Rising dollar marks big investment shift ZZ# Stock
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Rising dollar marks big investment shift
By George Magnus
Industrial commodities and EM currencies will be under pressure
Investors have come to regard a weak US dollar as an essential part of the
low real rate, high capital flow backdrop for about a decade, but things are
starting to change.
The US dollar has had a spring in its step this year, with the dollar index,
a weighted composite of the dollar’s strength versus its trading partners,
rising almost 4 per cent. This is likely to be the “amuse-bouche” of a
more substantial meal of appreciation that could go on until 2015, marking a
big shift in the investment environment.
A change in US dollar direction would be important partly because it has
form. Since the collapse in 1971 of the Bretton Woods Agreement, a system of
fixed exchange rates, the US dollar has been through three downwaves (1968-
78, 1985-92, and 2001-11) and two upwaves (1978-85 and 1992-2001), with an
average duration of a little over seven years.
The first appreciation phase helped to bring down Latin America. The second
helped to bring down Asia. Despite several causes, a common factor in Asia
was the desire to keep currencies pegged to the US dollar, in spite of its
50 per cent rise against the Japanese yen. During both phases, commodity
prices in US dollar terms performed badly.
This time, with the yen falling and likely to drop considerably further, it
is much more likely that Asian countries will lean with the yen rather than
the US dollar. Policy regimes have changed, and respite from a weak US
dollar will allow local central banks to unwind monetary distortions created
by currency intervention funding mechanisms used to mitigate a weak US
currency. But a strong US dollar is also likely to be associated with more
unstable capital flows and a rise in inflation, leading to some reactive
tightening of monetary policy.
Emerging markets will also be highly sensitive to the slowing trend in
Chinese growth. The economy is still rumbling along at about 8 per cent, but
the irresistible forces of rebalancing and other discontinuities, including
those related to the environment, credit creation and public social policy,
point to slower growth over the next few years, one way or another.
At the very least, China’s growth is going to become less commodity-
intensive. This will have important effects on industrial and mining
commodity exporters and countries, which have profited in recent years from
the China effect on commodity prices.
Commodity and emerging market assets are not only US dollar- and China-
linked, but have also been the object of “financialisation” in recent
years, as banks created products for investors in response to the
proliferation of zero rates and quantitative easing in advanced economies.
“If US debt and the country’s ugly fiscal politics are a negative for the
US dollar, and US assets, as often claimed, the markets have a funny way of
showing it”
This puts the Federal Reserve on centre stage, even if its Japanese and
European counterparts look committed to further significant expansion of
their balance sheets. This is not to suggest any change in the Fed’s asset
purchases is imminent, especially as fiscal drag continues and the
unemployment rate still stands at 7.7 per cent. But the ground is starting
to shift, and with it, the US dollar.
The positive market reaction to the February employment report was
illustrative. But in addition to a pick-up in the hiring rate, housing and
construction activity is improving, and capital spending and exports are
both contributing more to gross domestic product growth.
Competitive edge is also beginning to return to the US. The current account
deficit is now a manageable 3 per cent of GDP. Exports of goods and services
have risen to a record 14 per cent of GDP, with good gains in advanced
manufacturing. Net energy imports are falling. And based on relative unit
labour costs, the US is now the most competitive country in the OECD, except
for South Korea, and making big gains against China.
If US debt and the country’s ugly fiscal politics are a negative for the US
dollar, and US assets, as often claimed, the markets have a funny way of
showing it.
This is not to deny the issue of debt sustainability issues from the end of
this decade onwards, or the capacity of politicians to upset financial
market sentiment. But for now, the US budget deficit is falling. At about 5
per cent of GDP in 2013, it will be half of what it was in 2008 and, given
current laws, double what it will be in 2015.
The contrasting economic and financial conditions of the US vis a vis Japan
and Europe could not be starker. The US dollar should be expected to trend
higher against most leading currencies, and put industrial commodities and
emerging market currencies and local debt under pressure. Some reversal of
the significant diversification away from the US dollar in the past decade
by asset managers, central banks and sovereign wealth funds appears
justified and probable.
