Brexit

Brexit

Brexit. It’s all the rage these days. The word is whispered over candlelight glasses of wine in dark corners at swanky post-market-closeBrexit, Symbol of the Referendum UK vs EU cocktail bars. It is spit out over conference room tables amongst such phrases as “contingency planning” and “hedging strategies.” It has everything a news agency drools over, drama with the dark horse effect as the yes vote gains unexpected traction on the very last loop around the track.  It provides angry rants that skirt around xenophobia or at least a level of indignant nationalism that can generate eye-catching headlines. It paints the image of a battle of wills between the confident and worldly intellectual, gazing with vague annoyance over wire-rimmed glasses at the rough and tumble, calloused working man who is damn tired of those immigrants stealing jobs. It is a story filled with fear, hope, anger, frustration, isolation and unity.  Whatever version of the story attracts you the most, as an investor a “yes” vote for the UK to leave the European Union has two major impacts, currency and uncertainty.

Currency Effect

The currency effect means a stronger US dollar relative to the Euro and Pound Sterling. This would make american exports more expensive and imports relatively less expensive. The United States is the second largest exporter in the world, so when our exports become more expensive, that’s harder on everyone buying our stuff so it becomes a headwind to growth. With imports relatively less expensive, Americans are more likely to purchase an imported product than they otherwise would have been, which can also hurt american producers.

The currency effect can also be a problem for emerging markets where companies have issued unprecedented levels of debt denominated in US dollars. As the US dollar rises in value, that debt become more and more expensive, resulting in everything from reduced investment in growth to defaults which are further headwinds to global growth.

The currency effect can also have a secondary impact in its correlation with oil. With oil denominated primarily in dollars in the global marketplace, strengthening dollar means weaker oil prices. This can then affect the sovereign wealth funds from those oil-dependent nations as they are pressured to sell assets in order to pour more back into their domestic economies. This is a headwind to global asset prices.

Overall the currency effect is essentially deflationary for the US, which makes it more difficult for the Federal Reserve to return us to a more normal rate environment, prolonging the negative side effects from low-to-zero interest rates.

Uncertainty Effect

The uncertainty effect is all about the impact on companies. Although the word sounds easy enough, Brexit, short, simple and comfortably straightforward, the reality is no one really knows just how this darn thing will pan out! If there is in fact a yes vote, unthinkable a few weeks ago but now looking increasingly like it just might happen, no one is clear as to just how it would be implemented. Then there is the reality that the vast majority of politicians in the U.K., regardless of party, are all against a Brexit, so these folks will find themselves having to enact legislation based on a vote by their constituency that goes against what they believe is best; rock meet hard place.

With the realities of the actual implementation unknown, companies will be much less likely to invest which means less spending/less growth. There will be less M&A activity and the potential momentum of this vote with respect to rising nationalism is a further headwind to already falling levels of global trade which means even slower growth across the globe.

Brexit, the end of french kisses along the Thames?

Fed in a Rate Hike Corner

The Fed has trapped itself in a rate hike corner, having told the markets for nearly a year that the economy is doing great and it will need to raise rates, soon…very soon. Now there are signs of the economy weakening, other nations are devaluing their currencies and the U.S. is still stuck in ZIRP (Zero Interest Rate Policy). We’ve hit the point where the Fed must act or lose enormous credibility.

Yesterday was the biggest one-day decline in the Dow Jones Industrials Average since 2009 after the ECB provided less stimulus than was expected. This continued the decline that began with Janet Yellen’s testimony before Congress Wednesday, which left most market watchers thinking that a rate hike is all but assured. This morning we learned that private sector job growth for November came in above consensus expectations, which will have the market fairly convinced that a rate hike is all but assured. So what is this rate hike thing all about?

Why Do We Care About the Fed Rate Hike?

The rates set by the Fed act as the building blocks for all other interest rates, from the rates on your mortgage, to your auto loan, to rates of return on CDs and even corporate bond rates. When the Fed changes its rates, the rates on everything else move up or down with it as well. If the Fed does hike rates this month, for example, home mortgage rates will rise.  However, given that the Fed rate hike isn’t expected to be much, the increase will likely be minimal.

Why are super-low, zero rates a problem?

The problem with low rates is all about risk versus return. When the Fed pushes rates really low, it makes it hard to generate a reasonable return on savings. Right now this is particularly difficult for the nation given the baby boomers, the largest generation, are either in or about to enter retirement, when they need to generate income off their savings the most.

In order to deal with the low rates, investors are forced to take on more risk than they would otherwise.  You can think of risk as the likelihood of success. The higher the probability of success, the lower the demanded rate of return – no need to pay much to get people to invest in a nearly sure thing, but a really risky venture – now that takes a bigger promise of return to attract investors. So we have all these people needing to generate income from their retirement savings and they are being forced to take on more risk than they really should because interest rates are so low.

This has some major implications for the economy:

  • Some retirees/investors will refuse to take on excess risk. This means they have to live on less as their retirement cannot provide the kind of income that as reasonable to expect years ago. So they will spend less – that impacts the economy.
  • More “risky” investments are getting money than is normal. Risky investments by definition have a higher failure rate. This means we will have a higher failure rate in the economy, which means more money lost than is normal. This also impacts the economy. More money lost, less money to spend and invest in the future.

Fed in Danger!

The next problem is the Fed has presented itself as being able to jump start the economy. The first quantitative easing problem began in November 2008 – seven years ago! If the Fed hopes to have any credibility concerning its ability to affect the economy, at some point it has to be able to say, “Look, it worked. The economy can stand on its own now!”

