The Thrashing of the Dollar and the End of the American Decade

The past decade or so had been characterised by one overriding common denominator – the relentless flow of capital into American assets. From Johannesburg to Jakarta, everyone became an expert on US Megacap tech and hid in the same “safe” place – secular growth with the lowest risk. Right? Right? More on this later.

But first as always, we start with a story. There is nothing more enthralling for a storyteller than the chance to start a new chapter –a new mini-plot, maybe a twist or a change in direction somewhere. And market story tellers love nothing more than a new calendar year. New year, new story. Right?

As it happens, stories and narratives – intangible as they may sound – provide the context for interpreting hard data, as we’ve seen many times before.

The story of 2022 was that of a rising dollar, fuelled by the Fed going on what with hindsight was one of the fastest rate hike trajectories in history. Rate hikes and the accompanying roll-off of the Fed’s balance sheet holdings of Treasuries and MBS led to vertical charts in mortgage rates in the US (going up), and nearly vertical charts of almost everything else in the world (going down), especially in the more speculative pockets of the market which, thanks to the preceding extent of QE, was by no means a “niche” market segment. From unprofitable tech (even to slightly profitable but not profitable enough tech) to meme stocks to crypto, drawdowns from the peak were dramatic.

The combined effect of Fed tightening, accompanied by what is likely to be described in the future as a coordinated global tightening of monetary conditions by other central banks in tandem (even Japan, to some extent), took out the proverbial tide.

Dollar bulls, who were by construction “everything else” bears, were having their day in the sun. Yet even that shall pass.

Perhaps by chance, or perhaps by subconscious intent to “get the job done within the year”, that cycle appears to have passed its climax. The Fed has made its point – it wants rates higher, and they are higher. Its credibility for now is intact – it hasn’t bowed to political pressure to choose the easy route, much to the dismay of pundits that long for the return to the age of “up only” in a rising tide.

To be clear, inflation printing at 6.5% as per this week’s data release is FAR from ideal. It’s still high, albeit not nosebleed high. But there is a trade after the trade, and it is always in the transition that the waters get the choppiest.

We aren’t in the camp of “dollar debasement” or “dollar getting replaced as new reserve currency”, at least not at the moment. But we would certainly entertain the notion that the period of outsized USD strength may have come to an end - for now.

Thus, the possible plot twist for 2023: reversing the USD strength of 2022 doesn’t necessarily mean reversing the fortunes of everything that lost value in 2022. A new bull market always requires new leadership, and the signs are there even while we are not done with correction of the past regime.

Turning, not reversing

The base case which underpinned the bear market of 2022 was one of rising rates leading first to a de-rating of forward earnings mechanically as DCF models get marked down, and ultimately to a decrease in disposable incomes as wealth effects of higher rates kick in – through asset prices coming down. The USD was a wrecking ball. Capping off this entire scenario was the risk of an outright global recession as excessive tightening undertaken in the fight against inflation strangles the life out of economics.

But strength and weakness of the USD isn’t a simple case of up vs down, even if that’s all we can perceive on a price chart. As in all stories, there is path dependency – the fact that 2022 happened doesn’t mean that the reverse happening in 2023 takes us back to 2021.

And the narrative that has ironically taken the most damage as a result of 2022’s USD strength is the story of the US bubble itself: the structural flow of funds out of everything else and into the US since the aftermath of 2008-09.

After all, as we’ve learnt in recent years, the price of USD isn’t solely function of relative demand for US assets vs other assets, and also a reflection of the scarcity of liquidity, amongst many other reasons. Identifying ex-ante the reason for a USD move is likely a fool’s errand.

Observing a move, however, might be more instructive. And a quick look at charts suggests that one could argue that the path of least resistance for the USD is down rather than up for now. At risk of committing a chart crime, consider the Filipino Peso vs the USD – hardly a harbinger of global macro, and certainly more a confirmatory signal than a lead indicator – dishing up a textbook Head and Shoulders on the USD/PHP chart:

We don’t know if this move will endure, but for a move to start showing on a currency pair like USD/PHP, one at the very fringes of global affairs its means things are likely already pretty well-established.

The Trade after the Trade

The Philippines as an anecdote is an interesting one, because this was one of the key markets on our radar in our previous lives as EM specialist managers.