George Magnus is an independent economist, and senior economic adviser to
UBS
By George Magnus
Industrial commodities and EM currencies will be under pressure
Investors have come to regard a weak US dollar as an essential part of the
low real rate, high capital flow backdrop for about a decade, but things are
starting to change.
The US dollar has had a spring in its step this year, with the dollar index,
a weighted composite of the dollar’s strength versus its trading partners,
rising almost 4 per cent. This is likely to be the “amuse-bouche” of a
more substantial meal of appreciation that could go on until 2015, marking a
big shift in the investment environment.
A change in US dollar direction would be important partly because it has
form. Since the collapse in 1971 of the Bretton Woods Agreement, a system of
fixed exchange rates, the US dollar has been through three downwaves (1968-
78, 1985-92, and 2001-11) and two upwaves (1978-85 and 1992-2001), with an
average duration of a little over seven years.
The first appreciation phase helped to bring down Latin America. The second
helped to bring down Asia. Despite several causes, a common factor in Asia
was the desire to keep currencies pegged to the US dollar, in spite of its
50 per cent rise against the Japanese yen. During both phases, commodity
prices in US dollar terms performed badly.
This time, with the yen falling and likely to drop considerably further, it
is much more likely that Asian countries will lean with the yen rather than
the US dollar. Policy regimes have changed, and respite from a weak US
dollar will allow local central banks to unwind monetary distortions created
by currency intervention funding mechanisms used to mitigate a weak US
currency. But a strong US dollar is also likely to be associated with more
unstable capital flows and a rise in inflation, leading to some reactive
tightening of monetary policy.
Emerging markets will also be highly sensitive to the slowing trend in
Chinese growth. The economy is still rumbling along at about 8 per cent, but
the irresistible forces of rebalancing and other discontinuities, including
those related to the environment, credit creation and public social policy,
point to slower growth over the next few years, one way or another.
At the very least, China’s growth is going to become less commodity-
intensive. This will have important effects on industrial and mining
commodity exporters and countries, which have profited in recent years from
the China effect on commodity prices.
Commodity and emerging market assets are not only US dollar- and China-
linked, but have also been the object of “financialisation” in recent
years, as banks created products for investors in response to the
proliferation of zero rates and quantitative easing in advanced economies.
“If US debt and the country’s ugly fiscal politics are a negative for the
US dollar, and US assets, as often claimed, the markets have a funny way of
showing it”
This puts the Federal Reserve on centre stage, even if its Japanese and
European counterparts look committed to further significant expansion of
their balance sheets. This is not to suggest any change in the Fed’s asset
purchases is imminent, especially as fiscal drag continues and the
unemployment rate still stands at 7.7 per cent. But the ground is starting
to shift, and with it, the US dollar.
The positive market reaction to the February employment report was
illustrative. But in addition to a pick-up in the hiring rate, housing and
construction activity is improving, and capital spending and exports are
both contributing more to gross domestic product growth.
Competitive edge is also beginning to return to the US. The current account
deficit is now a manageable 3 per cent of GDP. Exports of goods and services
have risen to a record 14 per cent of GDP, with good gains in advanced
manufacturing. Net energy imports are falling. And based on relative unit
labour costs, the US is now the most competitive country in the OECD, except
for South Korea, and making big gains against China.
If US debt and the country’s ugly fiscal politics are a negative for the US
dollar, and US assets, as often claimed, the markets have a funny way of
showing it.
This is not to deny the issue of debt sustainability issues from the end of
this decade onwards, or the capacity of politicians to upset financial
market sentiment. But for now, the US budget deficit is falling. At about 5
per cent of GDP in 2013, it will be half of what it was in 2008 and, given
current laws, double what it will be in 2015.
The contrasting economic and financial conditions of the US vis a vis Japan
and Europe could not be starker. The US dollar should be expected to trend
higher against most leading currencies, and put industrial commodities and
emerging market currencies and local debt under pressure. Some reversal of
the significant diversification away from the US dollar in the past decade
by asset managers, central banks and sovereign wealth funds appears
justified and probable.
George Magnus is an independent economist, and senior economic adviser to
UBS