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.

 

 

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%.