Why a weak dollar is not what it used to be
Photo by Sharon McCutcheon on Unsplash
Two weeks ago, we asked the question: “How do we value value?”, and put some flesh to the idea that the world’s reserve currency, the US Dollar, was at risk of having its value further debased by the waves of monetary easing coming from the Federal Reserve.
The problem that we were trying to solve was that of measuring value when the base – the unit of measurement of value – is no longer a constant. It was, truly, all about the base.
Looking either backwards in time to the Gold Standard, or perhaps forward to alternative stores of value like Bitcoin, the answers aren’t clear for us. It's hard to imagine a world where value isn’t measured against the US dollar: from property prices in developing countries to the global traded price of commodities – even this week’s amazing episode of negative crude oil prices, which itself threatens to rewrite the rules of risk management and economic theory – almost every asset in the world finds its base in the US dollar.
The Pound, the Euro, the Renminbi and the Yen - some of the most respected currencies in the world find their measure of “strength” or “weakness” in the US Dollar. What of the currencies of developing countries like Turkey, South Africa, Brazil and India? That’s how they work: the value of currencies is always expressed pairwise, one against the other, in relative value.
Such a system works if there is a base from which value can be measured. So while you wouldn’t be sure about whether the Polish Zloty appreciating against te Mexican Peso is because of Polish strength or Mexican weakness, you’d settle the dispute by checking how the Zloty and the Peso each performed against -– guess what – the US Dollar.
Whether it’s evaluating the depth of an emerging market crisis or, more critically, if a government (or central bank) has been profligate with fiscal or monetary largesse, the gold standard (not capitalised) is the US Dollar, the rock upon which all monetary measurement is built.
It’s one thing to cite Zimbabwe, Venezuela or the Weimar Republic as examples of monetary profligacy. But what happens when the world’s base currency is the one that’s seeing unprecedented issuance?
We can’t measure the dollar against itself
We know when any other currency weakens against the USD base, but how do we know when the base itself is weakening? After all, we can’t measure the US dollar against the US dollar, and if everything in the world is measured against an unknown, how will we know the unknown is weak?
Conventional thinking suggests that a weakening US dollar would manifest itself in the form of a counter-rally where all of the beaten down currencies around the world rally against the US Dollar. To us this is unclear: this is a relative game.
For currencies like the South African Rand and the Turkish Lira, whose central banks have enthusiastically embraced QE in the midst of a cratering domestic economy, hoping to emulate the easing effects that the US has enjoyed, they may continue to fare far worse than the USD. Faced with two deteriorating sides of a relative trade, the one which is less bad outperforms, and that may well be happening as we speak with the US Dollar. Added to the demand the US Dollar enjoys from its global reserve status, such instances of relative USD outperformance are no surprise.
That much is commonly known. At this point, we want to be clear that we most certainly are not currency experts, and this is not intended to be a piece covering the merits of owning the US dollar against a basket of other currencies. We naturally have our own views on the many paths things could play out, but they are auxiliary to our process.
And our thought process suggests that conventional economic doctrine may have all but broken down. The extent of the Fed’s monetary expansion is unprecedented, with its apparent immunity conferred upon it primarily because of its status as the global reserve currency. And while the USD has been the reserve currency of the world “for as long as we can remember”, it turns out that we don’t have that long a memory. If Bretton Woods were the starting point for a USD based global economy, the status quo is only 76 years old.
Heading South.
As one respected former colleague puts it: “If you travel North for long enough, you’ll eventually end up in the south.”
We have now arrived in the South. The relentless expansion of the monetary base of the US Dollar, made seemingly without consequence by its unique status, seems to have now put it straight into the same bucket as the very currencies against which it stood in stark contrast.
Consider this: If one looks at a few relatively recent (over the past few decades) emerging market crises, it is interesting to see what happened to the stock markets in local currency terms following a bout of major currency weakness or a devaluation. Typically, the markets rally in local currency terms, so is it possible that the true value of the underlying companies, which may well be largely constant, gets revalued into a higher nominal price denominated in the now-depreciated local currency terms?
The numbers seem to support this: taking a cross section of huge currency devaluations across both developed and developing countries, the majority of major devaluations lead to pretty significant outperformance in domestic markets in the year following the devaluation. In most cases, domestic currency performance (green dot) and USD performance (red dot) were both positive and significant:
Expectedly, the most violent moves seem to be in the “emerging market” countries – frequent readers of our newsletters know how much we loathe that term. The one common thread here is that in all of these cases we could see that their currencies have depreciated: whether the won, the peso (mexican and spanish), the lira, the rupee, the pound, the krone or the aussie dollar, there “devaluations” were measured against the USD.
