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Back to the Drawing Boards

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Summer is coming to an end and there was not much resting under the trees in the Pomona orchard. Markets have again become a lot noisier with the return of volatility and amplified rhetoric around trade concerns, Turkey, Italy and, of course, monetary policy. They are not likely to get any quieter with the US midterm elections just around the corner. For the average investor it can be overwhelming and hard to know when to be concerned and when to tune out the noise.

Underneath the noise, there have been numerous divergences in financial markets despite another year of robust growth. At regional level, US equities have handily outperformed the rest of the world thanks to strong corporate earnings. The expected 19% earnings per share growth this year is nearly twice the average for the other regions. The booming US economy stands in sharp contrast with slowing emerging market growth, sharp declines in Chinese equities and a tanking copper price. At sector level, there has been a remarkable divergence in energy. Globally, the sector is up a mere 4% this year, which compares to a 15% gain in the Eurozone. Information technology has decoupled again; the sector is up 15%. This compares to +3% for MSCI World.

A major divergence is a political one between the Fed and the US president which could explain some of the trends above. The Fed is set to deliver on the current plan to raise rates again next month and four additional rate increases by the end of 2019. This can be easily justified by the US economy’s progress towards its dual objectives of full employment and 2% inflation. However, the Fed is not only the US central bank but also the pacemaker for the global credit cycle. As consequence of ultra-low US interest rates, quantitative easing and a relatively weak dollar, borrowers beyond the US have piled into dollar-denominated debt.

According to BIS data, dollar credit to non-bank borrowers outside the US doubled to USD 11.5tn since 2008. Within this, USD debt in emerging markets surged from USD 1.5tn to USD 3.7tn in ten years. As the Fed absorbs excess liquidity by shrinking its balance sheet — and the US currency and rates rise — this dollar debt binge has come back to haunt borrowers. The weakest links, such as Turkey, are being hit particularly hard. With the global credit cycle turning, the Fed’s proposed monetary policy could backfire in two ways.

First, the currency could continue to appreciate, putting further downward pressure not just on emerging market assets and economies, but on banks and exporters in countries with significant exposure to EM such as Europe. A further divergence between the economic performance of the US and the rest of the world would push the dollar even higher with negative consequences for the US corporate sector. Second, an even stronger dollar would likely lead to a widening trade deficit and provoke the administration to deliver more protectionist policies. It might even resort to currency intervention to weaken the dollar, creating a conflict with the Fed’s monetary policy intentions.

An obvious option for the Fed is to pause or finish raising rates in September to halt the rising USD. This would reduce the incentive for the US administration to engage in a full-blown trade war or intervene in the foreign exchange market. The risk with this option is that an economy already turbo-charged by fiscal stimulus, and close to full employment, rapidly overheats. Moreover, market participants might conclude that Mr. Trump’s intervention has had an impact on policymakers and compromised the Fed’s credibility. Faced with these two alternatives and their unpleasant consequences, a likely outcome could be for the Fed to raise rates in September but signal that it stands ready to slow down if global uncertainties and the dollar appreciation intensify.

Be it is it may, having a consistent view can help investors to know when to be concerned and when to tune out the noise. For long-term investors, a consistent view can provide a solid foundation and good perspective for reassurance and can help avoid overaction. Most of the time the markets and economy are in relatively good shape and investors should stay on track with their long-term plans.

Switzerland, August 31st

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