (bond yields). However, Eurozone nations do not have an exchange rate lever – an Italian euro will forever equal a German, French or Dutch euro. So, financial markets have to rely on the interest rate lever to undertake all the risk pricing adjustments.

It seems likely that Italy will be deemed ‘too big to fail’, unlike Lebanon. But what will be the cost? To Europe? To the rest of the world? To business confidence? To jobs? To household confidence and spending? To investor preferences?

Meanwhile, other global worries fester

COVID-19 has become the source of almost all news headlines, leading news stories, media opinion pieces and political posturing. That’s mainly because of the speed and severity of its global spread, its sudden negative impact on business activity, household spending and economic growth in the world’s second biggest economy (China) and the threat of the same negative economic and political impact on many other economies. It has become the number one geopolitical worry. However, other worries and hot spots continue to fester.

The US is about to send an aircraft carrier to Vietnam. The last such official US aircraft carrier visit Vietnam was two years ago and the one before that was in 1975. Also, over the last two or so years, the US has also increased its naval and air force presence in South East Asia in general and the South China Sea in particular. Vietnam is one of several South-East Asian countries who are in dispute with China over ownership or sovereignty of parts of the South China Sea.

The International Atomic Energy Agency (IAEA) has issued a report that suggests that Iran has enough enriched uranium to produce a single nuclear weapon. However, the IAEA believes that it would take Iran months or years to manufacture a warhead capable of delivering it over long distances.

Lebanon has announced that it will default on a USD1.2 billion bond payment this week – it’s first ever default on a foreign debt obligation. According to the Lebanese Prime Minister, the country’s “debt has become bigger than Lebanon can bear, and bigger than the ability of the Lebanese to meet interest payments.” Lebanese businesses are closing, people are losing jobs, inflation is soaring and (business, consumer and political) confidence is falling. The Middle East does not need another economically and politically unstable nation.

Meanwhile other struggles (political, economic, structural whether internally or with another country) continue or are intensifying in Israel, Palestine, Syria, Iraq, Turkey, Russia, India, Kashmir, Pakistan, Malaysia and various Latin American and African countries.

‘Just in time’ is bad risk management, or just plain greed, in an interconnected and China-dependent world

COVID-19 is a smart coronavirus because it can spread quickly among humans. The speed of that spread has been helped by the interconnectedness of humanity through international air travel.

The speed and dramatic impact on the global supply chain and responses by financial markets, governments and central banks have also been due to the world’s increased interconnectedness, both physically and virtually.

That same interconnectedness also means that the whole world can learn of COVOD-19’s spread and score as they happen, provided there is a free and honest flow of information.

The supply chain effects have been complicated by China’s ascension as a major global player in manufacturing, a global dependence on single sources of ingredients and components and so-called efficient inventory management, i.e. ‘just in time’. The latter is proving to be a short-sighted cost saving that works very well in good times but fails in bad times. Poor risk management or greed, depending on your viewpoint.

China is now the world’s biggest manufacturer of steel, active pharmaceutical ingredients, medical supplies and motor vehicles, as well as industrial and consumer electronics. People can live comfortably if they delay the purchase of that new phone, car or TV for a few weeks but most pharmaceutical and medical supplies wholesalers and suppliers have only a limited supply of these essentials.

The hopes are that China’s manufacturing will resume soon and supply chains will move again. Now though, we are seeing forced isolations in other countries that could result in the same supply chain blockages that China is trying to clear up; forced isolations and supply chain blockages that will have drastic implications for the earnings and spending of the average business and household in countries that do not have the draconian ability to impose the same sort of control over and co-ordination of businesses and people as China.

For the rest of us, the threat remains for further restrictions on the supply to health professionals and individuals of vital items of medical and sanitary products – all because of someone’s poor risk management, or greed.

Time for reasoned assessing and planning – not for panicking

The COVID-19 outbreak has hit the world just as governments, central banks and financial markets in many industrialised nations were seeing hopes of a recovery in economic growth after a slow down in response to the effects of major geopolitical events last year – the US/China trade war, Brexit and escalating tensions in the Middle East.

Those hopes promised governments and central banks some latitude to ease fiscal policy (i.e. spend) and to hold steady on monetary policy (i.e. not to worry about having to further cut interest rates that are already at record lows, or in many cases negative). But, COVID-19 has dashed those hopes, for now.

