As we move into the summer of 2012, we once again find ourselves in a world of heightened asset price volatility, concerns over European governments and the Euro banking system as a whole, as well as clear economic slowing in the emerging economies. As you’ll remember, we lived with very similar concerns and circumstances during the summers of 2010 and 2011. Is it déjà vu all over again?
In this discussion I want to look at what I believe to be a very important topic receiving far too little attention in the mainstream financial media that happens to have direct bearing on short term investment decision making and outcomes. I want to discuss the role and importance of currencies and global capital flows in the current environment. Quick word of warning. For many of you this may seem incredibly simplistic. This is one of those discussions where I’m trying to address those that do not work in the investment industry and do not follow the financial markets on a constant basis.
One of the most important big picture issues in the current environment is to remember that we are in a completely interconnected world. Amidst a period of sovereign debt crisis (in Europe for now), it’s not just the reality of the interconnected physical global economies that is important in determining short to intermediate term broad asset class or specific asset price outcomes, but the nature of continually adjusting global currency cross rates as well as the actual movement of global capital flows also very much influences asset prices. A bit of a three dimensional chessboard? Yes.
Let’s start with important facts that we know. Physical US goods exports to Europe total just under $300 billion annually and account for about 2% of total US GDP. IF Euro exports were cut by a third, we’d be talking about maybe .7% of US GDP at risk. Not fun, but clearly not something to sink the entire economic ship by any means. Plus, I believe an assumed 33% decline in US exports to Europe would be a stretch. The “fiscal cliff” (tax increases and automatic Federal spending cuts) issues faced by the US specifically at year end 2012 are much larger in terms of potential impact on the domestic economy than is a marked decline in exports to Europe. So why all the volatility and market angst if the physical economic reality of the European goods export trade is manageable in terms of impact on the greater US economy? Not to minimize physical economic impacts, but the short answer is currencies and global capital flows. Let me explain through example.
Because we are more interconnected globally today than ever before, actual physical goods trade is only one part of the greater global economic story. The second key driver is the relative value of currencies. If the currency of a specific country weakens, academically it will cost them more to purchase global goods and services, perhaps driving a reduction in their import demand, and vice versa. Not a good thing for those countries exporting to the country whose currency has fallen. Relative currency values influence actual economic activity, hence they are very important to monitor and incorporate into investment decision-making.
As a very quick tangent, we all know that global central bankers have been printing money for years now. Certainly part of the motivation for this has been to dilute or weaken their own currencies as the goods and services of a country whose currency has weakened are now “cheaper” for buyers in the rest of the world, hopefully meaning more export opportunities. This is exactly how cross currency relationships and movements can influence the reality of global trade, to say nothing of the perceptions of investors.
So let’s go back to Europe. We know US exports to Europe are meaningful, but are not a sink the ship proposition for the US. Why the weakness in US financial markets amidst Euro specific turmoil? Below is a chart of the US dollar and the Euro. As you can see, they are virtual mirror images of each other.
Over the last year, the value of the dollar has increased approximately 13% while the Euro has declined in good part sparked by Euro government and banking sector debt problems. What this currency movement implies is that US dollar denominated goods and services are now 13% “more expensive” to Europeans and European goods and services are now “cheaper” for dollar denominated customers. If it becomes more expensive for Europeans to buy US products, perhaps US corporations that sell in Europe (as do all the large multinationals), will face lower earnings prospects. Has the relative movement of the dollar versus the Euro impacted investor perceptions? As you’ll note in the chart above, we have seen quite the drop in the Euro and rise in the dollar during May. This is the exact period over which US stocks have struggled. Relative currency movement is impacting investor perceptions of future US corporate earnings prospects.
The second very important currency impact for investment decision-making again spotlights the dollar. As the global reserve currency, the US dollar is vitally important in global commodity pricing and transactions. Given the reserve currency status of the dollar, global commodities are priced in dollars. As an example, before a global/non-dollar buyer of oil can transact the purchase of oil, that buyer must first have dollars. Over time, this has been a tremendous support for the dollar itself and has allowed the Fed a lot of cover to print money.
Given that commodities are priced in dollars globally, the relative value of the dollar impacts physical commodity prices. Here’s an example. If you are a global producer of oil and the dollar declines 10%, since oil is priced in dollars you’ve just lost 10% of your revenues. How does that producer counteract the reduction in their revenue that has been based solely on the US dollar currency movement? They raise their prices 10% to offset the currency value reduction. So, what we see very often in the global financial markets is that when the dollar falls, the price of oil rallies. When the dollar rallies, the price of oil falls. This relationship really applies to the vast majority of commodity prices and this is exactly why we see these relative price movements among currencies and physical and financial asset classes.
