Market Viewpoints

Summary

It’s no secret that President Donald Trump loves a weak US dollar and despite the interest rate cut on Wednesday by the US Federal Reserve, the US dollar didn’t weaken, but instead strengthened against the Euro. In my opinion the currency war may have just begun. One of the key promises Trump made to his voters was to bring manufacturing jobs back to America. According to Trump that involves two things – tariffs on imports coming into the US and keeping the US dollar weak to promote US exports. As we know, he is working on the first point already and is very likely to embark on the second one, despite his current denials. A currency war may not necessarily be a bad thing in the overall context of a world suffering from disinflation and low short term rates. It sure is better than a tariff war which leads to a reduction in trade and hence consumption and investments. A currency war can go catastrophically wrong when a country responds to another country’s devaluation of its currency, by imposing tariffs on exports from that country i.e. a currency war that leads to a full-fledged trade war and therefore a reduction in overall trade and economic activity.

Whether or not we will see another interest rate cut in the US later this year, monetary policy will remain on the easy path and the Fed will not raise rates anytime soon. This type of stimulus could eventually result in a bubble, but until the manufacturing and housing sectors stop weakening and inflation starts firming up, there is little to be worried about. If growth in China and the Eurozone trends up, helped by a stimulus in their respective economies, then the future is bright for corporate earnings.

The Currency war

The news this week that President Donald Trump decided not to intervene in the currency markets, to weaken the US dollar, doesn’t at all convince me that he won’t do so in the future. Trump not only held out the possibility that he could take action in the future by saying he hadn’t ruled anything out, “I could do that in two seconds if I wanted to,” adding, “I didn’t say I’m not going to do something.” It’s no secret that Trump loves a weak dollar and despite the interest rate cut on Wednesday by the US Federal Reserve, the US dollar didn’t weaken but instead strengthened against the Euro. In my opinion the currency war may have just begun.

Last week, the European Central Bank (ECB) decided it was ready to cut its already low deposit rate of -0.4% (2.65% below the US Fed Funds Rate) further. The ECB also hinted it was prepared to go further into negative territory. It’s only a matter of time therefore, before the currency war accelerates and becomes the talk of everyday news.

One of the key promises Trump made to his voters was to bring manufacturing jobs back to America. According to Trump that involves two things – tariffs on imports coming into the US and keeping the US dollar weak to promote US exports. As we know, he is already working on the first one and is very likely to embark on the second one despite his denials. He is already leaning on the US Federal Reserve (Fed) heavily in this respect. Earlier this week Trump tweeted – “A small rate cut is not enough” and went on to add – “The EU and China will further lower interest rates and pump money into their systems, making it much easier for their manufacturers to sell product. In the meantime, and with very low inflation, our Fed does nothing – and probably will do very little by comparison. Too bad!”

Over the last ten years the Euro has weakened against the US Dollar by a sizeable -25%, whereas the Chinese Yuan (CNY) has weakened by a mere -0.74%. This week, the Fed delivered a 25bps rate cut. No doubt a “small rate cut” in Trump’s view. The Fed further indicated it was not looking to cut rates further immediately. Meanwhile, the ECB is set to cut rates and embark on a new round of Quantitative Easing (QE) and The People’s Bank of China (PBoC) is getting ready to cut rates too, for the first time in four years.

The latest Fox News Poll shows Trump trailing the top Democratic Presidential contender Joe Biden by 10 points. This, despite Trump reaching the highest approval rating of his Presidency. Trump has promised to boost US GDP growth to +3% or more through his policies of tax cuts, deregulation and a tougher trade stance. The most recent data for the second-quarter of 2019 indicate that the US economy grew at +2.1%. That is down sharply from a +3.1% pace in the first quarter.

Should we be afraid of a currency war?

A currency war may not necessarily be a bad thing in the overall context of a world suffering from disinflation and short term rates. It sure is better than a tariff war which leads to a reduction in trade and hence consumption and investments. One country devaluing its currency spurs another to do the same by printing money i.e. it leads to a spate of monetary expansion and it may lead to higher inflation.

A currency war can go catastrophically wrong when a country responds to another country’s devaluation of its currency by imposing tariffs on exports from that country i.e. a currency war that leads to a full-fledged trade war and protectionism and therefore a reduction in overall trade and economic activity.

In September 1931, Great Britain abandoned the gold standard in a “competitive” devaluation and many other nations followed suit. Nations abandoning the gold standard embarked on the path of aggressive monetary and fiscal expansion and mounted an economic recovery. As the chart above shows, France and the US held on to gold standard longer and this delayed the economic recovery in those countries. This “currency war” cured the world of the Great Depression.