Governments are having to loosen purse strings through unplanned public sector expenditure (e.g. at borders and hospitals) while witnessing a slow down (or, in some cases, a complete halt) in household spending and business production, which will translate into governments spending more and earning less.

Central banks are scrambling to identify the problems so that they can take action, just as they did when the GFC hit.

Financial markets are keenly waiting for central banks’ responses, confident that central banks can again come to the rescue of markets and economies. This time though, the problems are very different and so the required responses most likely will be very different, and central banks have less ammunition to call upon. The central banks’ interest rate quiver, at best, has one, maybe two, arrows left and the bow string is frayed. So, they must look at other targets and take other measures.

The dramatic falls in sharemarkets have rocked investor confidence with such force that bond and credit markets have also reacted forcefully. Cash exiting sharemarkets has gone into the safety of government bonds but there has been collateral damage by way of a sharp spike in market volatility, wider credit spreads and, more significantly, stymied primary and secondary market activity in the corporate bond markets. In the case of the US, the CBOE Volatility Index closed Friday at its highest since August 2015 and the US corporate bond market has all but ground to a halt.

Indications are that central banks are very worried about the impacts of this latest disruption on the liquidity and stability of banking systems, which carry higher priorities for central banks than managing inflation, unemployment and growth through monetary policy.

On Friday, the Chair of the Federal Reserve (Fed) Board, Jerome Powell, reassured markets that “the coronavirus poses evolving risks to economic activity” and that the Fed “is closely monitoring developments and their implications for the economic outlook. We will use our tools and act as appropriate to support the economy.”

Powell’s statement on Friday came a day after the Bank of Korea assured that “it will judge whether to adjust the degree of monetary policy accommodation, while thoroughly assessing the severity of the COVID-19 outbreak, its impact on the domestic economy, and changes in financial stability including household debt growth.” No mention of interest rates, rather a generic reference to “monetary policy accommodation” and a focus on “financial stability.”

Governments, central banks and (bank) economists are universally assuming that this will be a short to medium term event while planning for the worst over a longer period. Now is a time for governments and individuals to undertake reasoned and disciplined risk management planning, not to panic.

Be prepared for the indirect consequences of COVID-19

The COVID-19 coronavirus has become the dominant global news story and the prime driver of financial markets’ sentiment, volatility and direction. Only recently, have some of the short and long term effects been examined. I’m writing about some of the potentially dire consequences yet to be mentioned in mainstream media.

For some time, media have been reporting the number of people in China in isolation (quarantine) by official order. People stuck indoors are unable to turn up to work or go out and spend. Factories in China are running at well below capacity, if at all. There is also a shortage of truck drivers, port workers and officials to process both exports out of and imports into China. All of this adds up to a threat to key global supply chains, manufacturing capacity and household consumption.

Not only is China the world’s most populous and number one export nation but it also supplies key components and ingredients to manufacturers around the world. Key food imports have become stuck at Chinese ports (e.g. US and European pork, US and South American poultry and Argentinian beef) or held back at the country of export (e.g. New Zealand and Australia crayfish). Other imported goods are also stuck in Chinese ports, e.g. logs. Exports from China are also stuck at Chinese ports and warehouses.

Prices of beef, coffee, corn, crayfish, logs/timber and dairy products have fallen since the outbreak of COVID-19, more so recently, as producers seek alternative markets or simply want to dispose of surplus inventory.

Car manufacturers, from South Korea to Europe and the UK, are reporting two to four weeks inventory of Chinese supplied components and parts that are essential for vehicle assembly. Sellers of electronic consumables in Asia, Europe and the US are warning about low inventory levels of key components. Shipping companies are experiencing a sharp drop in traffic and demand. Construction companies in New Zealand and Australia are warning about an inability to source building materials from China.

Worryingly, China is the world’s leading supplier of active pharmaceutical ingredients (API) used in the manufacture of pharmaceuticals. India, the world’s number one pharmaceutical manufacturer, sources more than 70% of its APIs from China, which together with China’s pharmaceutical exports means that China’s APIs feed into almost 45% of the world manufactured medicines.

More than 10 years ago, the then (and still current) Chairman of India’s Cipla, one the the world’s leading producers of APIs and generic pharmaceuticals warned that “if tomorrow China stopped supplying pharmaceutical ingredients, the worldwide pharmaceutical industry would collapse.” If anything, the pharmaceutical industry’s reliance on China has increased substantially since that warning was uttered.

