The strength of the USD is not good for the world economy

The recent fall of stock markets triggered by the Chinese economic problems only confirms the slowness with which investors notice the consequences of long going macro trends.

I believe that the correction in August has finally broken the upward trend of stock exchanges and markets will unlikely be able to recover maximum values since an easy solution for the Chinese problems will not be found in the short term, and the instability coming from China and emerging economies will have significant global economic repercussions in the coming months.

At this point it is very likely that the underlying scenario will become even more complex and Central Banks will find it increasingly difficult to manage the situation. The Chinese peg with the USD could not have continued much longer and the devaluation was long overdue. In fact, in a context of constant contraction of Chinese economic growth and persistent deflationary pressures, the Renminbi (Yuan) has continued to appreciate against all other currencies because of the peg with the USD, placing China in serious trouble while all other developing and not developing countries where strongly devaluating against the USD. The devaluation was thus expected for some time and probably will not end here. However, the global currency situation is now becoming quite complicated as Europe and Japan would like a weak Euro and Yen and a strong USD, while Asia, China and Latam would need a weak USD.

As a matter of fact, the strength of the USD, as I highlighted in previous newsletters, is not good for the world economy because it will reduce the price of commodities, have a restrictive effect for all those who are indebted in USD (Asia and Latam) and accentuates the competitive devaluations of emerging countries that, by devaluing, export deflation in the world impairing reflationary policies. Therefore, if the USD continues to rise, China cannot hold the peg and revalue in a context of worldwide economic slowdown while Japan, Europe and Asia are devaluing. A stronger USD opens the way for further write-downs of the Renminbi and new instability for financial markets.

The bottom line is that the Chinese want to devalue at all costs since they have overly revalued while the whole world tries to pursue competitive devaluations and I order to do this they have only two options: 1) temporarily break the peg with the USD and cause a further phase of instability of world financial markets, 2) continue keeping the peg but at this point the USD should start to fall against all currencies dragging along the Chinese Yuan. I am inclined to believe that the USD ended its uptrend and is preparing for a turnaround that should bring it back to 1.20/1.25 vs the Euro and about 110/105 vs the JPY. The Bank of Japan has already hinted that it does not intend to make further writedowns of the JPY and the Chinese have made it clear to the US that they will not hold the peg if the USD continues to appreciate.

At this point it must be considered that some markets have been supported by the descent of the USD, while others were devastated by its force. In particular, the Euro and the Japanese asset classes have benefited from competitive devaluation and so, if the USD begins to weaken it will exert negative pressures on their stock markets of Japan and Europe. The Euro/USD Cross is extremely important for all carry trades which support activities in Euro and which were opened thanks to ECB’s QE, while the USD/ JPY Cross was crucial to the rise of the Nikkei. The markets that have suffered the greatest negative impact from the strength of the USD were Emerging Markets (both equity and bonds) and Commodities, which in case of a reversal of the strength of USD would have the greatest benefit.

Currently investors are extremely vulnerable to a reversal of the USD trend. All are very long on Europe and Japan (equity) and particularly bullish on USD, while all are selling all kinds of EM asset classes (FX, Credit and Equity). The current global asset allocation is very vulnerable to a weak USD and this is the main reason why the Chinese move has triggered a sharp sell-off on financial markets, which have found stability with the return of a strong USD, even though we know that this situation can hardly continue for long without other devaluations of the Rinmimbi and new phases of high volatility.

Since the strength of USD is benefitting only Europe and Japan, and since the Euro and JPY have already received their dose of competitive devaluation, it is very likely that at this point even the Chinese will want to tap into this “currency medicine” as all did in all last 18 months.
Therefore, in order to avoid further falls on financial markets, the US should allow China to keep the peg with a currency (the USD) that needs to scale down its recent revaluation or accept the Chinese devaluation, which will only accentuate the global deflationary pressures.
The investment strategy of Lemanik Global Strategy Fund is therefore aimed at taking advantage of these important forex scenarios that are emerging and that should significantly alter the behavior and trends of financial markets. In particular I expect in the coming months a strengthening Euro and JPY against the USD, a significant recovery of EM and Chinese asset classes, and a negative impact on the Eurostoxx and Nikkei following the correction of competitive devaluations (or a pronounced underperformance). As for the American stock market index (SPX 500) I do not see at the time the potential to recover the upward trend and I expect a period of lateral movement still characterized by some volatility in a broad trading range.

If the Fed decides to raise interest rates in this scenario, even though I do not see the conditions, the reaction immediately following it would still be a fall of the USD and a rise in Treasuries. The fundamental reason is that the US Central Bank is not in a position to initiate a monetary policy of rising interest rates in a continuous way and the likelihood that this adjustment could be a one and only case for a long time is quite high.

We have significantly reduced our short positions on the Canadian and Australian stock markets, but overall the underlying strategy remains negative for these stock markets, neutral on Europe and the US, positive on EM and China in line with the strategic vision on the currency front. The recent recovery of stock markets is still extremely vulnerable and exposed to significant backsliding to the low levels reached in August.

Monetary authorities, who have tried pushing increasingly on risk appetite, must now decide who and what to sacrifice for a potential return to stability: 1) protect and defend the Chinese peg pulling down the USD but sacrificing in part the policies pursued by ECB and BOJ, 2) safeguard the ECB and BOJ but sacrificing Asia, China and Emerging Markets to financial instability, with obvious repercussions for G3 markets.

Sometimes difficult choices take time to be implemented but the more time passes, the more they become inevitable and implicit costs are destined to rise.

Maurizio Novelli – Portfolio Manager – Lemanik