The Great Depression threw up many lessons and there’s one more important lesson to bear in mind. The misguided orthodoxy of monetary policy, then, particularly by France (and the US), made the Depression worse just as the orthodoxy of fiscal policy today by Germany is turning the Eurozone into a sick patient as growth keeps slowing down, unemployment remains high – whilst the ECB keeps lowering deposit rates further into negative territory.

The hoarding of gold by the Bank of France from 1927-32, although a very unfortunate event for the world – as it turned out was not without any basis. It had its origins in the terrible economic conditions that France endured from 1924-26. In 1925 the French Franc fell from 18 per dollar to 27 per dollar. By the following year, the Franc sank further to 49 per dollar, deficits soared and inflation rose to a peak of +346%. Between September 1924 and July 1926, France had ten Ministers of Finance and seven governments. The tide turned in what came to be known as the “Poincaré stabilisation.” On 23 July 1926, the right-centre government of Raymond Poincaré was sworn in. Poincaré served as his own Finance Minister and immediately went about reversing the course – higher taxes and lower spending. Poincaré cut the highest income tax rate from 60% to 30% and instead raised tax on consumption with the explicit aim of encouraging entrepreneurship and encouraging the French to repatriate capital they had parked abroad to escape from high taxes and the crisis of 1924-26. Poincaré’s policies produced the necessary change in expectations and the Franc recovered.

This hard-won stabilisation and the resolve to not repeat mistakes of the past, set a belief in French policymakers to prevent any return of inflation. Therefore when France started accumulating gold, it sterilized the inflows – which led to a contraction of the money supply in the gold standard system. France’s share of world gold reserves soared from 7% in 1926 to 27% in 1932 (chart below). By 1932, France held nearly as much gold as the US, although its economy was only about a fourth of the size. Together, the US and France staggeringly held more than 60% of the world’s monetary gold stock in 1932. As Economist Douglas Irwin put it – “if the United States and France had been monetizing the gold inflows that would have been playing by the “rules of the game” of the classical gold standard. Then the gold inflows would have led to a monetary expansion in those countries, just as the gold outflows from other countries led to a monetary contraction elsewhere. Both France and the United States were effectively sterilizing the inflows to ensure that they did not have an expansionary/inflationary effect.” The stockpiling drained everybody else of gold, and consequently made staying on the gold standard impossible. The US and France had to eventually abandon it as well, in order to reverse years of deflation.

Share of World Gold Reserves

Source: Douglas Irwin (2010), “Did France cause the great depression?”

British economist John Maynard Keynes could not resist this biting remark: “And, when the last gold bar in the world has been safely lodged in the Bank of France that will be the appropriate moment for the German Government to announce that one of their chemists has just perfected the technique for making the stuff at 6d. an ounce.”

Isn’t it fascinating we see the same orthodoxy in Europe this time albeit on the fiscal policy front with Germany the driving force? It just reminds you that history does repeat itself, only the characters are different.

Markets and the Economy

New British Prime Minister Boris Johnson has promised to negotiate a “do or die” Brexit deal and ensure the UK leaves the European Union (EU) by October 31. I am sure Johnson will live beyond Halloween even if he were to fail to deliver on his promise. However, what is not in doubt is that populism is here to stay. Not just in sound bites, but increasingly in actions on the ground. The Brexit Party, led by Nigel Farage, scored a stunning victory in the recently concluded election for the European Parliament. It’s not difficult to comprehend that if Boris Johnson were to fail in his endeavour to deliver a “clean Brexit”, his government would fall and the backlash could deliver a Brexit party government lead by Farage as Prime minister or indeed that of another populist Jeremy Corbyn heading a coalition of Labour, Liberal Democrats, Scottish Nationalist Party (SNP) and the Green party. The evidence on populism from France is, according to a recent survey, French military personnel are surging in numbers to support Marine Le Pen and the National Rally (RN). Things are not great in Germany either. Economic growth is down, manufacturing numbers are at seven years low (and getting worse) and unemployment is rising (albeit from a low base). Germany’s domestic intelligence agency estimates that there are now some 12,700 far-right activists in the country who are “ready to use violence.” Another reason for the mounting concern is the likelihood that far-right extremists have contrived to infiltrate the police, the armed forces and even the spy agencies in Germany.

Last week the ECB talked about “potential new asset purchases,” and a “rate cut”. i.e. everything is on the table for its September meeting.

Just a reminder that the balance sheet as a % of GDP stands at 18% for the Fed and a huge 40% for the ECB. Yet, the ECB wants to restart QE and buy more assets! What should worry savers in the Eurozone is that negative interest rates are not temporary – but are here to stay. This is financial repression and any hope of a turnaround for savers is now a mirage. The ECB’s deposit rate, already at -40bps, is likely to be cut more at its September meeting. So far negative deposit charges are being levied on deposits over €500k only and therefore the lack of a popular rebellion against such financial repression – but that may change.

