Dollar rises, Oil falls, World shivers

Raghuram Rajan yesterday said ‘Make for India’ in addition to ‘Make in India’. The underlying message in the statement was the world is not prepared to absorb the capacity India may set upon building. It rather feed its own demand and in turn creates an ‘isolated’ virtuous cycle. The world suffers from a lack of aggregate demand resulting in declining GDP growth across all markets except the US. The other aspect has been his action of stepping up intervention in the foreign exchange market to enhance dollar reserves to protect from adverse impact of dollar increase or shortage. Third, has been to push the government to expand domestic savings to increase the investment rate in the economy

As the dollar rises it will tighten financial conditions for all markets especially emerging markets. USD credit to all non-banks in emerging markets has steadily stepped up since the financial crises, moving up from ~USD4trn to ~USD8trn, the fastest growing segment. Emerging market index of exchange rates has already witnessed a decline of 20% since 2012 impacting unhedged exposures. This enhancement in USD credit has come along with longer maturities with average maturities now exceeding 8 years. While this mitigates roll-over risk but magnifies duration risk for investors, as now non-bank credit (i.e. asset managers) dominate the credit market. In the post Bretton Woods world, twice the dollar has rallied for a long duration both times it has caused a crises, in the 1980s in Latin America and the mid-1990s the Asian Financial Crises.

The dollar’s rise seems inevitable. Key thing to understand is currencies trade against one another and commodities trade in USD terms. The Yen has declined from 80 to almost 120 against the dollar and Euro from 1.40 levels to 1.25. These two large currency adjustments have happened against the USD. China is likely next year to follow with its own depreciation given the impact of lower yen on competitiveness, a sharply declining factory production and increasing real rates. Shale gas finds is enhancing US oil production potential manifold changing the current account structure in turn reducing the USD circulation globally and adding further to USD strength. Further, US Fed seems to have created a market perception of increasing rates based on unemployment levels boosting the USD against other currencies. This data has been strong with historical backdrop of low price of oil further enhancing job creation. Past Fed studies found negligible long run spill-over from oil prices into core inflation, whereas employment elasticities this decade suggest a 40 per cent fall in the oil price adds a million jobs. My view as I have earlier stated as well, the US Fed will always in its pricing action surprise the market on the upside given the levels of Fed balance sheet but in turn create volatility. The Fed has between now and 2018 to normalize rates as then we may see the next round of fiscal pressure due to social security liabilities.

In this context, decline in oil prices is creating an alternate dynamic of deflation in already low inflation or deflationary world. In addition, decline in oil prices will create credit risk:

• Global inventory value of oil has declined at USD60/barrel by almost USD400bn. Sovereign and large corporations like Exxon will absorb that loss, what about the rest?
• 18% of US high yield is dominated by energy.

I have already discussed the geopolitical and economic impact of oil in my previous article. Since then, global demand estimates have been further lowered as a reflective impact of low prices on oil producing countries. One of the leading global e-commerce company CEO last week told at a conference said pricing for ecommerce is typically 75% of offline prices – another driver of deflation. Maybe OPEC is selling at a discount to get e-commerce valuation!!

Some thoughts on what this portend for the world:

• Yen which has already declined from 80 to 120 is now being discussed at 145 levels. This could push up inflation materially leading to BOJ losing policy control. The Nikkei which has almost doubled since this new policy started could be staring at a nightmare. But in the short-term there is more gains;
• The Chinese look almost certain to devalue next year for the reasons mentioned above creating significant pressure on South-East Asian countries;
• The Aussies have had a great run with the commodity boom. Their GDP growth will continue to decline and may end in deflationary territory. Hedged Aussie bonds are a good place to be. It will be good time for tourists in Australia with the lower currency;
• Turkey, South Africa and Latam have high current account deficit and commodity dependence and Turkey particularly high short-term external debt. They would be difficult markets;
• Euro-zone’s last bastion Germany is bordering deflation and recession and its ‘first bastion’ Greece is in the throes of another bond crisis with 10-yr reaching 9.15% while the 3-yr is almost 11%. If the USD shakes the high yield market the pressure will increase. It is likely that we may begin to see the disintegration of the union in the next 2 years as economies struggle to re-adjust given the Euro’s shackle;
• To the Russians, it will seems like the late 80’s and 90’s, one which broke the Soviet Union and the second where Russia defaulted and devalued;
• UK nightmare of London property price decline may come true;
• The US is the cleanest shirt but with countries exporting deflation via the currency and commodities declining, US reversion to trend growth and Fed target of inflation will be difficult.

From an investment perspective globally, owning staples / healthcare delivery / utility / Japanese exporters equities, hedged developed market bonds like Australia and emerging market bonds like India and Mexico, agricultural commodities and oil at these or lower prices are the best options for 2015. The world will see consumption gains in oil and commodity importing countries but they will be marginal given household leverage across most market. 

India will benefit massively from commodity price decline (at $115 per barrel we consumed 6% of GDP and now it’s ~$60 per barrel) but key is policy action to increase growth capacity. Retail plastic goods, chemicals, lubricants and cement stocks will see profit enhancement from energy price reduction. But for policy action we wait and watch…