A currency market warning

Martin Pelletier sees a threat to stability.

The consensus view at times tends to rub us the wrong way, especially whenever it appears investors are working backward to justify whatever action taken by the market.

More recently, we’ve become very worried about the rocketing U.S. dollar and the large sell-off in bonds rationalized as a foreteller of inflation on the premise of monster-sized fiscal policies by U.S. president-elect Donald Trump.

Suddenly, the global deflation trade has magically disappeared and equity market participants are welcoming the Federal Reserve’s upcoming rate hikes — something that would have sent markets crashing down in the past.

As a result, investors have been stampeding into inflation-beneficial sectors such as insurance companies and banks while dumping utilities and REITs. Specifically, since the U.S. election, Canadian banks are up on average 3.6 per cent, insurance companies are up 7.1 per cent, while utilities stocks and REITs are down 4.7 per cent and 2.6 per cent, respectively.

More troubling is that pundits and strategists are almost universally viewing the action in the bond market and the U.S. dollar as a positive sign for the global economy — we think it represents the greatest risk to its stability since the onset of the financial crisis in early 2008.

We are not alone in our worries as Central Banks in Japan, Mexico and Europe are quite terrified of their collapsing currencies with some reacting by announcing “unlimited” bond buying or increasing their overnight rates.

Whenever the bond and currency market tell you something, you better listen. In particular, we see three major risks from the ICE U.S. Dollar Index, which is up 28 per cent from its May 2014 lows and now at 13-year highs.

CAPITAL OUTFLOWS IN EMERGING MARKETS

Higher U.S. interest rates and collapsing local currencies — or the fear thereof — have caused capital flows out of China and other emerging markets, which makes it very difficult for them to fund fiscal or current account deficits.

For example, there has been a whopping US$400 billion to US$550 billion of capital leave China this year, according to Bloomberg estimates.

In total, emerging markets experienced US$739 billion of capital outflows last year as an immediate reaction to the U.S. dollar rally, according to a recent Reuters report. This is quite the reversal from the US$4.6 trillion of gross capital that flowed into emerging markets between 2009 and 2013, according to IMF data.

HIGHER U.S. DOLLAR DENOMINATED DEBT

Another serious issue is all of the dollar-denominated debt that has exploded higher globally, with over US$9.8 trillion at the end of Q2 2015, according to the Bank for International Settlements (BIS). Of this, emerging market economies account for US$4 trillion, double five years ago. These debt service payments have increased by 20 to 50 per cent in the past two-and-a-half years thanks to the rise in the dollar.

WEAKER CORPORATE EARNINGS

Finally, corporate America has become overreliant on cheap and readily available capital to financially engineer their growth through either share buybacks and/or mergers and acquisitions while organic growth rates have been abating at this late stage of the market cycle. Not only has their cost of debt now risen with the sell-off in the bond market, but organic growth rates will be impacted, especially for those with international operations.