How Quantitative Tightening is Punishing Emerging Markets and Gold


The global synchronized growth story ended on September 2017 when the Federal Reserve announced an end to quantitative easing and an effort to normalize its balance sheet. With divergent Fed policy leading to a stronger dollar, and knock-on effects of that stronger dollar reverberating through emerging and precious metal markets, now is an exciting time for the global macro investor. The following is the situation I expect to continue to play out in global financial markets for the next several quarters—with a target date of Q2 2019. 

The situation is bearish for EM and gold while bullish for the USD and an already overvalued U.S. equity market. This scenario runs counter to the prevailing wisdom of many global macro investors that have run to EM and gold in the face of an overvalued U.S. equity market. If you are in this crowd—there may be more pain to come. Don’t shoot the messenger.

QT as a catalyst to dollar strength

Quantitative easing led to an explosion in the monetary base from $825 billion in 2007 to $2.9 trillion by the end of 2013 and during the heart of the QE program. Quantitative tightening, or allowing the bonds bought during quantitative easing to reach maturity, has the opposite effect. QT shrinks the global supply of dollars. Meanwhile, global demand for dollars remains the same. Global trade is largely conducted in dollars, with 64% of global central bank reserves held in the reserve currency. If a country increases its GDP by 4%, that means it needs 4% more dollars to buy oil, agriculture, base metals, etc. Decreasing supply with increasing demand leads to an increase in the value of the dollar. Until other global central banks hop on the QT train, or until the Federal Reserve tightens us into the next recession, the dollar should continue to strengthen while the EURO, YEN, ADXY, and EM currencies weaken.



EM to go lower

Countries that own dollar denominated debt (all of them) will have to make higher payments as their currencies weaken against the dollar and as interest rates rise in the U.S. Increased debt payments means they will find it harder to fuel growth through additional debt, leading to a slowdown in EM growth. Add global trade wars to the mix and it spells disaster for emerging markets. 

Case in point: Turkey. Turkey has an over-reliance on short-term foreign debt to the tune of $460 billion. The U.S. also placed tariffs on Turkish steel and aluminum due to the incarceration of a U.S. pastor in 2016. The Turkish lira has lost more than 40% of its value against the dollar this year. If the dollar continues to rally, rates continue to increase, and the U.S. continues its trade wars, expect more pain in China, Brazil, Japan, and Europe.

(As a side note, keep a close eye on Spain, France, and Italy, who own a combined $100+ billion of defaulting Turkish debt.)



Gold to go lower, then higher

The price of gold is inversely correlated to the value of the dollar. When the dollar loses value, investors seek to put their dollars in assets that serve as a store of value such as gold, commodities, and *mumbles under breath* bitcoin. While possible for the two to rise simultaneously (such as in the face of political risk), the dynamic is simply not there. I expect gold to rally in the next crisis, especially if it manifests itself in a currency war. Until then, expect gold to continue to fall.



Dollar strength begets dollar strength

As international currencies and stock markets weaken against the dollar and the S & P 500, international investors will flood to the U.S. The dynamic here is self-reinforcing: 1) dollar strength hurts international markets. 2) international investors run to the dollar. 3) dollar strengthens even further against international markets. 



Conclusion

I expect this dynamic to continue for the next 12-24 months. The catalyst for a reversal in this dynamic will likely be the next recession that forces the Federal Reserve to lower rates and increase its balance sheet once again. Until then, look for bargain opportunities in Gold and EM. Buy dollars if you haven’t already, and don’t sell your U.S. equities quite yet. Sell EM currencies and EM markets themselves if you favor a short-term orientation. 

The crisis in Turkey will invariably hurt Europe. The rallying dollar will invariably hurt China, Brazil, India, and other emerging market economies. The global macro investor and tactical asset allocator will reign supreme in the upcoming months. 

Sources:
https://www.nationalreview.com/corner/emerging-economies-dollar-denominated-debt/
https://www.thebalance.com/world-currency-3305931
http://www.atimes.com/could-turkey-trigger-the-next-global-financial-crisis/
https://tradingeconomics.com/united-states/capital-flows

Comments

Post a Comment

Popular posts from this blog

Chaos Theory and the Stock Market

Image
Are markets random in nature? Neoclassical economists have introduced theories such as the efficient market hypothesis and random walk theory that led to the contemporary passive investing boom. If the stock market returns were indeed random, they would follow a normal distribution. Trader turned author Nassim Taleb calls the application of the bell curve to financial markets “that great intellectual fraud,” and for good reason too. Firstly, the application of a normal distribution and its implied mean, variance, and standard deviation has had disastrous consequences because normal distributions underestimate actual risk in markets. Portfolio insurance in 1987 amplified that year’s flash crash and the implosion of the highly leveraged Long Term Capital Management in 1998 nearly crippled the global financial system. Both relied on underestimated standard deviation as a measure of risk. Secondly, empirical evidence shows that stock market returns do not follow a normal ...
Read more

On Dalio's "Paradigm Shifts" and the Second Act of Unconventional Monetary Policy

This post analyzes Ray Dalio’s recent article entitled “Paradigm Shifts.” Dalio is a global macro investor that I respect very much for his thoughtfulness and success. Unlike most SA articles or posts on this blog, what follows is more of a stream of consciousness than a structured thesis, point, counterpoint, and conclusion. “Every decade had its own distinctive characteristics, though within all decades there were long-lasting periods (e.g., 1 to 3 years) that had almost the exact opposite characteristics of what typified the decade.” What typified the last ten or so years? Extended stock market gains, global disinflation, stock buybacks, mergers and acquisitions, venture capital, the rise of passive investing, low real GDP growth, low volatility, Quantitative Easing/the expansion of the Fed balance sheet, artificially low interest rates, big tech, and reduced cost of labor.  Nearly all of these are related in one form or another. QE and low interest rates led to ...
Read more

The Petro-Yuan, One Belt One Road, and Chinese Economic Grand Strategy

In the global financial balance of power, China is on a collision course with the United States. Unlike the U.S.’s rapid ascension following World Wars I and II, China has taken a slow and methodical approach to surpass U.S. economic influence, mainly through subverting the dollar and creating trade links through the One Belt One Road initiative. The Chinese 30-year plan , with the ultimate goal of becoming a “global leader in terms of composite national strength and international influence,” demands that it challenge nearly a century of U.S. dominance. The question remains, will they choose to play within the western dominated global order or against it? Their deeds indicate the latter. The introduction of the petro-yuan, the One Belt One Road initiative, and smaller projects such as the recent peso-yuan trading facility are clear attempts to de-dollarize global trade and increase China’s economic sphere of influence. The Petro-Yuan In 1974 , President Nixon made an agreem...
Read more