Greenback drifts downwards
Strengthening yuan complicates China growth
WITH the onset of September 2017, the US dollar’s slide intensifies.
The European Central Bank’s (ECB) upgrade of its growth forecast sends the euro up 0.8% to US$1.2007 in midday trading in New York on Sept 7, adding new uncertainty.
This reflected growing concerns that the US dollar fall – initially welcomed as a boost to US economic growth and corporate profits, is becoming more unpredictable as the pace of its decline continues. Since the start of 2017, the US dollar has fallen by more than 8% against its basket of currencies, according to the US Federal Reserve Bank (Fed). It has fallen for five straight months; it’s now at its lowest level in 2½ years.
Of late, growing doubts over whether the Fed will be able to raise interest rates, rising tensions with North Korea and the impact of harsh hurricanes have accelerated the pace of the US dollar decline.
All this in the face of continuing strong growth (GDP rose at an annualised 3% in 2Q17) and the concomitant surge in the value of the yuan, which has blindsided Wall Street and is complicating China’s efforts to simultaneously manage a “soft landing” in growth, while deepening its ties to global markets. The yuan has since risen to its strongest level in 16 months; having appreciated against US dollar by 7% so far in 2017, more than offsetting its fall in 2016. It soared 2% in August, its biggest monthly advance since July 2005.
Why US dollar so weak
To know where the US dollar will go next requires an understanding of why it has weakened so much.
Here’s my take. First, the stance of monetary policy. The Fed has been surprised by the continued weakness of inflation. Less urgency to fight inflation means less chance of higher bond yields and the capital inflows they attract. Expectations for a third interest rate hike this year is now less than 50:50.
Second, the strengthening euro is driving the US dollar down. Eurozone GDP has grown for 17 straight quarters (up 2.5% in 2Q17) and the euro – up 14% against US dollar this year – has dampened inflation so much so the ECB can be expected to start tapering soon, i.e. reducing its pace of bond buying.
Third, there is the politics: mainly failure of President Donald Trump to enact his legislative priorities. Unfinished tax reforms could yet weaken the US dollar – deep tax cuts that raise the budget deficit will have the reverse effect of getting the US dollar to fall further.
Fourth, the impact on big money flows. There had been large inflows into US over the past three to four years. Some US$1.5 trillion left China and Europe each, much of which went into US markets. Improvements in economic conditions in Europe and recent US dollar weakness are fuelling a rally in emerging market assets which will lead to reverse capital outflows. All four fronts are exerting pressure on the US dollar.
The strengthening of the yuan reflects, in my view, Beijing’s desire to:
(i) Reduce tension with the Trump administration which repeatedly accused China of deliberately keeping its currency weak; (ii) Deter large capital outflows; (iii) Promote policies designed to foster financial stability ahead of the Communist Party’s key meeting next month; and
(iv) Reduce excessive optimism on structural reforms.
The overarching objective is to keep credit flowing to spur growth as the economy begins to show signs of cooling again, in the face of growing challenges from anaemic private investment, heavy corporate debt and continuing industrial overcapacity to an out-of-balance housing market and exporters already feeling the yuan squeeze. China’s exports rose 5.5% in August from a year earlier, lower than July’s 7.2% rise.
Also, Beijing resumes efforts to make the yuan a freer, market driven currency by rolling back recent strict controls on money leaving China: viz. (a) ends deposits required on “currency forward” trades; (b) removes reserve requirement on foreign banks’ yuan deposits, thereby releasing more local funds into the off-shore yuan market in Hong Kong; and (c) introduces new guidelines to encourage Chinese M&A deals abroad, especially in technology. Obviously, the tough restrictions had worked.
China’s foreign reserves rose for a seventh straight month to US$3.092 trillion in August 2017. Its stock market has done well in the past few months. However, the bond market has turned cautious as reflected in the flattening of the yield curve – with the spread on Chinese 10-year government bonds at just 0.09 percentage point above the three-year paper – its flattest in three years. Attention now turns to China’s progress at reforms, subject to assessment at the party’s key fall meeting.
Stocks defy odds
It’s a fact of life that stock markets go up and down. Except in 2017. The three major stock market indices in US (SandP500), Europe (MSCI Europe) and Asia (MSCI AsiaPacific ex-Japan) have avoided pullbacks (i.e. a 5% fall from recent highs) so far this year. Indeed, never in the past 30 years have all three indices gone in one calendar year without falling at some point by at least 5% (the last time being a quarter-century ago in 1993).
Also, price volatility has been low (CBOE Volatility Index or VIX – the fear index, was at its lowest since 1993 in late July 2017). History suggests the stretch of calm won’t last. The SandP500 avoided a 5% or more pullback in only just five of the past 60 years. For now, the stock markets just won’t go down. Sure, there is logic in the market’s “madness”. But things can also turn quickly and when they do, I am afraid, the fall can be severe.
