FUNDING DEFICITS FOR THE RESERVE CURRENCY 19 Jan 2021
There is a fundamental change underway to affect us all.
The pandemic has been occupying everyone’s thoughts and understandably so. It has changed a lot of things, the move to online buying and away from shops; the move to home cooking and away from restaurants, are two we are all aware of, but they are behavioural changes. Investors have been focussing on whether these human preferences will be reversed in post-pandemic normal times, or will they mark a perpetual change. That is one of the main questions in the investment world.
While investors have also been studying the personalities and policies of the two US Presidential candidates and now the move to a new Presidency, something more important and structural has been escaping attention. This concerns the huge deficits in the Western world due to the pandemic and especially the effect on the world’s Reserve Currency, the US Dollar. A Reserve Currency is seen as a ‘hard’ or ‘safe’ currency for international trade and investment and so it is held by central banks in their reserves. There has been a succession of Reserve Currencies over time, generally, that status lasts for 80 -120 years. It is a function of being the world’s dominant economic and political power. The UK had that role from around 1815 until just after the First World War when an exhausted Britain passed on the baton from the Pound to the Dollar.
So, what might suggest that the Dollar is coming to an end as the Reserve Currency? Three interrelated facts – China, Deficits and Funding. It is now estimated that China will overtake the USA as the top economic power by 2025. You cannot find alternatives to Chinese products in many trades.
To shorten supply line and onshore production is now a virtue but will not happen any time soon. This has enabled China to start to flex its muscles. Hong Kong is a good example. China takes a long-term view about its aspirations and acts differently from the West. In the 2008-9 Financial collapse, it overcame it with huge infrastructure investment, still going on today to make it more competitive. The US is fiddling about with $2,000 cheques to the populace, which just props up consumption. The US deficit is in Trillions of Dollars and going higher. It will soon reach 20% of US GDP.
The question is who is going to fund this borrowing? It cannot come from within the US, as personal debt is also at record levels. It must come from abroad and China has been a serious funder, until recently. China generates huge surpluses. In 2020, its exports rose 21% as it sold us all PPE and other necessities. But China is reducing its investment in US Treasury bonds – down from $1.25Tr to around $1Tr now. It is not just the reduction; it is a lack of new funding that hurts.
This at a time when the US is borrowing more. China is buying other currencies, such as the Yen, and working hard on a digital Yuan to boost its possibility of becoming a Reserve Currency. Now if you need to borrow abroad and are finding it difficult, then you will be forced to offer higher interest rates. In the US, as across the West, indebtedness is only serviceable with rock bottom rates, so the Federal Reserve will do anything to keep rates low. The natural result of this is twofold.
First, the Dollar will be a weak currency. Since the 2008-9 financial crisis, the Dollar has been strong as the rather anaemic recovery led the world to covet the safe Dollar. That situation has now started to change. Since the end of June, the Pound has risen from 1.23 Dollars to 1.36 today; a 10% gain. You might argue that this is the result of a Brexit deal, but you would be wrong. The Pound to the Euro has gone from 1.095 to 1.11 in the same period. A rise of 1.8% only. It is clearly the Dollar that has started to be weak and it will continue to be.
The second feature is inflation. When you devalue a currency, it is great for exporters, but bad for domestic inflation. Those old enough to remember can recall Harold Wilson’s famous sleight of hand when announcing a 14% Sterling devaluation in 1967. ‘’It does not mean that the Pound here in Britain, in your pocket or purse or in your bank has been devalued’’. No, the £1 note would be the same, but inflation would nibble away at its edges in terms of what you could buy! We could argue, who cares about deficits when the whole Western world has the same relative disadvantaged balance sheet.
Nevertheless, what happens when the Pound in your pocket is a Dollar and a Reserve Currency? As so much of the world’s commodities are traded in Dollars, their value must rise when measured in a depreciating currency.
Watch what is happening to oil prices (+33% since the end of June) and base metals such as copper (+37%). They are all rising just like a compensating see-saw and giving a view on the future. They are projecting that when the pandemic is over, world economies will be kickstarting together and commodities, where there has been little investment in capacity over the past decade, will be in short supply.
So how does this alter one’s investment perspective? We can draw a few conclusions. First, the average US consumer is going to have a tough time. How long will the Federal Reserve be able to hold low interest rates if inflation hits 3% or 4%? Secondly, UK businesses trading heavily in the US will face ‘headwinds’. High US earnings have been a big tick in the box for UK investors, but that should change. Analysts will comment on a constant currency basis, but it will mean less cashflow and less available for dividends, however, it is dressed up. Some of those sleepy domestic UK stocks such as utilities and food producers could be more attractive, particularly as the UK market is cheap against the rest of the world and is investable again. Money is flowing back now Brexit uncertainty has gone.
Commodities are suddenly starting a bull market after a 10-year bear. There are interesting possibilities here too. Gold and Silver remain a focus at times of uncertainty, but there is a wide range of industrial commodities where capacity will take a good while to increase.
This all suggests that we will see important structural changes to the way the world’s financial systems operate, with implications for all of us.