So here’s the multi-trillion dollar question: how does one perceive a USD devaluation? Against what currency might we measure a weakening USD?
Like everyone else, we can see the growth in the balance sheet of the Federal Reserve – evidence that the supply of dollars has gone through the roof, with the Fed’s balance sheet having grown a whopping 7x since 2008, an additional US$1tn (+19%) since 2 weeks ago!
To some extent, we could argue (as we have in the past) that tangible stores of value like Gold and (in our opinion) Bitcoin appreciate as monetary value gets debased. But perhaps the answer has been hiding in plain sight.
It’s rally time
As we suspected, the investment world is currently scratching its head and crying foul at the fact that the US stock markets have rallied sharply, at the same time we are seeing what some are calling the biggest economic crisis since the Great Depression. The solution to this paradox possibly lies (amongst many other factors) in the dollar.
Let us begin by looking at some other factors which we have written about. Firstly, the structure of the markets have changed dramatically, in that over 100% of flows in US markets are now passive. This is entirely possible, given the inflows are passive (from millennials) and the outflows are mainly active, as baby boomers retire and exit the market. What this means is that active managers who make buying and selling decisions as a function of “fundamental value” in the hope that other similar managers agree and move prices to match their “fair value” – hence driving their investment returns – are increasingly irrelevant as price makers in the market.
Frustratingly, this further diminishes their ability to perform, driving outflows and exacerbating the vicious circle. We wrote about these in our note about the unintended consequences of passive investing, in which we referenced Mike Green, to whom we also owe the above data.
That could well be one driver of the stock market’s blazing performance. But it’s just one possible contributor.
Let's go back to the dollar. In theory, if the dollar is weaker in true terms then whatever is valued in dollars is worth more in dollar terms – certainly anything of true value. We previously attempted to introduce the idea of units of true value (aka “vals”):
“Imagine Apple was worth X as a company in 2008, denominated in “true value” (“vals”, for the sake of argument), and the exchange rate between US Dollars to vals was US$1 = 1 val in 2008. Assume that today Apple is still worth X vals (it obviously isn’t, but we’d like to just illustrate the point) but the dollar is half as valuable, at say US$2 per val, then the value of Apple has doubled in dollars, even as its true value (X vals) remains the same!”
So just for the sake of argument, let's think again.
The main bear case around this economic crisis revolves, quite rightly, around earnings. Naturally, the questions of how long it lasts and how deep the earnings retrenchment will be are front of mind. But if, say, earnings (in dollars) fall by 50% for let’s say even a year, but the number of dollars in circulation is, say, triple what it was due to the various amounts of additional financial stimulus, the tailwind (in dollars) from the devaluation of the dollar in true terms dwarfs any potential short term earnings collapse.
Doesn’t make sense? Take the dollars out of the picture and do the math again.
A company worth 10 vals at a P/E of 10x trades at $100 (1 val = $10). Its earnings fall by 50%, but the supply of dollars triples. How much is it worth after a year? It would be worth 5 vals, but if 1 val = $30 now, the same company, with 50% lower earnings, is now worth $150.
Just like magic.
Now of course, there will be companies which go out of business or suffer a complete wipeout of earnings: all that is part and parcel of making the right individual stock calls. But for those that survive, the magic show goes on.
The bottom line here is whether the spectacular injections of dollar liquidity continue to inflate financial assets, since the little bit of magic we’ve described above actually embodies the true meaning of financial inflation.
This applies to stocks, to real estate, maybe even Birkin bags or anything really that has TRUE value. Think real estate now. The capital value of a blue chip real estate portfolio in dollars surely has to rise if the dollar weakens in “true” terms. But with its debt burden and repayments fixed in dollar terms, it perhaps doesn’t come as a surprise that the yields on property are so low (low interest rates notwithstanding).
This is the income inequality that everyone speaks of; stimulus makes the rich richer, and this is how and why.
How on earth does the stock market party end? We don’t know. It most certainly will, but many smarter people than us have tried to work it out and failed completely. Who would have thought that markets would be where they are today, especially given the economic cataclysm that has just engulfed us?
We fully embrace the enormous uncertainty through our process and the thought exercise above is merely one of many possible paths ahead of us. It’s our base path right now, until such time as it changes again. What will cause this? We have some ideas, but the world right now is made of so many unknown unknowns that it’s impossible to cover all the variables. We would love to chat to anyone who is keen to debate the ideas we’ve proposed, and we’re available any time.