After years of the U.S. Federal Reserve’s (the “Fed”) economic experimentation with the U.S. economy, Quantitative Easing (“QE”) has come to an end as the Fed first initially signaled its consideration to taper in May 2013 and in December 2013 announced it would reduce bond buying by $10 billion a month. While further QE reductions “are not on a pre-set course”, applying a $10 billion reduction at each of the eight meetings scheduled for the Federal Open Market Committee (“FMOC”) in 2014 would neatly see QE end in December 2014. In order to calm markets, especially regarding interest rates, Mr. Bernanke tweaked the Fed’s forward guidance as to when interest rates might rise. A rise in interest rates was previously predicated when unemployment fell to 6.5% (it is currently 7%). The Fed’s view now is that any rise likely to be “well past the time that the unemployment rate declines below 6.5%, especially if projected inflation continues to run below the FMOC’s 2% longer-run goal”. By the time QE has run its course, by the end of 2014 the Fed balance sheet may approach $5 trillion. The challenge for the Fed to manage a $4 trillion to $5 trillion balance sheet is one thing, the impact of its actions on its balance sheet and the U.S. economy resulting from higher interest rates is another.
The current interest rate environment presents investors with an asymmetrical risk, as interest rates on bonds can go a lot higher than they can go lower. When Mr. Bernanke first flagged the Fed’s intent to taper bond purchases, to September the 10-year U.S. Treasury yield rose to over 3% from 1.6%. Since then, a flow of capital from emerging markets has resulted in increased demand and lower yields on U.S. Treasuries. As of this week, 10 year U.S. Treasuries yield 2.7%. Some analysts, such as Pat McClusky of Wells Fargo Advisors, believe the rally in U.S. Treasuries is over and profits should be taken. Mr. McClusky expects U.S. Treasuries to end the year at 3.5%.
While the current economy displays slower growth that expected, yields can be expected to remain low. However, with the Fed cutting bond purchases, the key as to whether interest rates may rise will increasingly depend upon the largest buyers of U.S. Treasuries, the Chinese, the Japanese and the Saudis. The Chinese are the largest buyers of U.S. Treasuries. With its economy increasingly under stress as a result of higher debt levels throughout the financial system, the People’s Bank of China (“PBoC”) may have less resources to make foreign purchases of U.S. Treasuries. The Chinese economy is in transition as the economy becomes more domestically driven versus export driven, increasing financial dislocations.
Japan is the second largest foreign buyer of U.S. Treasuries. The Bank of Japan (“BoJ”) is experiencing a economy where the country’s trade balance is negative, and the current account is expected to follow at some point, leaving less of a surplus to be recycled into U.S. Treasuries. The BoJ cannot afford to see yields rise in any material manner as the Japanese economy’s gross debt is more than double the economy’s gross domestic product (“GDP”). If the interest rates surge, the BoJ will be stress as will be the economy. A problem that Kyle Bass has discuss and which we have written about extensively in 2013. However, if rates rise materially, it is likely that much of the Japanese money that now goes to U.S. Treasuries would either stay in Japan or revert back to Japan shore up the local market.
An 80 basis points move from current levels would have significant impact on bond values. Should an increase occur investors will be significantly impacted. While it is not the time to liquidate fixed income holdings, as deflationary pressures remain persistent and interest rates remain below the 3% level for 10-year U.S. Treasuries, it is not the time to add to one’s fixed income portfolio. The attractiveness of solid dividend paying equities may provide a more attractive alternative with less investment risk. This is a period in time in which investment strategy is key to realizing attractive returns. (February/March 2014)
Jay Charles Goodgal, Comment:
Portfolio Allocation An improving U.S. current account position is having a significant impact on the attractiveness of U.S. equity and fixed income markets. The improving U.S. current account balance is increasing liquidity in the U.S. which is making its way into the equity and fixed income markets. Given the uncertainty of China and Japan to continue to finance U.S. government deficits, the improvement in the U.S. current account balance may enhance, if not offset, investment in U.S. assets by foreign investors.
Equity Markets Investors should maintain an overweighted position in U.S. equities, primarily the result of the U.S.’s improving energy balance (which is causing the current account deficit to move to a surplus). Additionally, investors should focus on fundamentally, extraordinarily cheap on non-U.S. assets. A case in point would be the best Asian firms versus European investments which appear over-priced/expensive.
We believe investors should overweight their portfolio allocations in the following sectors: -
Fixed Income In spite of the risk the global fixed income market may experience higher rates, resulting from geo-political risks, a rise in default risk, and an increase in rates resulting from central bankers slowing monetary accommodation, U.S. bonds are significantly undervalued compared to their German equivalents at a time when the U.S. current account is improving. Hence, U.S. bonds should be massively favored.
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Contributor: Charles Gave, GaveKal Dragonomics Research Limited (Reprinted [and Edited] with Permission) March 2014
The U.S. dollar is the world’s reserve currency which in simple terms means that the United States is the only country which can settle a foreign deficit by issuing its own money. As such, any “improvement” in the U.S. current account balance means that fewer dollars show up outside of the U.S., while the reverse holds true in the event of a deterioration.
