Why dollar strength poses risks to the global economy

Appreciation in the greenback creates political and economic problems

Mohamed El-Erian

Hands sort US hundred dollar notes in a suitcase. Photo taken on April 17 2016
For some, a strong dollar is part of an orderly rebalancing of the global economy © Denisfilm/Dreamstime

The recent strength of the US dollar has triggered two very different reactions among economists and market participants.

Some see it as contributing to better global economic performance down the road. Others fear that it will create disruption.

Both cannot be right.

The answer is likely to be determined by politics rather than economics — specifically, manoeuvring in the run-up to next year’s US elections.

Investors and companies can take actions now to partially protect themselves from disruption.

Such evasive manoeuvres are warranted given the higher probabilities for more extreme outcomes in a range of areas.

Sustained dollar strength is not a surprise given three major factors pulling foreign capital into the US: a domestic economy that has consistently outperformed other advanced countries, a stock market that has outpaced others and, for fixed income investors, an unhedged yield advantage.

Investors believe that, in today’s weakening global economic environment, only America is able to sustain a prolonged appreciation in its currency. European and emerging economies fear that any persistent strengthening of their currencies would further slow their growth. This also explains the contrasting views as to what comes next.

For some, a strong dollar is part of an orderly rebalancing of the global economy. By boosting weaker economies that are more open to trade and that have suffered more from the global trade war, it helps them to catch up with the outperforming US.

But the strong dollar poses risks. First, it threatens a currency war on top of the protracted trade war — fuelled by the Trump administration’s efforts to undo what it views as unfair trade practices against the US.

Second, it exposes the Federal Reserve to further political attacks, undermining its credibility and the market confidence that comes with that.

Third, it can destabilise emerging markets with large currency mismatches, including what economists call the “original sin”. This is where countries have borrowed heavily in dollars but generate the bulk of the income used for interest and maturity payments in currencies that depreciate relative to the dollar.

All three factors weaken growth, increase market volatility and tighten financial conditions. They would come at a tough time for the global economy. Global economic activity and trade are decelerating, Europe could fall into economic recession next year, central banks are running low on policy ammunition, and there are few, if any, inspiring emerging-market reform stories.

What transpires will depend, first and foremost, on US politics — tilting probabilities in favour of the more disorderly outcome. Levelling the international playing field on trade, particularly with China but also with other countries, is one of the few issues that commands quite broad political support in America.

Not all agree on the methods, but most are united in pursuing better trade terms for the US.

This increases the likelihood of the weaponisation of currency policy.

Europe and China can counter this risk, albeit only partially, by making more timely concessions to the US, especially when it comes to longstanding grievances, such as intellectual property theft and forced technology transfers to China.

As part of a rebalancing of policies in favour of structural reforms and fiscal stimulus, the European Central Bank could also help by gradually moving away from its liberal use of unconventional monetary policy to influence asset markets. This has been a disappointing pursuit of better economic outcomes overall, and is becoming increasingly counter-productive.

The binary outcome associated with dollar strength is an example of a phenomenon that is playing out not only in economics and finance but also institutionally, politically and socially.

That is a declining probability for the continuation of status quo, and higher probabilities for
more extreme outcomes on either side of the status quo.

This phenomenon is gaining greater recognition, but not as much as it deserves. That is not surprising, perhaps, given that there are many behavioural reasons why we resist being taken out of our comfort zones.

In this age of extremes, what can companies and investors do?

They can reduce currency mismatches, increase their cash buffers and search for cost-effective hedges in order to bolster resilience.

In their fixed income activities, investors could also move up in quality and shorten maturities in order to limit exposure to extreme outcomes while retaining some upside.

And for US companies with operations abroad, they should narrow their focus to meeting demands there rather than also sourcing in size for the home market — the “in China, just for China” strategy.

Competing claims about the implications of a strong dollar is but one of a lengthening list of unusual uncertainties facing today’s fragile global economy.

Rather than ignoring the higher probability of extreme outcomes, companies and investors and companies need to confront it in their strategic planning. Think of it as minimising future regret.

Mohamed El-Erian is Allianz’s chief economic adviser and president-elect of Queens’ College, University of Cambridge

Better data on modern finance reveals uncomfortable truths

It is unnerving that the shadow banking sector is swelling, given its role in the financial crisis

Gillian Tett

Downtown Georgetown overlooking Caribbean sea Cayman Islands aerial
Almost 20 per cent of banks’ cross-border dollar funding is supplied by entities based in the Cayman Islands © Getty

What the heck is happening in the Cayman Islands? That is a question often asked in relation to corporate tax. This week, for example, the OECD called for an end to the loopholes that let global companies cut their tax bills in places like the British overseas territory.

As the debate bubbles on, there is another facet of globalisation that merits more discussion: the financial flows associated with offshore centres, particularly between banks and non-bank entities. Until recently, this activity seemed like a mystery wrapped in an enigma for investors.

Yes, regulators have long published data about the onshore activities of regulated banks. But there was little information available about the financial flows around non-banks, least of all when they were based in murky offshore locations.

