Brexit, sterling and InterContinental Hotels Group (LN:IHG)

Early indicators after the UK vote to “Leave” the EU are already showing the country is dipping into recession.  Nevertheless, large-cap stocks in the UK have held up surprisingly well.

This can clearly be seen in the results just announced yesterday by IHG.  The fear of markets before Brexit about hotels had been that the post-recession cyclical upsurge in vacationing had just about run its course–and that, as a result, hotel profits were just about to peak/had already peaked.  But the figures from IHG were good and the stock rose by about 3% on the news.

To see how this can be, it’s important to note    that the post-Brexit decline in the fortunes of the UK has been expressed almost entirely in a 10%+ decline in the British currency.  This is an unexpected boon for British-based multinationals.

As Richard Solomons, the CEO of IHG, put it in yesterday’s report to shareholders:

“Note that whilst the UK comprises around 5% of our group revenues,

approximately 50% of our gross central overhead and

40% of Europe regional overhead are in sterling.

At 30 June 2016 exchange rates, approximately 70% of our debt is denominated in sterling.”

All of these figures are now 10% less in purchasing power terms than they were pre-Brexit.  Without any price changes, revenues will be 0.5% lower in dollar terms than they would have been.  But overheads will be down by much more.  In addition, the dollar value of the company’s debt is sliced by about $128 million.

This situation has two positive effects in the minds of UK investors:

–profits will likely be higher than anticipated, making the stock more attractive, and

–to the extent that a company like IHG, which has the lion’s share of revenues outside the UK, is affected by Brexit, the influence is likely to be positive.  This means that it can act as a way for British residents to preserve the purchasing power of their savings.


internal and external economic adjustment

This is ultimately about the euro and the EU.  Today’s post is about creating a framework for thinking about this issue.

It’s a condensed version of a longer post I wrote six years ago on Balance of Payments (actually, a series, for anyone who’s interested).   Although a big simplification of what is actually going on in the world, it highlights what I believe is a central structural issue facing the EU and Japan today   …and potentially the US, at some point.


imports and exports

The residents of any given country typically don’t consume only items made in that country.  They buy imported goods as well.  In fact, the marginal propensity to consume imports is normally higher than the marginal propensity to consume, meaning that as spending increases imports rise at a faster rate.

paying for imports

The country as a whole gets the money to pay for imports in one of a number of ways:  it can make things to sell to foreigners, it can use accumulated savings, it can sell assets to foreigners or it can borrow.


In an ideal world, every country would make and sell exactly enough goods and services through export to pay for the imports it purchases.  That’s seldom the case, however.

chronic deficit

Consider a country that, year after year, buys more from foreigners than it can pay for with the proceeds from what it sells.  To continue consuming foreign goods at the same rate, such a country has to either sell assets, like land or companies, or borrow from foreigners.  At some point, however, it will reach the limits either of what it has that others want to buy or the amount foreigners will lend.

This situation sets the stage for a potential foreign currency/trade/economic growth crisis.

internal/external adjustment

Here’s where we get to internal/external adjustment.

There are two ways of dealing with this issue:


–the government can slow down overall consumption (essentially, create a recession) by raising interest rates/taxes by enough to decrease consumption of foreign goods and services

–domestic industries can voluntarily restructure themselves, with/without government help, to improve quality and lower prices so they make more things foreigners will want (unlikely to happen on a large scale)

–the government can erect tariff or regulatory barriers to imports, to try to redirect consumption to domestic goods (almost always a bad idea:  look at the US auto industry since the mid-Seventies)

None of these actions are likely to win unanimous applause from voters.  And if legislative action produces negative results, it will be completely clear who is to blame.  So politicians everywhere, and particularly in badly-run countries, tend to not to want to choose any one of them.  Instead, they most often opt for the external adjustment route.


–This means to encourage or embrace a decline in the local currency versus that of trading partners.  That simultaneously makes foreign goods more expensive for locals and local goods cheaper for foreigners.  Devaluation will encourage exports and inhibit imports, achieving the same end as rising interest rates, but without the sticky legislative fingerprints attached.  It’s those horrible foreign exchange markets instead.


More tomorrow.







yen strength a minus for Abenomics

This time a year ago $1 bought about 120 yen.  That figure was 125+ last June.  The rate was 113, however, a week ago–and 108- today.

This amounts about a 10% year-on-year gain in the yen’s purchasing power against the dollar, half of that strength during the past week.

The rise is good for consumers for whom the cost of imported items like food has skyrocketed under the administration of Prime Minister Shinzo Abe.  Not so good, though, for Mr. Abe’s grand plan to resuscitate his country’s still moribund industrial sector through massive currency depreciation.

