Emerging markets rely on greenbacks
How’s your portfolio looking this morning?
The S&P/ASX 200 is up 0.83% so far this morning. The major bank stocks are up. As is mining giant Rio Tinto and BHP.
Although, we had a nice lead-in from the US market overnight. The Dow Jones Industrial Average rose 2.50% while we were sleeping.
What does this mean, though? Does it indicate that the recent market falls are behind us?
If Jim Rickards’ analysis is anything to go by right now, perhaps not.
Jim talks specifically about the US market today. However, I’m sure you’re familiar with the saying ‘when America sneezes, Australia catches a cold’.
What happens in the most powerful stock exchange in the world greatly impacts our own local market.
So, the overall direction of the US market has an impact on Australians’ portfolios.
But there’s something special in Jim’s insight today that I want you to pay close attention to.
It’s what’s going on with the US dollar. Not whether the greenback is going up or down in value…but how many US dollars are available for use.
You see, the US dollar is the lynchpin of the financial system. The flow of greenbacks around the world actually supports the financial system. Because US dollars are in demand around the world, the American government can run up enormous US$21 trillion debts.
However, when you start to pull US dollars out of the financial system, the value of the US dollar goes up. Making paying off US dollar-denominated loans harder for foreign countries.
Believe it or not, the biggest risk facing investors today isn’t the day-to-day gyrations of the market.
No. A much bigger threat is growing in the background.
And that’s how more US dollars are being pulled out of the global financial system.
Almost no one is discussing the implications of this.
Don’t get caught off guard.
And now, it’s over to Jim.
The US Stock Market Is Going Nowhere Fast
Jim Rickards, Strategist
The Dow Jones Industrial Average index ended October at 24,874, almost exactly where it stood on the first trading day of the year.
You read that right. US Stocks have gone nowhere this year.
Of course, individual names have rallied or fallen back.
There was plenty of volatility along the way with a market correction in February and March, a decent rally from April–September, and a second correction in October.
The occasional investor may have been able to buy low and sell high through these dips and rallies.
Most investors haven’t been so lucky.
They either sold into the dips and bought the rallies, losing money in the process, or they bought and held and watched from the sidelines as stocks went… nowhere.
There are more opinions on what has caused this strange stagnation than there are stocks in the Dow Jones index.
There are a variety of arguments around this, but they all contain enough substance to offer some explanatory power.
Combing the explanations, they converge and amplify each other to explain the weak performance by stocks.
The net impact is that US stocks are facing significant headwinds that imply more turbulence ahead (at best) or a full-blown bear market (at worst).
It’s not a crash, just a correction
Just as there are multiple explanations for the stock market’s weak performance this year, there are multiple reactions to the performance by investors.
One group views the 2018 price action as little more than a bump in the road in one of the longest bull markets in history.
The stock market’s fall since February can be seen as an overreaction to some inflation fears arising from the January employment report released in early February.
In contrast, the October correction can be seen as a delayed reaction to Trump’s trade war with China.
Of course, it took markets until October to realise the trade war was serious and likely to last a long time, something we warned readers about last January.
Still, the market has now made its price adjustment and is ready to push higher based on corporate profits, stock buybacks and continued US economic expansion.
Or…is the worst is still to come?
Another group views 2018 as a warning of worse to come.
Technicians see a ‘triple top,’ or three peaks, in the index series where the Dow Jones failed to break out to the upside.
These peaks were on 26 January (DJIA 26,616), 21 September (DJIA 26,743) and 3 October (DJIA 26,828).
Having failed to reach DJIA 27,000 on three tries, the market appears exhausted and primed for a major move down.
Again, there is no shortage of adherents to each of these views. That’s what makes markets.
Not enough dollars
Nothing in the analysis above points strongly one way or the other.
The market could continue to rally if growth continues and debt fears are seen as overblown.
Likewise, the market could continue to sag as growth slows and higher interest rates take their toll.
Both scenarios are plausible and it’s not surprising that markets have traced a seesaw path this year as enthusiasts for one or the other perspective take the lead in setting prices.
For better predictive analytics, we need to widen the aperture and search more broadly for causal factors.
It may be that the driver of US stocks prices is not found in the US among interest rates, growth, taxes or technicals.
The driver of US stock price falls may be found abroad in the combined impact of the global US dollar shortage and an emerging-markets debt crisis.
The idea of a global US dollar shortage seems odd given that the Fed created US$3.6 trillion of new money between 2008–2014.
The problem is that while the Fed was creating this money, the world was creating new dollar-denominated debt at an even faster pace.
Over US$70 trillion of new US dollar-denominated debt has been created since 2008 on the back of the Fed’s US$3.6 trillion of new money.
Much of this debt was created by foreign banks in the form of Eurodollar deposits used to finance dollar investments in US Treasuries and corporate loans.
Now, these US dollar deposits are being withdrawn and used to invest in higher-yielding US dollar investments in the US.
This flow of funds is part of the reason for a stronger US dollar.
The result is that foreign banks cannot roll over US dollar loans because of the scarcity of US dollar deposits.
This causes a liquidity crunch in foreign markets, especially in Europe, that tightens monetary conditions and slows growth.
This leads to fewer US exports of machinery and equipment purchased by foreign buyers.
Emerging markets rely on greenbacks
The emerging-markets liquidity crisis is related to the Eurodollar shortage.
Corporations have created trillions of US dollars of corporate debt in reliance on foreign bank lenders.
With the stronger US dollar, that debt gets harder to pay off using local currency receipts.
Borrowers are resorting to layoffs and reduced imports to cope with the financial crunch.
This problem is especially acute in Turkey, Iran, Indonesia and Argentina, but has the potential to spread widely to emerging markets, as happened in 1994 and 1998.
China is a case study in all of these effects of the US dollar shortage.
It has huge US dollar-denominated debts, but its US dollar receipts are being slowed down by Trump’s tariffs and other trade war effects.
China has tried to devalue its currency to boost its exports, but it can only go so far without further angering the Trump administration and inviting even more punitive measures from the US.
These foreign factors are what are driving US stocks lower in addition to the US factors noted above.
There is still a bull case for US stocks, but the bear case gains the upper hand once the international situation is included in the analysis.
Investors should prepare for more volatility, more down days and ultimately a bear market as global growth slows and global liquidity tightens.
The Fed will discover this the hard way — when it’s already too late.
All the best,