HSBC says the dollar is peaking

HSBC (Hong Kong Shanghai Bank Corp) has begun to seek publicity for a research report arguing that the US dollar has peaked.  I’ve seen mention of it both in the FT and on Bloomberg (the link above).

HSBC is generally pretty good at economics, and has been ahead of the curve on major moves like this before.  So I think its argument is worth considering.  It also fits in with the way I’ve been thinking over the past few weeks.

The HSBC argument:

–the EU is starting to show economic strength as the US is beginning to slow a bit

–on purchasing power measures, the US$ is more overvalued than everything except the Swiss franc

–the Fed is reaching the end of its tolerance for dollar strength

–sentiment is universally bullish for the dollar (i.e., where are new buyers going to come from?)

–the dollar typically weakens after the first Fed Funds rate hike.

 

Risks to the view are mainly geopolitical:

–Greece exits the euro

–emerging markets crisis

–perceived failure of Abenomics

–US legislation forcing American companies to repatriate foreign cash holdings.

 

my take

I don;t know David Bloom, HSBC’s chief currency strategist and the report’s author, personally.  But I see his work as another piece of evidence that the pro-dollar consensus is beginning to crack and that at least a mild reversal of form is likely sooner rather than later.

 

 

a dollar shortage?

response to a reader’s question

A reader asked me to comment on this post on the Zero Hedge website about a potential US$ funding shortage.  The post was sparked by (is a rehash of) this recent commentary by JP Morgan’s currency strategist.

Let’s be clear that this is not my area of expertise.

Nevertheless, here goes:

the blogger

The Zero Hedge post, following the JP Morgan piece, observes that it has become unusually expensive to buy large amounts of US dollars.  The last time this happened was just as Lehman was failing, signalling serious problems with the world financial system.

The post author concludes that because dollars are again pricy we’re warming up for another round of severe banking problems.

JP Morgan

I don’t think the blogger is correct.  It seems to me he’s mixing up cause and effect.  Also, this is not what JP Morgan is saying.

history

Back in 2008-09, the main issue  was counterparty risk.

Bear Stearns, whose financial statements showed assets–mainly bonds, loan participations…worth about $80 ended up bankrupt, with those “assets” really worth close to nothing.  Lehman’s value was coming under similar questioning.

The conclusion the financial markets drew was that maybe all the banks’ financials were similarly not worth the paper they were written on–and that therefore anyone you lent money to, even for a few days or weeks, might go under before you were repaid.  So the wisest–and only–course was to lend to no one.   The world financial system froze up.

An important leading indicator of this mess was the increasing cost of borrowing dollars to finance trade.

today

Today’s situation is very different.  Two factors are involved in the current high cost of finding dollars:

–it’s cheaper to borrow in euros, hedge currency exposure and convert the loan proceeds into dollars than it is to borrow directly in dollars. (Similarly, in recent years it’s been cheaper for a Mets fan to fly to San Francisco to see the Mets play there than buy a premium seat at Citi Field.) Enough American corporations are doing so to dramaically up the cost of obtaining dollars.  They will presumably continue to do so until do so until this arbitrage makes no sense.

–today’s carry trade is sell euros (or just about any other currency)/buy dollars.

my conclusion

Today’s situation, unusual as it is in post-WWII history, doesn’t signal the onset of a new banking crisis.  Rather, it’s a function of differences in central bank monetary policy between the US and EU caused by differences in the relative economic health of  the two areas.

an aside

JP Morgan mentions one thing for which it has no hard information but that may prove important.

The corporate borrowing situation described a few lines above makes no net impact (in theory, anyway) on the fx value of the euro.  The currency hedging contract exactly offsets the effect of the purchase of dollars.

Suppose, though, US companies aren’t hedging.    After all, multinationals have tons of money in overseas banks and lots of physical assets in foreign countries.  Currency losses on both are currently ripping gaping holes in firms’ income statements.  Companies might consider that having, say, euro-denominated liabilities would neutralize some of the damage (I feel confident that the JPM strategist has either made, sat in on, or at least heard about, financing pitches arguing US companies should do precisely this).

If so, their dollar-buying isn’t  being offest by hedging contracts and  is putting upward pressure on the US$.

equity implications

If so, once converting euros into dollars becomes expensive enough, US companies will presumably stop doing it.  This could cause a significant bounce in the euro.  This would likely switch European stock market preferences away from dollar earners toward (beaten down) domestic issues.

