When sifting through the winners and losers in what may still turn out to be the eye of the storm on the world's financial markets one of the most remarkable stand out features has been the strength of the dollar. Clearly the knee-jerk reaction from investors to ongoing concerns regarding the health of the world's financial system has been an apparently sharp reduction in risk appetite which has manifested itself in what might strangely be described as a "flight to quality" including short dated US Treasuries and the dollar.
But where do we go from here? A return to the aggressive equity bull market conditions of the past four years seems fanciful given the extent to which the derivatives market has lost face. With the likelihood that more bad news continues to seep out of the banks and other financial market operators, apparently attractive valuations may yet count for not very much in a more wary world.
Equally, it is not yet clear that this market-related event will have much, if any spill over into the real economy, with negative and lasting ramifications. The first data pertaining to the real economy in August is due from early September; it will be watched with more than usual interest as, by that time, the summer holidays will be over and industry practitioners will all be back at their desks. Ahead of that data views are polarising with regard to what it all might mean.
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"The downside risks to growth have increased appreciably"
So spake Federal Reserve Chairman Ben Bernanke as the world's most powerful central bank performed a dramatic volte-face over a mere two day period as it altered its risk bias and acted to stem rising crisis by cutting the discount rate by 0.5% point to 5.75%. The more significant (from the perspective of the real economy at least) Fed Funds Rate remained unchanged at 5.25% for now but continuing evidence that commercial banks are still unwilling to lend anything other than incredibly short dated money indicates that the central banks (including the ECB and Bank of England if necessary) must be prepared to countenance a steepening bond yield curve in order to help restore profitability to the banking system.
It is our strongly held belief that the Federal Reserve must do more than make a largely symbolic gesture by cutting the discount rate. It must cut the core Fed Funds rate aggressively and it must start doing so soon. We also suspect that real economy activity and confidence levels in Europe are taking so sufficient a beating that even the historically impervious Jean Claude Trichet may have to take notice. Furthermore, we suspect that the uneasy calm returning to equity markets at the end of the week may be as clear an indication as anyone might need that it is the pricing in of a Fed funds rate cut that is encouraging confidence in high beta sectors. The Fed dare not let the market down, thus seriously undermining its own credibility.
A conundrum for supporters of the global economy
Often we are told of the scope for the Asian economies to decouple from those of the West and the huge benefit to the long-term sustainability of the already prolonged global economic upturn. The argument, in the context of the past two weeks goes along the following lines: Hugely volatile financial markets do leave some collateral damage in the real economy but that it is insufficient to cause more than a growth pause in the West. The relative lack of severity encourages a gradual return of investor risk appetite including the return of the yen carry trade (which has been called into question in recent weeks) and concomitant recovery in investor interest in emerging markets.
However, central bankers remain concerned that the growth slow down does little to ease the apparently narrow output gap, raising fears that monetary policy may have to be tightened again to avoid a more widespread inflation problem reasserting itself from 2008. To many investors and, we suspect, central bankers schooled in the traditional boom / bust cycles of the past, the fear of rising inflationary pressure and consequent monetary response represents the single greatest threat to this period of prolonged economic prosperity.
The early stages of the physical manifestation of this view playing out are likely to be seen in the regions' currency markets. Specifically, investors should look for a period of renewed yen weakness and a recovery in the currencies of China and other satellite Asian countries including the New Zealand dollar as regional monetary policy continues to tighten.
This, it hardly needs saying, is not a particularly rosy picture. Sadly, the ensuing / alternative is far from rose tinted either.
Market turmoil adversely impacts US activity, and global activity only tangentially
Whilst it seems highly unlikely that the prolonged global expansion will turn into a "train wreck" just because of a crisis in the US residential property market, uncertainty is created by the knock-on effect of one domino falling on top of another or, as has been described elsewhere, a film of a train wreck in slow motion in which steadily but surely and with the same terrible inevitability a de-railed train carries a number of carriages with it. We have gone into what we see as the inevitability of a US growth slowdown in some detail in earlier Week In Preview articles and optimists believe that the strength of domestic demand in places such as the eurozone and Asia should be sufficient to ensure that growth in these regions is barely impacted.
Indeed, such is the nature of higher risk premiums and asset price volatility in one area that attention inevitably switches to other areas for alternatives. The implication here is that economies running significant and rising deficits (such as the US and UK) and which rely increasingly on ever more complex financial instruments to create demand from elsewhere to service those deficits are likely to be shunned in favour of those economies enjoying structural surpluses.
This has profound implications for the continuity of what we have earlier described as the delicate confluence of desires which has helped support the now ultra-long lived global economic upswing and for the currencies of those deficit nations as attention gets diverted elsewhere.
Already weighed down with reasons why not to continue financing the massive US (and growing UK) trade deficits, overseas central banks are hardly likely to view the spill-over effects from the US residential property markets favourably. Be aware that even if a sub-prime inspired US economic slowdown ensues, causing the US trade deficit to narrow, so uncompetitive are US exports likely to be (irrespective of dollar weakness) that the imbalance between what that country exports and what it imports is likely to remain sufficiently huge as to ensure the continuing need for overseas capital to prevent a slide into a full blown balance of payments crisis.
In this respect we see an important watershed moment as having been reached. As is the way with global economics, events tend to take a number of months rather than a number of hours or days. This slow paced change gives rise to a third deficit, an attention deficit, on the part of economic observers, which tends to result in significant long-term reserve allocation shifts being overlooked amidst the general blizzard of fast-moving short term economic data releases.
Whilst a pity, as important asset allocation decisions arise as a result, the slow paced nature of the transformation should at least provide long-term strategic investors with plenty of opportunities to take advantage of what we have for a long-time described as the dollar's date with destiny. Needless to say, we view the latest market turmoil as another pot hole in the currency's long and rutted road to crisis.
The dollar takes another step towards its inevitable destiny
Up until now, the reaction of the world's central banks to the financial market volatility has been unanimous. Huge amounts of additional liquidity have been freed up to prevent earlier speculative excesses de-railing the world's financial system. "Helicopter Ben" (As Ben Bernanke was once described to reflect his Friedmanite desire to head off a financial crisis by dropping bales of dollar bills out of helicopters) has joined his central bank counterparts elsewhere in opting to restore the markets' animal spirits by doing the financial market equivalent. In this instance, swapping increasingly worthless paper for hard dollars, euros, yen etc in the hope of creating short-term paper profits which can in turn form the basis for a revival in confidence.
As we have already mentioned, we view these attempts as failing and suspect that further aggressive action is likely to be needed to avoid increasingly critical investors crossing yet more items off their shopping list. The unavoidable concern is that once you've opted not to go for sub-prime, Alt A, other asset backed securities, low grade corporate bonds and high grade corporate bonds there aren't too many more items on the list before you get down to the bottom line, the dollar. (Investors might wonder whether interest in corporate bonds, agency bonds and emerging market debt might hold the line? Time will tell).
Whether the dollar represents rock bottom on the check list remains to be seen. The omens are not good. As an ultimate store of value the US currency's performance against gold and oil has hardly inspired over the past four years. Throw in the Fed's preparedness to create billions more dollars if necessary, a massive loss of confidence in some of the more esoteric, but previously hugely popular, corners of the financial markets, an economy which has become even more unstable as the sands of debt on which its foundations have been built shift again and personal debt which, per capita, is greater than that recorded by any other peoples in history and maybe what we are about to witness is a major turning point, the bottom line of which is a major and profound loss of confidence in the dollar itself.
By Jeremy Batstone-Carr, Director of Private Client Research at Charles Stanley