This is starting to change. One reason is that the Financial Stability Board, a Basel-based entity created in the aftermath of the 2008 crisis, has now been publishing data about non-banks (or “shadow banks”, as they are popularly known) for nearly a decade. Last month the Bank for International Settlements also started publishing data on cross-border financial flows between banks and non-banks — even for opaque offshore centres.

This is very good news, since the two data sets shed a little light on the reality of 21st-century finance. The FSB research, for example, shows that the non-banking world has grown in recent years, as activity has moved out of regulated entities. “Non-bank intermediaries’ share of total financial system assets increased from 31 per cent to 36 per cent” between 2007 and 2017, observes a report from the IESE Business School, using this FSB data.

Meanwhile, the BIS data shows that banks’ cross-border dealings with non-bank entities has been swelling too. One reason is that banks are increasingly funding governments (by buying their debt.) But their exposure to non-financial companies is also rising noticeably, both to onshore and offshore subsidiaries. “Banks lend significant amounts to non-financial corporations located in financial centres . . . [providing] credit to the financing arms of multinational corporations located there,” the BIS notes, adding that banks’ claims on NFCs in the Cayman Islands are larger than on those in Italy. (Yes, really.)

Cross-border lending by banks to non-bank financial institutions, such as hedge funds, has also jumped, from $4.8tn in 2016 to $6.6tn in 2019. More striking, those non-bank institutions have quietly “become important sources of cross-border funding for banks, particularly in international currencies,” the BIS notes.

Yet again, those offshore financial centres feature: almost 20 per cent of banks’ cross-border dollar funding is now supplied by entities based in the Cayman Islands, a ratio only topped by those in the US, while entities based in Luxembourg and the Caymans are crucial in the euro markets. Or as the BIS concludes, “Banks’ positions with [non-banks] are concentrated in few countries, particularly financial centres.”

Should we worry about this? Not in the short term, perhaps. After all, the non-bank entities that banks deal with in offshore centres tend to be subsidiaries of the same asset managers or companies they deal with inside their home markets. There is no evidence that these exposures pose significant threats now.

But there are three longer-term issues that investors and politicians should ponder.

First, it is distinctly unnerving that the shadow banking sector is swelling, given that it played such a key role in the 2008 financial crisis.

After all, as the IESE report notes, while we do not know where the next crisis will hit, “if the past is any predictor of the future, we can be sure that entities that perform the functions of banks, but are outside of the regulatory perimeter, will play an important role.”

Second, it is also unnerving that the cross-border dealings between banks and non-banks appear to be so concentrated around offshore financial centres, particularly in relation to dollar financing. This could be a stress point if turmoil erupts in currency markets.

Third, the efforts that the BIS and FSB are making to produce better data on modern finance need to be supported by politicians and expanded (particularly since the data still has holes).

After all, it is not just the technology companies that are engaged in cross-border arbitrage games; the BIS data suggests that arbitrage is endemic in the modern finance and business world.

We need to shed light on this if we want to build a fairer and more resilient corporate system.

Those Cayman Islands might be one place to start.

Navigating The Conclusion Of This Economic  Slowdown 

by: Eric Basmajian


- A massive monetary deceleration started in late 2016, spreading to manufacturing, housing, and big-ticket consumption.

- The slowdown was of sufficient magnitude to impact services and employment growth.

- Global central banks flipped from tightening to easing which is aiding the housing sector.

- The ongoing employment slowdown poses a risk to an easing cycle that likely began too late.


Navigating The Conclusion Of This Economic Slowdown
Secular economic cycles, business cycles and the short-term 12-36 month growth rate cycle are all highly influential to asset prices depending on the time frame of the analysis.
The 30-year decline in sovereign bond yields can be largely attributed to a secular decline in the rate of population growth and productivity growth while "crashes" in the stock market tend to revolve around the realization or acceptance of a business cycle recession.
The growth rate cycle, the focus of this note, represents the 12-36 month fluctuations in the growth rate of the economy that occur within a business cycle.
Below we will take a deep dive into the sequence of growth rate cycles, the basis for leading economic indicators and the overlap between the growth rate cycle and the business cycle.
Economic cycles have a fairly predictable sequence that if followed correctly, can provide early warning signs of accelerations in broad economic growth or decelerations in closely followed coincident data.
By following the sequence of economic cycles and focusing most closely on the early movers of the cycle, a significant advantage is gained over analysts and investors that rely on the end of the sequence to provide color on the economy.
Central bank policy and monetary tightening/easing typically start the process. It is commonly reported that central bank policy works with long and variable lags. This is true. The problem, however, is that most analysis ends here and skips to the end of the sequence, or coincident data, overlooking the steps in between monetary action and coincident data.