The Fed also faces asymmetric risk in that if the economy strengthens, it has plenty of room to hike rates, but if it weakens, there isn’t much room to maneuver as there is no evidence that negative rates at a central bank are stimulative.

The Fed has also been telling the markets for over a year that the economy was just about, almost there, oh so close… to being ready to stand on its own without the super low rates to support it. Chairwoman Janet Yellen has been telling us that she needed to see table job growth…well, we’ve been seeing at least headline job growth. (The underlying reality of the quality of the jobs is another thing entirely.)  Once again, the Fed is facing a credibility problem if they don’t raise rates here after so much lip service.
Problem is, our domestic rates are effectively being raised when other central banks around the world lower their rates.  The ECB just lowered their primary rate to NEGATIVE 0.3%.  Yup, they now charge interest on the money banks leave with them… That’s like Wells Fargo charging ME for the money I have in a savings account with them. However, the ECB didn’t lower rates as much as was expected which has given Yellen and company a much needed reprieve! Since the ECB didn’t go as negative as was expected, the dollar index actually fell over 2% yesterday for its largest single day decline since 2009.

You can almost hear Draghi, “Here’s your chance Janet, if you are ever going to do it, do it now!” Want to bet that after the Fed raises this month, the ECB will lower rates again further?

Strong Dollar Implications

With the US raising rates while other major economies are lowering rates… some to even below zero, that makes the US dollar stronger and stronger.  Now this is fantastic for traveling as an American, but it is pure hell for American businesses that sell internationally. This means they sell less and will need to look to making more of their stuff outside the US where it is cheaper.

The strengthening dollar is also a major problem for emerging markets.  Earlier we talked about how investors needed to put money in riskier stuff than normal to try and generate any sort of reasonable return. One of the places they put money was in emerging markets.  Companies in these economies figured out that Americans were desperate for returns and they could get us to invest if they sold bonds denominated in US dollars.  Given that the dollar has been falling in value since the mid 1980s, with a brief upturn around the dotcom boom/bust, these companies were confident that they could issue in USD and lower rates than in their domestic currency, but wouldn’t likely have to worry about the exchange rate changing against them.

Ooops –the dollar has been strengthening significantly, which means those bonds are becoming insanely expensive for companies in emerging markets and many will end up defaulting. Ouch!  That hurts investors, but also isn’t likely to make us a whole lot more friends around the world. An argument can easily be made that we exported the pain we would have felt from all that quantitative easing to emerging markets and now they are paying the price for us! Not helpful at a time when the US is already struggling with its international relations.

China and Emerging Markets – A tale of QE

China and Emerging Markets – A tale of QE

This week I sat down with Erin Ade on RT’s Boom Bust to discuss what is happening in China and emerging markets and how it may affect U.S. investors as well as our domestic economy.

When the Federal Reserve began its Quantitative Easing Programs, many feared that it woul16d lead to high levels of inflation. Today, after three rounds of quantitative easing, we have very little evidence of domestic inflation and with the dollar gaining strength against most all other currencies in the world, we are actually facing some deflationary forces.

First, what is Quantitative Easing and why do people say it is all about “printing money?”

Quantitative Easing refers to the process shown below wherein (1) the Treasury Department sells Treasuries to Banks in return for cash to fund the annual deficit. This money is then spent by the federal government. Banks then turn around and sell the Treasuries to the Federal Reserve in return for cash. This cash is typically in the form of a “ credit”  in their reserve account, but for all practical purposes it can be thought of as cash since these reserves can then be used to loan money to businesses and individuals, who then effectively have cash in hand.

QuantitativeEasingPicture

 

So just how much of this did the Fed do?  The chart below from the Federal Reserves shows that it bought about $4.5 trillion dollars worth of Treasuries and mortgage-backed securities during the three rounds of quantitative easing.  To put that in context, that is over 25% of US GDP during that time.  With all that new money coming out into the economy, inflation was a very real concern, yet it didn’t happen.

2015-09-16 Fed Assets

So what did happen to all that “money printing?”  A lot of it went into emerging markets.

A recent working paper published by the Bank for International Settlements titled “Global dollar credit and carry trades” found that one of the unintended consequences of the Federal Reserve’s quantitative easing program, was the significant increase in issuance of dollar denominated corporate bonds by emerging market companies where the proceeds primarily fed into existing cash balances, a form of corporate dollar carry trade.  The paper cites a 2015 study that estimates that the outstanding USD-denominated debt of non-bank entities located outside the U.S was around $9.2 trillion at the end of September 2015, an over 50% increase from the beginning of 2010.

In an earlier post I pointed out just how much the USD has appreciated relative to most every other currency since the end of Quantitative Easing, making this carry trade increasingly untenable.  We’ve seen more and more slowing across the globe, with commodity-heavy countries like Australia, New Zealand and Canada, (who just reported that it is now in a recession after two quarters of negative GDP growth) engaging in pretty aggressive easing cycles, that will only further weaken their currencies relative to the dollar. What is even more concerning is that a rather large percentage of these firms are in mining, oil and gas sectors and we all know what has happened to prices for those commodities!  This means we have companies whose domestic currency is sliding further and further against the USD in sectors that have been utterly slammed, with outstanding USD denominated bonds, making those bonds more and more expensive every day – pushing an unwinding of this USD carry trade.  I suspect traders on Wall Street aren’t the only ones stocking up on Mylanta these days.

Our discussion begins at the 20 minute mark in the video below.

https://youtu.be/867G1p-Pfzg?t=18m17s