The Big Conversation
Episode 67: Dollar strength undermines the consensus
This week we look at the cracks that have been appearing across the financial landscape after only a small bounce in the US dollar. Many of these issues will be dismissed as one-off events, unconnected by geography or asset. But they could all stem from cheap and abundant dollar liquidity that is showing increasing signs of sensitivity to a small reversal in the fortunes of the dollar. Turkey and Brazil have recently shown their vulnerabilities and the problems of leverage within a family office all represent risks that are lurking under the bonnet.
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The last week has seen one of the biggest unwinds of leverage from a single firm, the family office Archegos since the blowup of Long Term Capital Management back in 1998, which along with the Russia crisis, helped erase 20% off the S&P500. The macro implications today appear far more muted than events back then, which required a coordinated bailout by the Fed and a consortium of banks. It might, however, have an impact on the availability of future leverage and the cost of capital within the shadow banking system, which has been providing liquidity in lieu of the major investment banks whose activities were curtailed by regulation after the Great Financial Crash.
And it's a reminder that apparently unconnected events are nearly always interlinked in today's financial system. The main repercussions are probably still ahead of us. In recent weeks, a number of cracks have also started to appear in the reflation narrative. In particular, a few seemingly idiosyncratic stories across emerging markets are beginning to paint a picture of a global economy that's not as robust as some asset price returns might suggest. These events could trigger much bigger corrections that end up having global implications, not least because they could force us to reevaluate the drivers of asset price performance since November of last year. In this week's Big Conversation, we'll be looking at some of the signs that consensus trades are coming under pressure.
Over the last few months, we talked about the difference between dollar-based reflation trades, where reflation assets perform well in response to a weaker dollar, versus the synchronized global growth reflation trade where the dollar is weak as a consequence of robust global growth. Now is the current reflation trade a reflection of underlying economic strength? But if it was, then why the emerging markets beginning to falter? Emerging markets are supposed to be a leveraged play on global growth, but the cracks are now appearing in places like Turkey appear to call into question this assumption. We can, of course, say that Turkey's injuries are self-inflicted, but the magnitude of the response across assets suggests that the backdrop has also shifted. Last week, Turkey's President Erdogan sacked the central bank governor after only four months, replacing him with an academic economist who's critical of rate increases. The lira immediately collapsed by almost 15% and is retesting its recent weakness after a tepid recovery over the last few days. 10-year lira bond yields surged 420 basis points towards 18%, with dollar denominated yields up 125 basis points to over 7%. The benchmark equity index fell 20%, one month deposit rates doubled to 35.5%, while Turkey's sovereign CDS surged 160 basis points. This turbulence is starting to spread to other emerging markets. Across that universe, stocks and bonds are breaking down. The ratio of the S&P500 versus the MSCI Emerging Market Index has now retraced over 50% of the EM outperformance since the highs of last year and is back at the levels of the vaccine announcement in early November 2020. So does this EM underperformance tell us something about the real state of the so-called reflation trade that's been driving markets for the last few months? Perhaps in reality this was just a U.S. relative value trade with the reflation impact of fiscal stimulus concentrated within the domestic shores rather than spreading out across the rest of the world. Now, whilst the US dollar was falling, emerging markets and commodities were beneficiaries, giving the impression that reflation was global. But now, after only a small rebound in the dollar, we can already see those vulnerabilities starting to reappear. What if the Euro positioning continued to reverse from current extremes? Historically, these have led to corrections of 10% or more in the Euro. After about a relative weakness, the dollar looks to be strengthening against a range of currencies. In fact, we can see how dollar weakness was mainly strength in just a few currencies, such as the Euro, the Yuan and the Aussie Dollar. And the dollar, when represented by the dollar index, which is 60% euro, has significantly underperformed the emerging market currency index, which is inverted here. Emerging market currencies never really caught the reflation bid. And the developed market currency that is now one to watch is the Japanese Yen. After a few years of relative yen strength versus the dollar, the yen is now weakening again and is testing a powerful trend line to the downside versus the US currency, which on a logged scale extends back 50 years. A stronger dollar means higher borrowing costs given that the large proportion of emerging market borrowing is done in dollars. The relationship with the dollar index against the ratio of the S&P versus the emerging markets makes it quite clear. Dollar strength today would put pressure on EM equities, which at the end of last year was the number one trade that people expected to outperform in 2021, favored by 50% of respondents, according to the Bank of America Investor Survey in November of last year. Dollar strength is deflationary, and it's very difficult to manage against a backdrop of unparalleled debt and speculative leverage. Toss in an epic mania in equities, derivatives trading, crypto currencies, and as we've seen with the problems that Archegos leverage, and it's easy to picture an environment that has significant risk behind the relatively calm exterior. Today, all eyes are focused on that leveraged speculative community, many of whom have driven the reflation trades with one-sided bets in commodities and the dollar. Popular emerging