The Pain & Opportunity of a Dollar Squeeze

Global investment markets are becoming very macro driven and it’s pretty important to understand the big picture dynamics at play right now.  The US dollar is the key to everything and there has been a growing shortage of dollars throughout the global economy over the past few years which we’re now seeing create the usual pain.  Countries that run large current account deficits, meaning they need to import money to fund deficits (which usually means US dollars), are typically the first to feel this pain.  The usual suspects are countries like Turkey and South Africa. 

The reason there is a growing shortage is largely two-fold.  First, since 2014, the United States has gone from a huge importer of oil (which we pay for in US dollars) to pretty much balanced as we are now exporting so much energy.  And second, the Fed ended its QE program a couple years ago and is now reversing the process by slowly reducing its balance sheet at the same time that President Trump and Congress are making structural changes to fiscal policy by trying to reduce our trade deficit and lowering tax rates to repatriate foreign profits and invest in the US.  These add up to a significant reduction of US dollars being sent out to the world each month (flow) on top of a reduction of the existing supply (stock). 

The problem with this is that the US dollar is still the main reserve and trade based currency in the world.  Since most commodities are still priced in US dollars, countries need dollars in order to purchase the commodities needed to grow their economy.  For example, if India’s economy is growing at 6% per year, it needs at least 6% more US dollars than it did last year.  If those dollars aren’t available, mainly through credit, we choke off their ability to grow.

To make the problem worse, since 2009, Emerging Markets went on a US dollar denominated borrowing spree from the lure of low-interest rates.  If you borrow in US dollars, you need to repay the loan in US dollars.  And if the value of the US dollar rises between when you borrowed the money and when you have to repay it, the cost of repayment increases in your home currency terms.  The shortage of dollars is making it much tougher for foreign borrowers to “find” the US dollars needed and this is creating a short-squeeze of sorts on the dollar. 

Investment flows are just about the last source of US dollars for the rest of the world and these are typically called “hot money” because they can dry up and reverse instantly.  This is what we’re seeing at that moment.  Better economic conditions in the US are attracting investment flows into the US.  This is strengthening the dollar and boosting US asset returns relative to international, which just continues in a reflexive loop: greater outperformance attracts more money to the US, which lifts the US dollar, which improves US asset relative performance, and so on…

Just look at Turkey as an example of what can happen when you depend on US dollar inflows and they dry up.  The Turkish lira dropped 25% in two days last week and their government bonds dropped so far that the yield crossed over 20%!  Don’t be fooled by that high yield though – 20% does you no good when the currency drops by even more, creating a net loss on the investment.  The lira has bounced back nicely this week but I doubt we’ve seen the end of the pain.

US dollar (rising) vs. Turkish Lira – 1 year 

I think the markets are underestimating the length and severity of how far these trade tensions and tariffs will go.  The US and China are at the center of it as the two major players.  Politically speaking, neither side has a reason to back down.  The US thinks China will blink first because their economy is much more export reliant than ours (which I agree with).  If the tensions continue to ramp up, it should only add more fuel to this dollar rally and thus further pressure on foreign economies.  However, I see two results from these trade tensions, one positive and one negative for the US. 

The positive aspect is that reworking our trade agreements will be a net positive for the US economy (at the expense of other countries though).  The negative aspect is that we are accelerating the move away from the US dollar as the world’s main reserve currency.  This transition has been ongoing for a few years but we’re really seeing it pick up pace now.  The US has long used the dollar as a financial weapon (e.g. sanctions) so the more that other countries move away from the dollar, the less influence we have on them.  Click here for just one example that is the tip of the iceberg.  I think this makes the world and global economy more fragmented but will be very positive for most emerging markets, Asia especially, as it will allow them to grow without the typical once-a-decade financial crises caused by being tied to the US financial system, US interest rates and hot money flows. 

I recently wrote in my letter to clients that I’m hoping the US dollar continues to rally through the second half of 2018, as I currently expect that it will.  The more it climbs, the better.  I’m playing the long game which ultimately means we see a financial “reset” of sorts, a much weaker US dollar, stronger independent growth in the emerging market economies and substantial outperformance for emerging Asia over US investments.  So, the more the dollar rallies in the near-term, the better the long-term buying opportunity that is created.  After years of overweighting US, I’ve slowly been trimming exposure to US stocks lately and adding it to emerging Asia (click here for why).  However, I’m still expecting more trouble to come this fall and will be looking to do much more buying if and when that happens. 

Thanks for following!

-Nick

Emerging Market Stocks – 5 years

US Stocks (blue) vs Emerging Markets (black) since 2010