What happens when the deposit rate is cut from -40bps now to say -80bps as things get worse? How long will banks resist and not charge their depositors and continue to bear the cost of the levy they have to pay on their own deposits at the ECB? Data indicate that Germans savers have parked just under € 2.5 trillion in checking accounts. With a current inflation rate of +1.6%, German savers are losing €40 billion in purchasing power every year. This is besides not making any money on deposits or in some cases paying for the privilege of keeping the money on deposit. At the press conference last week, Mario Draghi, the ECB President, warned that the picture is getting “worse and worse,” in the Eurozone.

Turning to the markets and taking a look at the performance numbers. The S&P 500 index (SPX) is still holding on to a stellar +20% return for the year. European equities are recovering too now that the ECB is back into an easing mode and doubling down on both rate cuts and additional QE. Nobody doubts that the incoming ECB President Christine Lagarde will follow an easy money policy path set by her predecessor. The question is – the Eurozone already has an easy money policy (rates -0.40%). How much easier does it have to get?

If the Eurozone’s challenges could be solved by rate cuts and/or bond-buying alone, then the bunting would be out and folks would be celebrating in the streets of Paris, Berlin, Madrid and Athens. The Eurozone has had near-zero or negative rates for 5 years now and things haven’t improved much (if any). However, one shouldn’t trade against the announced policies or intentions of a central bank. Therefore, if the ECB follows easy money policy as announced, one has no option but to buy European equities and particularly the Eurozone banks which will end up getting help from the ECB in the not so distant future.

Benchmark Equity Index Performance (Year-to-Date)

As the chart below, from analysts at JP Morgan, indicates the negative yield on bonds in the Eurozone is getting worse. Deutsche Bank research indicates that 43% of the global ex-US Investment Grade (IG) Index is trading at negative yields at the moment, up from 20% late last year. As if to underscore the point on negative yields, last month we learnt that Germany sold a new 10y German government bond (Bund) with no coupon. Think about it for a minute – a bond that pays NO coupon, and promises to return to the investor €100 in 10 years time is trading at €104.5 i.e. the investor is guaranteed to lose €4.5 on this investment. Of course, regulations and risk weightings mean that the pension funds in the Eurozone have no choice but to invest in these loss-making “safe assets.” Another way to look at it – Pension funds in the Eurozone are being robbed. If this continues (and the signs are it will), soon Pension funds will be meeting their pension commitments from capital rather than from returns on capital, as they should be doing. If you and I did it, we would be apprehended for running a Ponzi scheme. The longer the yields remain negative, the more Ponzi the whole thing becomes. The Eurozone needs urgent reform. We live in hope.

Whether we get another rate cut in the US later this year or not, monetary policy will remain on the easy path and the Fed will not raise rates anytime soon. Therefore, I feel very comfortable holding on to long US equity positions. This type of stimulus could eventually result in a bubble, but until the manufacturing and housing sectors stop weakening and inflation starts firming up, there is little to be worried about. If growth in China and the Eurozone trends up, helped by a stimulus in their respective economies, then the future is bright for corporate earnings.

I like to be long the cyclical sectors at this stage – Financials (XLF), Consumer Discretionary (XLP), Energy (XLE) and Industrials (XLI) in particular. Cyclical stocks have had a bit of a mixed run of late but have been outperforming since the end of May sell-off. Semiconductors have broken out to highs and are likely to continue heading higher. The fact that Industrial stocks have risen despite falling Purchasing Managers Index (PMI) numbers globally indicates that the global economy is bottoming out. Individual stocks in the Technology (XLK), Communication Services (XLC) and Materials (XLB) sectors also offer good upside. For specific stock recommendations, please do not hesitate to get in touch.

Here are few other statistics to bear in mind. If we take the time between the first rate cut and the next rate hike as a cycle, since 1982 there have been fourteen such cycles:

• Of the 14 cycles, only on three occasions, the SPX has had negative returns. The average annualized return for the SPX during those fourteen cycles has been +20% (median +13%)
• The length of the cycle on average was 571 days (longest 3,011 days, shortest 31 days, median 180 days)
• So if one were to take median data into account – then one would not expect a rate rise for at least 6 months (if not more) and by the time the rate rise comes the SPX would have risen to 3,360 or better (that is up +13% from current levels)
• After the 1995 Fed pause, it should be noted that Emerging Markets, as well as the Technology and Financials sectors were the biggest winners

Best wishes,

Manish Singh, CFA