Global Update – Preparing for a weaker U.S. Dollar
The global economy is in a state of stabilization rather than normalization and despite the various negative events in the first quarter (earthquakes, Japan, Middle East), the global economy is still set to grow at a rate of about 4.5% this year, only marginally lower compared to 2010. However, global economic growth is very unevenly distributed these days, emerging markets are growing much faster than developed markets like the U.S. and Europe. Emerging markets are expected to grow by about 6.5% versus only 2.5% for developed markets.
In its recent update “World Economic Outlook”, the IMF writes that global growth has been gathering momentum in the past few months and that the economic recovery has broadened. Also the IMF thinks that the risks for a renewed global recession have diminished. It also thinks that the sharp increase in commodity prices is not a real problem for the global recovery. In their view, even an increase of oil up to USD 150/barrel would only lower global growth by about 0.75%. The IMF on the other hand is concerned about the increasing debt levels of the U.S. and the fact that there has not been enough done to address the problem of rapidly rising debt levels. While we share some of the views in this latest IMF report, our own outlook is more negative and we think that the state of the global economy is still more fragile. We continue to see higher growth rates in emerging markets that will offset at least some of the lower growth in the western world but in our view the outlook for emerging markets is a lot more uncertain. There are a number of factors that could impact growth in emerging economies very negatively. We also can’t share the IMF’s view on commodity prices, in our view rising commodity prices are a much bigger problem. While the fundamental supply/demand relationship is clearly supporting higher prices, the increasing share of speculative investment money that has come into the sector, is creating new problems. The rapid increase among all sorts of commodities has led to a very broad increase in global food prices. An increase in food prices has a very direct impact on disposable income. Today we are seeing a growing number of people getting pushed to the limits because of higher food prices and that is, among a few other factors, contributing to political changes like we are seeing in the Middle East right now. These changes can have far reaching implications in coming years, not only to the Middle East but to all major economies in the world.
We think that the global economy can grow by about 4.5% in 2011 and 2012, that is a very realistic assumption, but the reality that we are dealing with many economic imbalances today and a much higher degree of interdependence among major economies is increasing the risks for the global economy. The main risk factors are obvious, with the western world experiencing sluggish growth and growing levels of debt, painful adjustments have to be made eventually. We think that it is highly questionable that the ongoing loose monetary policies among most major markets can bring these economies back to the growth levels seen historically.
Higher economic growth in developing economies is in sharp contrast to the very moderate growth in developed markets and there are also growing imbalances between them, mainly due to the fact that developed markets have been increasing government debt very significantly in recent years while emerging economies have been able to reduce their debt.
The following two charts illustrate the current trends of debt levels and deficits in developed economies and in emerging markets:
(pls see www.alpineatlantic.com for original with graphs)
The charts show that the situation in the U.S. and in Japan is bad and about to get worse while most countries in the European Union have finally started to address the debt problem, so at least the trend for them is improving even though it might take many years to turn things around. The big difference between the U.S. and Japan is that the U.S. has a much higher percentage of the debt financed by foreign investors as the following chart shows:
NET PERCENTAGE OF DEBT HELD BY NON-RESIDENTS
While the U.S. continues to increase the debt burden, emerging nations such as China are accumulating foreign currency reserves and are reinvesting them in developed markets, a large part of it in government debt securities such as U.S. Treasury bonds. This can’t go on forever and it is clear that emerging markets are increasingly concerned about reinvesting their reserves in U.S. Treasury bonds, these investments are actually already declining. While the attempt to provide the domestic economy with ample liquidity is certainly understandable, it is giving the wrong signal to foreign investors; this comes at a time when the need for foreign investment is bigger than ever. The Federal Reserve in the U.S. is currently trying to stimulate the domestic economy and create jobs by providing the market with a lot of liquidity. We don’t think that liquidity alone will create jobs. In our view the fact that job creation has been so disappointing has to do with a number of structural factors that are much harder to correct. Politics and most central banks will do whatever serves them best and when you have so many people looking for jobs and being unemployed, it’s natural that this is a key priority. However, by creating excess liquidity and therefore forcing a devaluation of the currency, the ultimate consequence is inflation. I think we are currently in the first phase of this development. This is going to get worse in coming months and probably years and we will hear and read about it much more in the future. Inflation is becoming a much higher priority item and therefore policymakers will gain much more by fighting inflation. Here history repeats itself. In the early 80’s inflation was by far the biggest problem, peaking at more than 13% in 1981. The fight against inflation began in the late 70’s with the appointment of Paul Volcker as the chairman of the Federal Reserve. He raised the Fed Funds Rate to 20% against widespread protests, however, eventually inflation began to slow and fall back to about 3% in 1983. It was a matter of setting the right priorities at that time, yes it was painful, but also a much needed measure. Eventually the economy began to recover and returned to healthy growth for much of the 80’s.
In light of the lessons from the past, it is obvious that the current Fed strategy is not sustainable in the long-run, however, even if rates eventually start to go up, we think it is highly doubtful that the value of the U.S. Dollar will go up significantly, I think it might only devalue at a slower rate. Remember even in the last few weeks with all the negative events in Japan and the Middle East, the U.S. Dollar was not able to benefit. Historically, in troubling times like this there was always a flight to security and that was usually positive for the U.S. Dollar, but now not even all the bad news helped the greenback. This should have been big headlines in financial news, but it wasn’t. However, it is a further sign that the U.S. Dollar is about to lose its status as the world’s main reserve currency and therefore causing a large rebalancing of currency reserves in coming years. The world has become increasingly aware of the declining status of the U.S. Dollar in the last couple of years and it seems like the world is now accepting a weaker U.S. Dollar going forward. This is a real game changer with far reaching consequences for investing.