 

 

the euro, the US$ and the Swiss franc

With the beginning of quantitative easing by the European Central Bank, the euro has slipped against the USD by about another 3% today to a value of 1 € = US$1.12.  That’s a decline in the euro of about 7.5% just since January 1st.  The EU currency has tumbled by more than 14% vs. the greenback over the past year, and by almost 20% since its high of $1.39+ last May.

This is an astounding fall for the world’s second most important currency.  It’s an enormous boost for EU-based enterprise overall and for exporters in particular–as well as a huge burden for their hard currency-based rivals. It would also be a mind-boggling loss of national wealth for EU citizens, were it not that Japan has depreciated the yen by a third over the past few years in a bid to regain global relevance for its manufacturing base.

Enough of this.   Down to brass tacks:

the euro/dollar

The income statements of US companies with EU exposure will be savaged by the currency decline.  Yes, in theory they may be able to raise prices to recover some of their depreciation-created losses.  But the general rule in this situation is that prices can only go up in line with overall inflation–which is non-existent in the EU at the moment.

My strong feeling is that Wall Street hasn’t fully worked this out yet.  So combing through our holdings to find euro victims should be a high priority for each of us.

the euro/Swiss franc (CHF)

The CHF has gained almost 25% against the euro since the Swiss central bank depegged its currency from the euro a little more than a week ago.  The speed of the move clearly shows what should have been apparent over the past year of euro depreciation–that the Swiss government was trying to maintain a peg that was miles away from where the cross rate would be without constant economy-distorting intervention.

We know this sort of thing can’t last.  If the forty-year history of floating exchange rates shows anything it’s that trying to maintain an artificial exchange rate always ends in disaster.  Yet what continues to come out in the press post-depegging is that:

–lots of EU property owners had decided it was a great idea to take out a CHF-denominated mortgage on their homes.  Short-term rates were negative, after all.  Ouch!

–a number of commodities brokers are in serious financial trouble because they allowed individual clients to build up short-CHF positions on margin that were so big there’s no chance they’ll ever be able to repay the losses they’ve incurred.

–there’s been a parade of currency trader departures from hedge funds caught out by the same short-CHF bet.

I guess this just shows that P T Barnum was right–that despite the examples of the collapse of the pre-euro Exchange Rate Mechanism in the early 1990s, the Asian debt crisis later in that decade and all of the problems with one-size-fits-all Eurobonds, there are still tons of people willing to take what history shows is the losing side of a wager.

 

 

the shrinking euro (and yen)

the shrinking euro

This time a year ago, it cost $1.36 to buy a euro.  It was $1.39 by March.   The euro then moved sideways vs. the greenback until early summer–when it began an almost continual descent that has the EU currency now trading at just above $1.19.  That figure is down 14% from the 2014 high, and off 12.5% from the year-ago level.

reasons?  

The surprising revelation last summer that the overall EU economy was slowing, not accelerating as most observers, myself included, had expected is the most important, I think.  Sanctions against Russia and recent worries that a new Greek government might repudiate its sovereign debt have just added to the funk.

The Japanese yen has tracked more or less the same course vs. the dollar as the euro–meaning that neither Japan nor the EU has gained/lost competitiveness vs. its main global manufacturing rival.

Looking at the situation from a more conceptual level, both Japan and the EU have relatively old populations and both give much higher priority to preserving their traditional social order than to achieving economic progress.  Neither characteristic argues for long-term economic/currency strength.

consequences

economic

In the short run, currency declines stimulate overall economic activity.  They also rearrange growth to favor exporters, import-competing industries and service industries like tourism.  This means that local currency profits for firms that have their costs in euros and revenues in harder currencies will likely be higher than generally anticipated.

The huge fall in oil prices will still be stimulative, but the edge will be taken off the benefit a bit by the currency decline.

Euro-oriented holders of dollar-denominated assets benefit; dollar-oriented holders of euro assets are hurt.

financial markets

I expect European bond managers will continue to boost their holdings of US Treasuries, figuring they’ll get both yield pickup and an anticipated currency gain.  This flow will keep long-term interest rates in the US a bit lower than they would be otherwise.

Equity managers will shift European holdings more toward multinational firms with dollar-denominated assets and earnings.  Some of this has happened already.  Many times, though, PMs will wait until they see the weak currency stabilize before reallocating.  Personally, I don’t think waiting makes any sense, but that’s what people seem to do.

US firms with European assets and earnings will face the double negative of slow growth in the EU and the diminished value of EU profits in dollars.   I think US-based manufacturers of consumer staples are particularly at risk.

hedging

While the extent of the decline of the euro may be a surprise, the fact that it’s a weak currency shouldn’t be.  This means many US companies that have euro exposure will have hedged away part of this risk.