There’s no particular reason for the yen to strengthen that I can see.  Yes, Mr. Abe did recently observe that aggressive intervention in currency markets is an imprudent strategy.  And, yes, this is the time of year when corporate cash flows back into Japan causes mild currency strength.  But the Bank of Japan recently initiated a negative interest rate policy designed to weaken the yen.  And in my view there’s no sign yet that Mr. Abe’s bet-the-farm gamble on 1980s-era export industries is paying off.

Yet the currency is going up.

This may just be bad luck.

If we assume that the US dollar has peaked, then the question for short-term currency traders is which of the two remaining majors, the yen or the euro, is a better bet.  Given renewed uncertainty about Greece and the upcoming vote in the UK on a referendum to exit the EU, traders may think they have little choice other than to shift their holdings toward yen.

Still, the biggest economic problem for Japan–and the reason Japan is a cautionary tale for the US–is that the political power structure there is totally committed to defending the status quo and retarding structural change.  It’s subsidizing industries whose heyday was in the 1980s, and it’s allowing its workforce to shrink by its anti-immigration stance in the face of an aging domestic population.  A rising currency will only make the circle harder to square.



currency effects on US companies’ 1Q16 earnings

Over the past year or more, the international portion of the earnings results of US publicly traded companies has suffered from the strength of the US dollar.

Data dump:

-By and large, US products sold in foreign countries are priced in local currency.  When the dollar rises, the dollar value of foreign sales falls.  Speaking in the most general terms, firms can raise prices without damaging sales volumes only at the rate of local inflation, meaning that it can take quite a while for a US company to recoup a currency-driven loss through price increases.

-The rise in the dollar has come from two sources:

–the collapse of the currencies of emerging countries with unsound government finances and radically dependent on exports of natural resources like oil and base metals, and

–the greater strength of the US economy vs. trading partners like the EU and Japan.

-What appears on the income statement as a currency gain or loss is the result of a complex process with two components:  cash flows; and an adjustment of balance sheet asset values. There’s no easy way to figure out what the exact number will be.

-We do know, however, the very important fact that the dollar has been weakening against the euro and the yen for the past several months.  If the quarter were to end today, the euro would be 3.2% stronger vs. the dollar than at the end of 1Q15.  The yen is now 5% stronger than it was at the end of last March.  The Chinese renminbi is 5% weaker against the dollar than this time a year ago, but there’s much greater scope to raise prices in China.

My conclusion:  US companies with mainly and EU or Japanese assets/earnings will likely post modest foreign exchange gains during 1Q16 vs. large losses in 1Q15.

Hedging?  Many international  firms try, more or less successfully, to smooth their foreign earnings by hedging.  This activity is crucial for an exporter with long lead times, cosmetic for everyone else.  The key point, however, is that in my experience when hedging results in a gain, this is recognized in operating profit and companies say nothing.  When the hedging makes a loss, companies disclose the figure and argue that this is a non-recurring item.  For whatever reason, Wall Street usually ignores a loss of this type.

So, ex emerging markets, currency can be a significant positive surprise for internationally-oriented firms this quarter, instead of the earnings drag it has been in recent quarters.  My guess is that Wall Street hasn’t factored this likelihood into prices yet.





Shaping a Portfolio for 2016: currency and interest rates


Japan and the EU have tried over the past several years to jumpstart their economies through massive currency  depreciation.  This has resulted in a gigantic loss of national wealth in both regions.  It has also depressed the local standard of living by making dollar-denominated commodities–energy, food, metals, textiles–more expensive.

But the move has also revived industry, at least in the EU, by making end products cheaper.

Therefore, Europe could see substantial export-based growth in 2016.  As usual, I’m thinking that Japan is a lost cause.

interest rates

The US is alone among major countries of the world to have recovered far enough from the 2008-09 recession to begin to raise interest rates from their current intensive care lows.

The Fed Funds rate will most likely be be boosted to +0.25% next week.  And the benchmark will doubtless be raised again in 2016.  Nevertheless, the initial increases will probably have little, if any, negative effect on economic activity.

My guess is that we’ll exit 2016 with the Fed Funds rate at 1%.

At first blush, it would seem that by increasing interest rate differentials between the US and the rest of the world, the Fed would induce international fixed income investors to reposition their portfolios. Selling foreign bonds and buying US Treasuries would give them both higher interest income and the chance at a currency gain–since the flow of foreign funds into the US would imply further strength in the US$.