And what has happened in May of this year? The dollar has risen about 5% and the price of oil has fallen about 17%. Did the global supply and demand balance for oil change meaningfully in four short weeks? Of course not, but relative currency values did change and so did the price of oil. In investment decision-making, we need to look not only at the global physical reality of supply and demand economics, but also incorporate actual and anticipated relative currency movements.
At the outset of the discussion I mentioned a three-dimensional chessboard of important investment considerations that included physical economics (actual global trade), relative currency movements, and global capital flows. Let’s look at the last issue of global money movement and how it can impact prices and investment considerations specifically because of what is occurring right now in the global economy.
Again, lets start with what we do know. As a really big picture comment, during periods of sovereign/government debt crisis, global capital flows to the asset or currency offering the highest perception of safety and quality. At the moment that happens to be the US and the US dollar specifically. Is the US problem free? Far from it, but for now the weakest link in the global financial solvency chain is Europe. It’s all about relative safety and risk when it comes to how global capital moves at any point in time. Receiving far too little attention over the last few months has been meaningful capital outflows from the BRIC countries (Brazil, Russia, India and China). Euro area financial and economic problems are problems for the emerging economies that are heavily export dependent and commodity intensive. Europe in aggregate has been a very large customer of the emerging economies. The Euro area inclusive of the UK is China’s largest trading partner. As the Euro area weakens, that implies forward weakness for the export driven emerging nations and heightened economic risk. Hence, global capital is incrementally moving out of the BRIC countries as economic risk increases.
Secondly, and this is very meaningful, we have seen banking system runs in Europe. Greece was the frontrunner, but Spain and Italy are not too far behind. If bank solvency comes into question, depositors have a right to be concerned and they are voting with their feet in Europe by withdrawing money from these institutions.
So if we have capital leaving the BRIC countries and deposit runs on Euro area banks, to where is this global capital flowing? Below is a table that summarizes select country US Treasury purchases over the past year that I believe tells a very important story. Each month the US Treasury publishes global purchases of US financial assets. Remember, in a period of global sovereign debt crisis, capital FIRST moves to the immediate perception of safety and quality. What really are Treasury purchases by the foreign community? They are purchases of dollars. They are purchases of the perception of safety and quality.
The implications in the table appear pretty darn clear. The most troubled periphery Euro countries saw the most meaningful purchases of US Treasuries/dollars over the last year. Global capital flight to perceived quality and safety? If not, then what is this? Likewise the BRIC countries experiencing capital outflows are seeing simultaneous increases in UST/dollar purchases. Hopefully connecting a few spots on the three dimensional chessboard, global capital flows influence relative currency values. The table above tells us that US dollars are being bought and other foreign currencies are being sold as Treasuries are purchased by the foreign community. And remember, relative currency movements, as explained above, influence global corporate earnings, commodity prices, etc.
This is exactly the reason I’m suggesting that global capital flows during a period of sovereign debt distress are so important to incorporate into decision-making. In the multi-act drama that is a sovereign debt crisis, the first act is a move of global capital to perceived currency safety and quality, which is exactly what I believe we are seeing right now. It’s the implications of this move for the dollar that is the issue of the moment for investment decision-making near term. At least so far in the current cycle a higher dollar has been accompanied by what has become known as the “risk off trade” in financial markets, almost regardless of underlying and long-term asset class fundamentals.
As a final example, there has been incredible acceleration in Chinese physical gold purchases through Hong Kong over the last year. The numbers are truly off the charts relative to historical perspective. From a pure longer-term physical supply and demand standpoint, not much else could be as bullish. But the gold price as of late almost seems to ignore this new reality as it meanders. As such, it compels me to suggest that for now global capital flows and the perceptions of currency safety are in most cases (such as this) trumping the reality of longer-term fundamental supply and demand in the greater commodity price equation. The very same conceptual construct applies to the perceptions of corporate earnings strength. As stocks decline with a higher dollar, it’s not that they are now bad companies, but rather investors are attempting to price in how a stronger dollar will for a while make US corporate goods and services relatively more expensive from a global perspective. This will not be forever, but for now it’s an important construct to incorporate into our decision-making. All part of the really greater global sovereign debt drama playing out that necessary influences relative currency values and global capital flows..
I know this discussion has been a bit long winded, but hopefully important in getting across the key point that in today’s global economy and marketplace, it’s not just physical economics (supply and demand) that determine assets values. Relative currency movements and the ongoing movement of global capital clearly also influence asset prices. The important issue is to identify just which variables are primarily driving price at any point in time and successfully anticipating how these variables can change over time. The long term is all about the real economics of supply and demand as well as profits derived from real activity. Shorter term, we know currencies and capital flows enter the mix of ongoing perceptions and actual price movement. If we have a clear picture of how this three dimensional chessboard interacts, we can make more informed and less emotional decisions over time. We’re not in Kansas anymore, or in Karachi, Kazakhstan, Kopenhagen or Kuala Lumpur exclusively. Looks like Walt Disney had it right, it’s a small world after all.