Hence, a worsening U.S. current account deficit creates more global liquidity, while an “improvement” reduces the amount of liquid funds sloshing around the world. All international financial crises have occurred against the backdrop of an improving U.S. current account deficit.
It is noteworthy that this is only the third time since the start of the floating exchange rate system in 1971 that the US current account deficit has improved in the absence of a U.S. recession. The previous cases were 1988-1989 against the backdrop of German reunification and Japan’s bubble and during the 1997 Asian crisis. There were periods when the rest of the world was booming. This is not the case today, which implies that the improvement is due to an undervalued U.S. dollar. The simple fact is that the U.S. current account improvement has come on the back of a massive devaluation of the dollar which started in 2002.
In normal times, the financial flows that result from a U.S. current account deficit are used by the private sector to trade and invest worldwide – as such the U.S. current account is the primary source of working capital that countries use to trade with each other. Put another way, this deficit is the only source of “earned” foreign exchange reserves. Indeed, earning dollars through a trade surplus is somewhat analogous to having had a gold mine during the gold exchange standard.
If the U.S. current account deficit exceeds what private sector entities within reciprocal economies need for working capital, then part of this flow will move to reserves held by foreign central banks. And these reserves will be deposited back at the U.S. Federal Reserve (the “Fed”) to finance U.S. budget deficits. This circle of dependence was described by the French economist Jacques Rueff as the “imperial privilege”.
However, if the amounts generated by the U.S. current account are insufficient to meet overseas nations’ needs, then those economies will, as already outlined, be forced to either borrow dollars (not a long term solution), flog domestic assets or run down foreign exchange reserves. Hence, when central bank reserves deposited at the Fed are falling, we know that we are getting close to a “black swan” event, as dumping these precious “savings” is, for any country, always a desperate last resort.
This is the pattern which started to unfold last July 2013. But in the intervening period a most unusual pattern has unfolded. Central bank reserves held at the Fed (ex-China) have fallen, while the number is rising when China is included.
Question #1: The impact of the U.S. current account on financial markets Question #1: When have bear markets in the MSCI World index historically occurred?
Answer: When the U.S. current account is improving.
Hence, a reasonable deduction from the above is that we face the very real risk of a global equity bear market, although this is not a certainty.
Question #2: What geographical asset allocation should I hold when the U.S. current account improves?
Answer: Overweight U.S. financial assets. If the world outside of the U.S. faces a shortage of dollars, then one should be invested in the place with a concentration of enterprises that hold positive cash flows in dollars.
Equity Allocations The S&P 500 outperforms the MSCI EAFE index when the U.S. current account is improving. The same pattern holds for the ratio of total returns between the French and U.S. stock indices on a currency adjusted basis. This makes sense as an improving U.S. current account balance points to US companies being more competitive than foreign rivals and so gain market share.
Since the U.S.’s improving energy balance means that the overall current account is likely to keep improving, investors should maintain an overweight position in U.S. equities. Exceptions would be high quality non-U.S. assets which are extraordinarily cheap. A case in point would be the best Asian firms. The same argument does not hold true for Europe where the best quality firms are as expensive (sometimes more so) than the good quality U.S. firms. It appears poor quality Europe pose solvency risk.
Bond Allocations Over the long term, the returns of the U.S. and German bond markets are pretty much the same. However, today, U.S. bonds are significantly undervalued compared to their German equivalents at a time when the U.S. current account is improving. Hence, U.S. bonds should be massively favored.
Question #3: Where should I allocate my cash, if at all? This is another way of asking the direction of the U.S. dollar exchange rate?
Answer: In U.S. dollar cash. But why is the dollar so poorly valued given that the U.S. economy is not doing so badly? The answer lays in the monetary policy settings, or to be more precise, the pursuit of a zero interest rate policy.
When the Fed sets its headline policy rate below the inflation rate, it is in fact asking the rest of the world not to save in dollars. This breaches the last condition of any currency, that it should be a unit of account, a means of exchange and a store of value. This approach is central to good Keynesian theory which stipulates that the way out of economic stagnation and “over saving” is to pursue the “euthanasia of the rentier”. It also fits with the bigger beggar-thy-neighbor policy orientation that is typical of the Keynesian school.
Currencies ultimately return to a level dictated by their relative purchasing parity. What we don’t know is the timing. Will the dollar stabilize at its current level which is roughly around one standard deviation undervalued? That requires long term investors to stay put on the basis that one indeterminate day hence the unit will return to its correct level, and so compensate them for the absence of interest.
In the meantime, the low value of the dollar deters U.S. investors from investing overseas since they know that ultimately they will take a beating through the currency adjustment. Moreover, an undervalued dollar perpetuates the “improvement” in the U.S. current account balance, with all the nefarious consequences.
In short, we have created an environment where we have too many dollars in the U.S. and not enough outside. And this is potentially a very dangerous situation.