However, the Fed move has been widely telegraphed for an extended period of time.  We’ve already seen considerable struength in the US$ in 2015.  My guess is that most of the potential asset shift has already taken place in 2015.

So, I’m thinking that the Fed’s interest rate moves will be a non-event in both domestic economic and currency terms.

Tomorrow:  petrodollars

thinking about 2016: currencies

There’s no overall theory of how world currencies interact with one another.  Rather, there’s  patchwork of general relationships.  I find two most useful:

general creditworthiness, or would I lend money to these guys (WILMTTG)?.

Another way of asking the same question is whether a country can generate enough foreign exchange to pay for its imports and meet the minimum service requirements on its foreign borrowings.  A “No” answer means trouble.

Natural resources-oriented emerging countries, both in the Middle East and in Latin America, are going to flunk this test, suggesting that for them currency depreciation is in store.

relative interest rates 

Generally speaking, countries where interest rates are rising will have stronger currencies than those where rates are stable or falling.

This rule suggests that the US$ will continue to rise against the euro, yen renminbi and emerging markets currencies–meaning just about everything.


As a practical matter, domestic stock markets seem to work best when a currency is stable or depreciating slightly.  A rising currency, because it lowers the domestic currency value of foreign earnings, acts as an earnings headwind.


I’ve found that the currency markets–read: traders in the big multinational commercial banks–are always three or four steps ahead of me in figuring out where currencies are going.  For equity investors, there may also be an issue of how the companies whose stocks they hold are acting internally to hedge their foreign currency exposure.

Typically, this second isn’t as big an issue as it might seem at first.  Stock markets most often understand that hedges now protecting profits will soon expire and, in consequence, pretty much ignore the earnings per share generated by hedging.

The question of what’s already baked in the currency trading cake is a more serious one.  It has me questioning whether any interest rate rises that may come in the US next year aren’t already factored into today’s currency rates.

my conclusions

The US$ will be flat to up vs. all other currencies next year.

The yen will be down, on my “No!” answer to the WILMTTG question.

Emerging market currencies will generally be weak.

The renminbi will be flattish, on weak relative rates but “Yes to WILMTTG.

Too soon to act on, but will the euro be stronger in the second half?

stock market implications

All other things being equal, companies with costs in weak currencies and revenues in strong currencies will have the best financial results.

Multinational companies based in the US with exposure to natural resources emerging markets may do poorly.

Those with EU exposure may show slim growth, if any, in their operations there in the first half.  Better news in the second?

As a general rule, when the domestic currency is rising, look for purely domestic companies and for importers.


inflation on the rise?

Regular readers know that I like the economic work done by Jim Paulsen of Wells Capital, the Wells Fargo investment management arm.  His May 1st “Economic and Market Perspective” piece argues that the US has turned the corner on inflation, which will –contrary to consensus beliefs–be on the rise from now on.

His argument:

–the first signs of upward wage pressure in the US are now becoming visible (in developed economies, inflation is all about wages)

–recently, a rising dollar has kept the price of imported goods from rising (in some cases, they’ve been falling) and suppressed demand for US goods abroad.  That’s changing, turning the currency from a deflationary force into in inflationary one

–productivity is low, meaning that companies will have no way of offsetting higher wages other than to raise prices

–in past economic cycles, the Fed has somehow invariably remained too loose for too long.


I’m not 100% convinced that Paulsen is correct, and to be clear, he expects only mild inflation, but I’ll add another point to the list:

–although it doesn’t talk much about this any more, the Fed has clearly in mind the lost quarter-century in Japan, where on three separate occasions the government cut off a budding recovery by being too tight too soon.  In other words, there’s little to gain–and a lot to lose–by being aggressive on the money tightening trigger.


Suppose Jim is right.  What are the implications for stocks?  This is something we should at least be tossing around in our heads , so we can have a plan in mind for how to adjust our portfolios for a more inflationary environment.

My thoughts:

–inflation is really bad for bonds.  As an asset class, stocks benefit by default.  But bond-like stocks–that is, those with little growth and whose main attraction is their dividend yield–will be hurt by this resemblance.

–if the dollar is at or past its peak, it’s time to look for domestic-oriented stocks in the EU and euro earners in the US (the basic rule here is that we want to have revenues in the strong currency and costs in the weak).

–companies that can raise their prices, firms whose labor costs are a small percentage of the total, and consumer-oriented firms that are able to expand unit volumes without much capital investment should all do well.

–I think that average workers, not the affluent, are the main beneficiaries of a general rise in wages.  So firms that cater to them may be the best performers.