Are stocks overpriced? Conventional wisdom suggests they are; citing the most commonly used measure of high P/E ratios, i.e. relationship between stock prices (P) and their earnings (E). A June 2017 Bank of America Merrill Lynch survey indicated that 84% of investment managers felt US stocks are overvalued.
Going back to 1936, the average P/E of S&P500 stocks was 17; today, it’s around 24. Nobel laureate economist Robert J. Shiller modified the index for short-term distortions to arrive at a cyclically adjusted PE, averaging over 10 years of earnings adjusted for inflation.
The result was a frightening 30 – matching that on Black Tuesday in 1929 (but below the peak of 45 in 2000). Others have argued that stock prices are at a record for a reason. The often cited being the combination of low inflation, low unemployment and low interest rates. What then could cause a turn?
Rising interest rates are the most obvious vulnerability. Also, a run of weak data, or a “Trump bump” that calls into question the US economy’s staying power. Markets are not as yet crazy. But investors are surely giddy.
The weakening US dollar, on the whole, is good for emerging markets (EMs), especially in fuelling a rally in EM assets.
First, a falling US dollar makes EM’s US dollar debts cheaper to service, roll-over and repay. Moreover, international lenders are usually more willing to lend whenever the US dollar falls.
Second, the value of EM equities and bonds has surged. The MSCI Emerging Markets stock index has returned more than 30% so far this year (against 15% for developed market MSCI World Index, and 13% for MSCI USA). Net inflows into EM equity funds are up. Third, EM bonds (in local currencies) have returned 17%, compared with 10% for bonds in hard currencies.
Fourth, the economic outlook for EMs has brightened as the recovery in commodity prices has helped Brazil, Argentina, Nigeria and Russia climb out of recession.
Further, economic expansion in China and India as well as in Asean is set to remain robust. Since the late 1990s, EM equities and bonds usually outperformed when US dollar fell, and struggled when the greenback rallied. Fifth, low US dollar lending rates are benefitting EM borrowers. Yields on 10-year Treasury are now below 2.2% (2.5% at start of 2017).
Growth-inflation disconnect
Strange things happen in 2017. Growth’s constant companion is always inflation. Economics teaches that prices are set by supply and demand. When growth is strong, people demand and consume more and companies meet them by hiring more; and so prices rise.
Empirical studies have shown that strong growth eventually leads to inflation. This relationship appears to have broken in 2017. The US economy has been rising steadily since 2009 to reach an annualised 3% in 2Q17. Yet inflation rose only 1.7% in July from the previous year. Japan’s economy rose at an annualised 4% in 2Q17, its strongest expansion since 2006. Yet, inflation hovers around zero as it has been for the past 20 years.
Similarly, eurozone’s persistent low growth has led to inflation being stuck at around 1.5%. All this has serious implications for policy (as inflation is way below target, interest rates cannot rise to keep demand stable); as well as for investors to help them decide what to invest in. Bonds do well when interest rates fall because their prices rise. Falling interest rates traditionally are taken as reflective of concerns about growth.
So stocks and bonds typically cushion one another. Not so in 2017, and much of the post-crisis period since 2008/09. Indeed, stocks and bonds have been moving in the same direction. This year, the S&P500 has risen almost 10%, while 10-year Treasury prices have gained 6%, pushing the benchmark US bond yield down to near 2%, a level typically associated with financial distress rather than with rising growth.
Explanations for this disconnect between growth and inflation abound, including: (i) the economy isn’t as strong as the numbers suggest (according to ECB); (ii) long experience with low inflation leads to expectations of low inflation in the future (Fed); (iii) bond markets are giving out wrong signals about inflation because of persistent demand for safe debt arising from an ageing population, regulation, and central bank buying (UBS); (iv) structural changes such as globalisation (Dallas Fed), declining labour union power (BIS); and market power of large super-star firms which hold down consumer prices to grab market share.
Then, there is the impact of “disruptive technology” which keeps inflation down (Chicago Fed). So, even if growth and demand increases, prices need not. The new situation remains puzzling to policymakers and investors.
What then, are we to do
Deeper losses for the US dollar cannot be ruled out. But this hints of trouble ahead. Further US dollar weakness can threaten economic progress in Europe, where lack of jobs remains worrisome. Eurozone unemployment still stands at a high 9.1% (its lowest in eight years). Nearly one-half of unemployed has been jobless for at least a year (only 13% in US).
Elsewhere outside-US, a further drop in US dollar will rapidly push up other major currencies, putting pressure on China and Japan in particular which are counting on an uptick in foreign demand.
At home, it complicates the Fed’s monetary policy strategy. If the US dollar falls far enough, quickly enough, it could raise fears that inflation will accelerate beyond the moderate pace anticipated by policymakers and investors.
Overall, any slowdown in global growth will be a blow to EMs, which count on steady demand from the developed world to support their exports. In the end, I believe the US dollar will remain broadly stable towards year-end because of the Fed’s cautiousness.