I have conflicting thoughts on this issue.  Almost universally, investors ignore profits gained by hedging.  The idea, which I agree with, is that in short order the favorable hedges will run out, exposing the weaker unerlying profit stream.  There’s no sense in paying for profits that will be gone in a quarter or two.  On the other hand, while firms always reveal hedges that have gone wrong (and argue that investors should ignore these losses), they don’t always highlight hedging that has worked.  I guess I’m saying that I’d be leery of companies with EU exposure even if reported profits don’t show any unfavorable impact.

 

 

 

Shaping a portfolio for 2015 (iii): currency movements

When economies are deviate from the path that government policy would like them to follow, two basic options are available to get them back on track:

–internal adjustment, meaning the government alters tax/spending/interest rate policy to speed up/slow down the pace of growth; or

–external adjustment, meaning it changes policy with the aim of strengthening/weakening the currency.

In almost all cases, raising interest rates or raising taxes creates economic hardship and makes voters angry.  In bad times politicians have an overwhelming preference for external adjustment through currency movements, because the pain can’t be traced back to a given legislator’s votes.

rising/falling currency

A rise in a country’s currency acts like an increase in interest rates.  It slows down economic activity.  A decline in the currency does the opposite.

Either move has the secondary effect of shifting the composition of growth, as well.  A strong currency increases national wealth; it favors importers and hurts exporters and import-competing industries.  A weak currency does the opposite.

Right now, the EU and Japan are both following weak currency strategies aimed at simulating growth by devaluing their currencies.  In contrast, the US is about to begin the process of raising interest rates to wean its economy away from the emergency monetary stimulus it began in 2009.  The withdrawal of extra money will result in higher interest rates.  These differing policies are already having an effect on relative currency values, and therefore on publicly traded securities.

stocks in a weak currency country

The weak currency tends to stimulate overall economic activity.  Therefore, surprises in domestic earnings growth will tend to be positive–and good for stock prices.  Investors will also seek to benefit from foreign currency strength (i.e., the US$) by rotating their portfolios toward strong currency earners.  These will either be multinationals with significant operations/assets in the strong currency country or exporters.  They will also tend to shun importers, whose offerings will be more expensive and therefore less attractive.

stocks in a strong currency country

Holders of strong currency assets get more bang for their buck in buying weak currency goods and services (like vacations).  They are better off simply from the fact of local currency appreciation.  But for the local stock market, the currency appreciation isn’t an adulterated plus.  Quite the opposite.

The appreciation slows down domestic economic activity, making negative earnings surprises a greater possibility.  In addition, the strong currency value of a firm’s foreign (weak currency) earnings and assets is diminished.   Both will mean that year-on-year earnings comparisons in foreign operations will be unfavorable.  Neither is easy to predict, so the possibility of earnings disappointment will increase.

Therefore, holding stocks in a strong currency country isn’t always just a walk in the park.

Stock market participants typically deal with this issue by rotating their holdings toward importers and purely domestic firms.

other investor influences

carry trade

Weak currency fixed income investors may shift their holdings toward strong currency sovereign bonds.  We’re seeing this already being done this year by EU portfolio managers, who are buying Treasury bonds in large amounts.  To them buying Treasures seems like shooting fish in a barrel.  They get an immediate yield pickup plus a potential currency gain.

EU alternative investors can amplify their returns by shorting their own sovereign bonds and using the funds to buy Treasuries.  That’s the carry trade.

Although the Fed controls the overnight-money Fed Funds rate, foreign portfolio investors may well keep long-term US interest rates lower than they would be if domestic investors were the only market participants.

foreign investment

Foreigners may judge that the currency gain they achieve by buying US stocks will more than offset possible stock price softness due to slower earnings growth. There’s no general rule I know of to decide whether this is a good move or not.  In the 1980s, the return on Mexican stocks was fabulous, even though the peso lost virtually all its value during the decade.  Japanese stocks were also super in the same time frame, even though the currency was very strong.

for 2015

My experience is that traders in the currency markets are way ahead of me in evaluating where currencies should be.  I think I’m better off concentrating on general trends–orienting my active stock holdings in the US toward strong currency beneficiaries and my foreign positions toward weak currency beneficiaries.

One other tactic is to try to find companies that are growing fast enough that currency won’t matter much  (see my post on Pandora).