market and carry trades are taking body blows. Long short strategies have been hurt by out of control speculation, market dislocation and vicious short squeezes whilst various quant factor strategies have also suffered at the hands of anomalous market behavior. And despite trillions of dollars of monetary and fiscal support, there remains deep seated liquidity issues. The Treasury market, the ETF universe, corporate credit and derivatives are all liquidity accidents in the making, and all have been providing inklings of serious issues. And that gets to the heart of the problem with contemporary bubble finance. It works almost miraculously to the upside, but will quickly succumb to illiquidity, dislocation and crisis on the downside, requiring yet more rounds of central bank support. To the extent that we've seen de- risking in emerging markets, this will ultimately reduce global liquidity while stirring risk aversion. Vulnerability is systemic for EM and the entire world. Instability here could well feed problems in core countries. In Brazil, the local currency, 10-year yields are marching higher, gaining nearly 250 basis points in 2021, far outpacing the rise in U.S. yields. Brazil CDS has jumped 30 points this week to a five month high of 222 basis points. The Brazilian real's losses versus the US dollar in 2021 are close to 10%. The contagion is spreading to other parts of Latin America, where currency weakness is happening while rates are rising, which suggests that currency flight is starting to take hold. The problem in the emerging markets have been festering for a while now. And to go back to Turkey again, Turkish local currency yields spiked in the second half of 2018 just as global liquidity tightened and then again under similar circumstances in the summer of 2019. Yet each episode was followed by a further easing of monetary policies by the world's leading central banks, which led to outsized speculation in emerging markets and loosening of financial conditions in places like Turkey and EM generally. Hot money was moving to emerging markets in search of those higher yields. At the same time, a weaker dollar and low rates would encourage more borrowing in the US currency. In Turkey, for example, the country has around 140 billion of debt coming due over the next year, of which 44% is dollar denominated. But according to some economists, Turkey's total 2021 external financing requirements exceed 200 billion, which is in excess of 20% of GDP. The problem is that Turkey holds only 54 billion of international reserves, down from 81 billion at the end of 2019 and a peak of 113 billion back in 2014. The risk now is if the US dollar starts to catch a real bid, policymakers can tolerate a drifting dollar in either direction, but when the dollar rises rapidly, bad things happen. Right now, the US looks like an attractive destination for capital. Spreads between U.S. and German 10-year yields have reached a 12 month high, and this could suck in capital, driving the dollar higher. Turkey's one canary in the coal mine, the currencies of EM economies with the weakest balance sheets tended to lead the pack prior to the pandemic, especially when China stepped away from its 'growth at any cost' policies, as it again appears to be doing. From the middle of last year, reflation assets primary went up on a weak dollar. This was nicely self-fulfilling whilst the dollar was well behaved, but is already showing signs of trouble now that the U.S. dollar is bouncing. We've experienced this before. Consider some ominous parallels with the summer of 1998. During that time, the IMF, the Federal Reserve and global central banks had pulled the global system back from the 1997 Asian emerging market crisis. This time, it's the global pandemic. At the July 1998 highs, the S&P500 was up 22%, with U.S. bank stocks gaining better than 25%. Any indications of fledgling global instability were easily disregarded. Greenspan, Rubin and Summers were lauded as "The committee to save the world". The problems that had emerged in 1997 seemed on their way to resolution. Yet only weeks following those record highs, markets were caught incredibly unprepared for the Russia and Long Term Capital Management debacle. In response, the S&P500 dropped more than 20% and the banks sank by 40%. And all of this occurred in a space of less than three months. And now today looks like the fallout from Archegos will be contained because the bets were far more concentrated in specific stocks. But it may have implications for the leverage that's been deployed across the financial system, which may now have to be reduced, added to which in many parts of the world, global financial conditions have already begun to tighten. Chinese policymakers are seeking to rein back speculation, which has badly affected the stock market, although the benchmark indices are now bouncing off their 200 day moving average. While the tightening has been initiated with understandable cautiousness, the strength of China's economic recovery could provide Beijing with the confidence to switch support back to the banks and SOEs and away from the post-pandemic growth policies. Global economies are far more leveraged today than they were in 1998 or 2008. As a percentage of GDP, total global debt jumped to a record 355% from 320% in 2019. Risks from emerging markets may initially be hidden by speculative flows back into the US, which creates a sort of picture of stability. But if that fuels a further bid under the US dollar, it could create a disorderly rise, with Julian Brigden of MI2 Partners calls "the dollar napalm run" putting global assets at risk. Now this isn't the base case, but the dollar remains pivotal as a factor for portfolio performance. Currency volatility is denoted by Deutsche Bank's CVIX or CVIX remains towards the bottom of the five-year range. If the major risk is a broad-based surge in the level of the dollar, then investors should think about hedging against dollar strength, such as by buying puts on the euro as a partial hedge to a disorderly move in the currency. Policymakers will try to prevent such an outcome, but if events in Turkey are the canary in the dollar coal mine rather than an isolated political event, then a repatriation of capital and a flight to safety could once again become a significant headwind to global growth.