The COVID-19 coronavirus, in itself, may or may not be as deadly as the SARS coronavirus but, in the 17 years since the SARS outbreak, China has become a global economic powerhouse, a key player in the global supply chain and a significant consumer. Not only has the world become a much more connected place, both personally and virtually, but it is also highly dependent on China for many essential products and trade. This gives the human response to COVID-19, rather than the virus itself, the potential to produce the greater global harm.

We can do without the latest car, phone, computer or television but, consider the potential life threatening implications of a shortage of antibiotics, anti depressants and pain killers.

Almost all of that human response is outside our control but it is up to us to assess and manage COVID-19’s risks to the personal, family and business aspects of our lives.

Just because you can doesn’t mean you should.

The US Constitution gives the President the power to forgive a federal crime. The Supreme Court has ruled that the President’s authority to grant pardons is unlimited. That authority also extends to commuting the sentence for a federal crime.

In the past week, Donald Trump granted full pardons to seven people and commutations to four others, all of whom committed their federal crimes some years ago. Like Presidents before him, both Republican and Democrat, Trump has used this power to benefit supporters, friends and friends of friends/supporters but for historical crimes.

Now the US media and Donald Trump are posturing about a pardon or commuting for just convicted Roger Stone, something that Trump has the power to do.

The US Constitution defines the three separate and independent branches of government – legislative (Congress), executive (President) and judicial (Supreme Court and Federal Courts). Each branch may influence, respond to and change some of the actions of the other branches through a constitutionally defined system of checks and balances.

It would be a shame, and a kick in the guts for the Constitution and the Judiciary, if Trump crossed the Constitution’s separation of powers with regard to Roger Stone so soon after the court’s sentencing was handed down because it smacks of interference in an independent judiciary.

The realist in me expects Trump to pardon Roger Stone after the November presidential election – whether he wins or loses. It is election year, after all. But the cynic in me expects an announcement much, much sooner.

Is history repeating?

A well known American politician, according to one of his biographers, Richard H. Rovere, was:
– “an essentially destructive force
– “a chronic opportunist
– “a political speculator
– “a Republican who had started as a Democrat
– “a fertile innovator, a first-rate organizer and galvanizer of mobs, a skilled manipulator of public opinion, and something like a genius at that essential American strategy: publicity
– “a vulgarian
– “a man with an almost aesthetic preference for untruth.”

Rovere also wrote that he:
– “faked it all and could not understand anyone who didn’t
– “made sages of screwballs and accused wise men of being fools
– was “the first American ever to be actively hated and feared by foreigners in large numbers
– “favoured the third person
– was “a great sophisticate in human relationships, as every demagogue must be. He knew a good deal about people’s fears and anxieties, and he was a superb juggler of them. But he was himself numb to the sensation he produced in others. He could not comprehend true outrage, true indignation, true anything.”

In summary, Rovere wrote, “if he was anything at all in the realm of ideas, principles, doctrines, he was a species of nihilist” and “the haters rallied around him.”

At a Senate hearing, a counsel said to him “you have, I think, sir, something of a genius for creating confusion — creating a turmoil in the hearts and minds of the country.”

His closest and longstanding advisor, in a book about him, wrote that he:
– was “impatient, overly aggressive, overly dramatic
– acted on impulse – tended to sensationalize the evidence he had”
– “would neglect to do important homework
– had an “inattention to detail
– was “gifted with a sense of political timing” and “on balance, his sense of what made drama and headlines was uncommonly good
– was “the first important public figure to touch an exquisitely sensitive nerve in the thought leaders of our society. This small but immensely powerful group of intellectuals.”

Who is the subject of Rovere’s biography? Senator Joseph McCarthy.

Rovere met Donald Trump in the early 1970s and quickly became Trump’s trusted adviser and one of the most important people in Trump’s life at that time.

There is a significant parallel and potential here but, as with much in life and history, “Time shall unfold what plighted cunning hides:Who cover faults, at last shame them derides” (William Shakespeare – King Lear)

Invaluable selfless actions matter but they are not measured and therefore are NOT VALUED

This morning, I was preparing to write on a different topic but got distracted by an interview on Radio NZ with Professor Sir Partha Dasgupta about ‘Putting a dollar value on biodiversity.’ So, I put aside what I was writing and started this post.