One final note:  the 1997 Asian economic crisis was triggered by dollar strength.  Many regional firms had borrowed extremely heavily in dollars because interest rates on local debt were much higher.  Balance sheets were destroyed when the dollar appreciated.  If there’s similar trouble in 2015 look for it in South American and Africa, not Asia.

 

 

 

Pandora (CPH: PNDORA) and the dollar

This is one case where it’s easier to write the name than the symbol, which includes its principal trading market, Copenhagen.

Pandora is the jewelry company that burst on the scene early in the decade with an innovative line of charm bracelets.  It IPOed to much fanfare in Copenhagen in 20111   …and almost immediately collapsed as its product began to be knocked off by established jewelry chains.

The company has since rebuilt itself.  The stock is now about 10x the price at its nadir almost exactly three years ago.  I’m still learnings the story–and this is not a stock I feel comfortable enough with to recommend that anyone else buy it.  But the turnaround seems to have been accomplished with better management, stronger control of inventories and the introduction of a line of rings, which are harder to knock off.

There are more pluses to the story, like development of the company’s own retail channel and increasing e-commerce presence, which is boosting purchases by men.  But the knockoff issue still exists:  here in the US, for example, Signet Jewelers’ Jared sells Pandora; its lower-end but much larger sibling, Kay, sells its own knockoff line.

 

Two ideas attracted me to Pandora a few months ago:  the rings, and the possibility that continuing economic weakness in the EU would force people to trade down further–meaning that a company like Pandora might increasingly be in the sweet spot for jewelry.  My main worry is that I’m very late to the party, as the stock chart illustrates.

 

The main reason I’m writing about Pandora, though, is not to highlight the company but to point out a fact about the dollar.  In Danish kroner, I’m up by 11% since buying the stock in August.  In US$, however, I’m up a tad less 3%.  Yes, I’ve wildly outperformed European stock indices but I’ve given almost all of it back in losses on the currency.

My point:  that’s what’s been happening to every US company that has a presence in Europe (or in Japan, for that matter) since May.  Of course, not all of them have sales that are way above average for Europe, so they generally have US$ losses on operations.  On the other hand, the biggest of them will have hedging operations that temper the near-term effects of currency fluctuations.

Given that about a quarter of the earnings of the S&P 500 come from Europe, it seems to me that the combination of weak economic performance there plus weak currencies represents the biggest threat to earnings growth facing the S&P 500 today.

I don’t think this issue is a reason to sell US stocks across the board.  It’s more a reason to reposition away from firms with European exposure.  Upcoming earnings reports from companies like Tiffany will give us more information.

Conversely, European currency weakness is setting up another opportunity to buy Europe-based multinationals with significant dollar exposure, just as we had several years ago.  Typically, the negative effects of currency depreciation are factored into stock prices first, and the positive effect on earnings only with a lag.

 

PS.  On December 3, 2014, in kroner I’m up about 22%, in US$ about 12%.

 

the euro at $1.30–what’s a stock investor to do?

The €, which had been on a steady rise vs the US$ since spending time at around the $1.20 level two years ago, has been sliding again, after peaking at $1.39 in May.

Several related reasons:

–anemic economic growth, which has conjured up in investors’ minds the specter of deflation and begun to evoke comparisons of the EU with 1990s Japan

–political troubles with Russia and Ukraine, which have created higher uncertainty and lower trade flows, and

–further cuts in interest rates by the ECB to address the persistent economic weakness.  Today’s include a reduction in the equivalent of the Fed Funds rate from 0.15% to 0.05%, and in increase in the penalty fee for keeping deposits with the ECB (instead of lending out the money) from 0.1% to 0.2%.

The important thing for equity investors to note is that the financial markets are reacting to the bad economic developments by selling the currency rather than by selling €-denominated stocks and bonds.  The latter two have been rising in € terms, rather than falling.  The decline against the $ and £ has been about 6% since the peak in May, and about 4% against the yuan.

The currency decline will likely end up being a much larger spur to economic growth than the interest rate cut, which is all about numbers that are basically zero already.  But currency declines rearrange the focus of growth, as well as promoting growth overall.  Export-oriented and import-competing industries are relative winners: purely domestic companies, like utilities, are relative losers.   Typically, too, the currency decline comes in advance of the positive equity reaction.

So, I think it’s time to look at Continental Europe-based multinationals again.  This “good” news doesn’t apply, of course, to their UK-based counterparts, since sterling has been steady as a rock against the dollar recently.

The flip side of this coin is that US- or UK-based multinationals that have large businesses on the Continent have lost a significant amount of their near-term allure.