2019 will most likely be remembered as the beginning of the end of the biggest monetary experiment ever — the year that kicked off a global recession despite the lowest ever nominal and real interest rates in history.
Monetary policy has reached the end of a very long road and has proven a failure, according to Steen Jakobsen, Chief Economist and CIO, Saxo Bank.
Jakobsen says that in a global system of failed monetary policies and a long and difficult path to fiscal policy, there is only one other tool left in the box for the global economy and that is lower the price of global money itself: the US dollar:
“There is an estimated USD 240 trillion of debt in the world, roughly 240% of global GDP,” he says. “Far too much of this debt is denominated in US dollars due to the dollar’s role as reserve currency and the deep liquidity of the US capital markets. In this respect, the prospects for all asset classes become a function of US dollar liquidity and direction. If the dollar rises too much, the strain in the system increases: not only for US export, but also for the emerging market with its high dependence on USD funding and export machines.”
According to Jakobsen, weakening the Killer Dollar will likely put the final nail in the coffin of the grand credit cycle that started in the early 1980s, when the US balance sheet was reset, and the USD was anchored by Volcker’s victory over inflation after Nixon abandoned the gold standard in 1971. The grand cycle since then has been turbocharged by globalisation and by lending money into existence via offshore USD creation.
He adds: “A weaker USD can only buy us some time; it won’t offer a structural solution. It’s the easiest quick fix to what ails global markets, and the one with the least political resistance. The mighty dollar is set to tumble. But be careful what you wish for, USA.”
The end of US equity outperformance
In August 2019, the USD reached a high enough level for the US Treasury Secretary Steve Mnuchin to declare that the US government does not intend to intervene in the USD for now — although he also said that the Trump administration had weighed up intervention. In other words, the US is planning to intervene if the Fed does not manage to weaken the USD through monetary policy.
“Whenever the USD weakens equity markets should strengthen,” says Peter Garnry, Head of Equity Strategy at Saxo. “As the world’s reserve currency, largest trading currency and the currency used in commodity markets, the USD is an important component in financial conditions. Since the 2008 crash, emerging market countries have seen a large increase in issuance of USD bonds which has added another growth constraint from the USD.”
Garnry thinks that if we break the period into regimes of stronger or weaker real USD, a clear pattern appears. Whenever the USD strengthens, the US equity market outperforms the world ex-US and emerging markets and vice versa.
Some form of USD intervention is the next logical policy step. Monetary policy has lost its effectiveness and fiscal stimulus is coming to slowly to offset the weakness in the global economy (the OECD’s leading indicators have been declining for 18 straight months). A great irony of any USD intervention is that it will partly help China, which is not exactly the strategy of the Trump administration but as with everything in life there are always trade-offs.
In February 2019, equity markets celebrated the 10-year anniversary of the equity market bottom during the financial crisis. The celebration occurred with a historic equity outperformance over aggregate US government bonds of 339% or 16% annualised. This is one of the best 10-year periods for US equities relative to government bonds since 1973, only marginally topped by the dot-com peak. It is quite likely that the next 10 years will not offer attractive equity returns in terms of outperformance and especially not when factoring in the downside risk relative to upside risk.
Investors attempting to escape low yields with pure equity exposure are running portfolios that are at risk to policy mistakes and a potential global recession — which has a probability of around 25-40% within the next 6-12 months.