Among the many points made by Partha Dasgupta, a few struck me.

Societies, encouraged by governments and businesses, convert virgin land into other uses – agricultural, housing, industrial and infrastructural. This human activity has imposed a cost on the environment. As the population increases, so does that cost. We measure that activity, mainly through GDP, but we don’t measure the cost on humanity and the environment, nor do we measure or assess the initial value of the environment.

A fundamental tenet of Economics is that the individual behaves in that person’s best interests or, according to Dasgupta, each of us is an egoist. However, Dasgupta acknowledged that many of us make selfless decisions based on what he called “socially embedded preferences” that result in us taking a cut in our standard of living because that cut will be shared by others in our community or will create a legacy. The outcome of such selfless decisions is a drop in GDP and the measured collective wealth. Dasgupta talked about shared communal behaviour but he missed what, in my opinion, are two more significant selfless but related actions.

Yes, we all want to be better off but we feel a need to make a net positive impact on the world – on those around us, those to come and the environment. Some of that can be achieved through measurable outcomes, such as earning an income and accumulating savings to house, feed, clothe, educate and support ourselves and our whanau, and developing and applying technological solutions to environmental challenges. But an awful lot is achieved by actions and outcomes that cannot be measured.

How can you put an economic value on spending time with family, taking time to teach valuable life lessons to our rangatahi, our tamariki (e.g. how to ride a bike, how to cook, how to play safely in our rivers and the ocean and along the way learning vital skills of problem solving and critical thinking), and doing voluntary work whether in the community or within our own whanau?

Our government is attempting to measure these selfless actions with its Well Being Budget, which received considerable international attention and acclaim when released last year, enthusiasm that was unfortunately not shared domestically.

The younger generation are showing more care and urgency about nurturing the environment in the face of increasing evidence of the damage already done to the environment and climate change. Yet, leaders of the main industrialised nations refuse to resist pressures from industrialists and businesses or, in some prominent cases, publicly deny any damage or change.

None of this matters to financial markets because it cannot be defined or empirically valued or traded. Yet, these are intrinsic elements in defining the quality of life today, what we leave behind and what we have to fall back on in times of strife.

Most people will say that not everything important in life can have a financial value placed on it but, without some attempt to measure its financial value, we will continue to make decisions that ultimately make us all poorer.

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Have we really escaped the GFC?

The slowdown in global economic growth over the more than 10 years since the Global Financial Crisis (GFC) seems to have bottomed out. Sharemarkets (by definition, an indicator of future company cash flows and profits) have had a stellar 2019 and started 2020 in the same vein, much to the delight of investors. Given that most of us are (or should be) KiwiSaver investors, that is good news.

Yet, other key forward indicators are proclaiming the opposite. Prices for industrialised commodities (e.g. oil, iron ore, aluminium and copper), global bond yields and official (central bank) interest rates not only are below 2019’s peaks but also are well below their respective peaks since the GFC.

Many (including the writer) attribute rising sharemarkets to historically low funding costs as a result of low benchmark interest rates and credit spreads.

Low benchmark interest rates are the legacy of central banks’ vigorous monetary easing since the GFC, to avoid a repeat of the economic and geopolitical devastation after the 1929 sharemarkets’ crash, and the interest rate markets’ response to still sluggish economic growth and inflation.

Low credit spreads are the result of investors chasing yield in a low interest rate environment but, in doing so, they are lowering their risk tolerance. That, in itself, is another worrying sign that the financial community has leveraged its investments. Leverage is a useful business tool but too much leverage reeks of greed. And, unlike a Gordon Gekko, I believe that greed is anything but good.

I really hope that the messages from sharemarkets and credit spreads presage the future. But I am not hopeful, although I want to be for the sake of my family, especially future generations.

Over-enthusiastic sharemarkets and credit spreads were signs of greed that preceded the GFC and the crashes of 1987 and 1929, among others. Furthermore, bond yields have been a more consistent forward indicator than sharemarkets and, historically, the longer that bond yields and sharemarkets have proclaimed divergent outcomes, the more reliable has been the message from bond yields.

I do not know the future. No-one does! A prudent risk manager assesses all the risks in the context of risk preferences, objectives and the intimate relationship between risk and reward.

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