The effects of the growing US bubble weren’t effects that were evident in the headline index levels or the performance of blue-chip large cap stocks. Beneath the surface, what the Philippines experienced was common across many of the smaller non-index heavy “emerging market” economies: a multi-year exodus of foreign capital, depleting liquidity in everything but the largest, most liquid stocks in the domestic market which were supported by domestic insurance funds, government pension funds and large conglomerate treasuries (typically in their own stocks).

The mid-cap and small-cap space, which thrived during the “Emerging Markets!”™ era, dwindled into nothingness. In markets like Indonesia and Malaysia, the outcomes were similar; in markets like Turkey, the effects were rather different albeit from the same cause – an exodus of foreign capital. One could argue that the same was happening at the EM index level: with capital exiting the space, the remaining allocations float to the largest weights in the index, none other than Chinese internet ADRs and Semiconductor stocks.

And it’s not just EM, or a function of QE – the Eurostoxx 50 put on a grand total of c. 13% over the same 10-year period, despite having equally accommodative monetary policies.

So, while the US was having both a bubble in FAANG AND the broader market including smaller caps (the Russell 2000 index almost tripled over 2010 to 2020), most cross-sections of the non-US universe demonstrated the same symptoms as the Philippines: outflows of capital, with liquidity congregating at the top of the market cap table.

For those fortunate enough to have a supportive narrative (e.g. China Internet), index level performance was solid; for everything else, owning stocks was more a function of there being no alternative.

And for everyone that could, the US was the place to be; and within the US, tech was the place to be.

It wasn’t even only liquid capital that was moving in that direction: human capital, too, was categorically departing the investment banking floors (and probably the management consulting suites, too) of Hong Kong and Singapore in search of opportunities in Silicon Valley.

For a decade, if it wasn’t tech, it wasn’t worth anyone’s time, effort or capital.

The ongoing deflation of the US tech bubble is triggering a reconsideration of decisions by many. For one, we’ve written about the dire underinvestment in commodities over the past decade which is now coming back to haunt us with the threat of persistent inflation, not to mention the accompanying geopolitical shifts which further entrench that inflation as we move out of the prior decade of monetary abundance.

The market moving to make up for the past decade’s imbalances is where we think we’ll find the trade after the trade.

And the trashing of the USD that we’re starting to see might just be the beginning.

Never in a straight line

Let’s be clear: the USD remains the lifeblood of international trade and commerce, the base currency for most FX pairs that have any decent liquidity, and most certainly in a sharp global risk-off event, a flight to safety would be to the USD. Many things, including our funds, have their values measured in USD – so to actually get to a situation where the USD structural bears (or abolitionists) find happiness is a rather long way off.

There are a good number of reasons why USD strength might return with a vengeance from time to time, and we expect sporadic bouts of possible extreme strength as the end of this market cycle still plays out, but the general direction of travel seems to be shaping up to the downside. As always, we trade the market that’s presented to us, not the one that we want.

Ideology and rigidity should play no role when investing in markets, if not only because the market itself has no ideology but to seek maximum profit for minimal risk. But the lack of ideology makes for difficult marketing – an inability to latch onto a dominant narrative just makes a product that much less emotionally appealing.

At the sector level, we’ve had enough experiences (mostly the painful ones) that remind us of how these shifts in market leadership and narrative are never linear. Grappling with such a profound change in market leadership is a challenge especially when intellectual positions have been deeply entrenched over many years. Surely after flaunting ESG credentials by investing in renewable projects with long-dated cash inflows vs short dated cash outflows and proudly shunning high teens FCF yield commodity producers for the sake of being “green”, doing an absolute U-turn even if the risk/reward of the trade is compelling is anathema, at least for the marketing team.

The same likely applies after making outlandish price predictions on stocks of companies with business models meant to change the world. Perhaps they eventually will in the long run, but we’d tend to agree with the Keynesian view of long-run survival, so getting there is the main challenge.

And so, the narratives will take time to turn and that process of reorientating large sums of AUM invested in a certain way for so long means old narratives, positioning and hope for a return to the old ways (“soft landing” seems to be making the rounds recently!), as well as a risk of a final capitulatory flush of a decade of positioning and elevated earnings expectations in a sharply inflationary world potentially stand in between where we are and the Trade after the Trade.

What we do know is there is always a bull market somewhere and we think we have a pretty good idea where it is blooming.

Eugene LimJanuary 13, 2023