As the diagram below shows, after monetary action has rippled through various monetary aggregates, sectors of the economy that respond most quickly include manufacturing, housing, and durable goods consumption.
Growth Rate Cycle Sequence Overview:
Source: EPB Macro Research
These sectors are early movers in the sequence, responding to changes in monetary policy (interest rates) because they are capital intensive industries, are highly cyclical and all have a heightened level of interest rate sensitivity.
After the monetary action flows through these early cyclical sectors, should the slowdown persist long enough and be of sufficient magnitude, changes in employment, income, and activity in these cyclical sectors flow through the less cyclical and less interest-rate sensitive service sector.
Lastly, the four coincident indicators that we all follow, industrial production, income, consumption, and total employment are impacted. These data points, when aggregated, provide a real-time gauge of the business cycle. This final stage is where the growth rate cycle (early cyclical sectors) and the business cycle (coincident data) overlap.
It is critical to hold these separate and at times opposing thoughts simultaneously.
With this sequence in mind, let's dive into the cycle and understand where we are today, what the risks are, and two possible ways to invest through the next several months.
Monetary Action
The current business cycle expansion that began in 2009 has come with 3 very distinct economic slowdowns (growth rate cycle) that can be closely tied to monetary action.
The chart below shows the GDP weighted global policy rate. In other words, an aggregation of all "fed funds rates," weighted by GDP.

As the chart shows, this cycle came with three attempts by central banks to tighten monetary policy.
When each tightening carried through the sequence described above, recession fears flared and central banks reversed course before the slowdown sufficiently impacted coincident data to be recessionary.
GDP Weighted Global Policy Rate:
Source: Bloomberg, EPB Macro Research
Each tightening attempt translated to a deceleration in global money supply growth. The chart below shows the growth rate in the money supply for 27 countries, weighted by GDP.
If we look at the prior two recessions, we can see that global money supply growth, an early mover, troughed before or during the recession, responding to the change in monetary policy upon realization of the recessionary threat. In these two instances, monetary tightening was too aggressive or the Fed did not act in time to prevent a recession.
In each of the prior two recessions, before the recession was over, global money supply growth soared, an early indication a recovery was on the way.
GDP Weighted Global Money Supply Growth:
Source: Bloomberg, EPB Macro Research
This stage is not the time to change portfolio positioning. We must see confirmation across short leading indicators in the next phase of the sequence.
Global money supply growth peaked at the end of 2016 before a massive monetary deceleration. The magnitude and severity of this current monetary deceleration was the first clue that the upcoming slowdown would be recessionary or near-recessionary.

By the middle of 2017, several months of monetary deceleration were clearly evident.
At this point, by the middle of 2017, understanding the global monetary tightening and the reaction in global money supply growth, the focus should be shifted to the early cyclical industries, most likely to be impacted by the change in policy impetus.
Cyclical Industries & Monetary Policy Impact
Starting with manufacturing, by the middle of 2017, we should have been on high alert for a change in trend.
The three-pane chart below shows the ISM Book to Bill ratio, core durable goods new orders growth and core capital goods new orders growth.
These three indicators all provide a short lead time over industrial production growth.
Right on cue, short leading manufacturing indicators peaked in Q3 and Q4 of 2017.
By Q1 of 2018, a slowdown in long leading data was confirmed by short leading manufacturing data.
This slowdown was baked in the cake long before any discussion of a trade war or tariffs.
Analysts and pundits attributing a majority of the economic slowdown on the trade war ignore the typical sequence of economic cycles and discount the impact of a massive monetary deceleration that began as early as December 2016.
Manufacturing Sector:
Source: Bloomberg, EPB Macro Research
Similarly, at the end of 2017, the housing market experienced an undeniable correction.
Pending home sales declined 12% peak-to-trough and total building permits fell 11%.
Building permits in the West, perhaps compounded by tax changes, plunged 17%.
In response to higher interest rates and tighter lending standards caused by monetary tightening, the housing sector corrected as expected.
Furthermore, it should be noted that from November 2017 through January 2019, the median sales price of a newly constructed home fell 11%.
Housing Sector:
Source: Bloomberg, EPB Macro Research
Durable goods consumption growth, which includes motor vehicles, home appliances, and furniture, all peaked at the end of 2017 in response to higher interest rates and tighter financial conditions.
Durable Goods Consumption Sector:
Source: Bloomberg, EPB Macro Research
Considering the classic economic sequence, by the start of 2018, a major monetary deceleration spread through all three cyclical sectors we'd first expect to see a change in conditions.
Attributing the current economic slowdown solely to the trade war is empirically misguided.
Not many analysts of the business cycle would argue that causing supply chain disruptions and denting confidence was a helpful policy in regards to economic growth. However, the prevailing wisdom that suggests fixing the trade war will solve the slowdown in growth overlooks the real cause of the economic deceleration that started over two years ago.
Summary Of The Growth Rate Cycle
To summarize the sequence above, starting in late 2016, a major monetary deceleration began which spread through the manufacturing, housing, and durable goods consumption sector. This slowdown was large enough and lasted long enough to impact services and all four critical areas of the business cycle, including employment growth.
Global central banks are now in a race to ease conditions and spark a recovery in the cyclical industries shedding jobs (manufacturing) before the decline in employment growth starts the vicious cycle of lower income growth, consumption growth, and employment growth.

Longtime Berkshire Hathaway Investor Loses Faith in Warren Buffett

By Andrew Bary 

Photograph by Johannes Eisele/AFP/Getty Images

A longtime holder of Berkshire Hathawaysold out of the stock in the second and third quarters, citing investment mistakes by Chairman and CEO Warren Buffett over the past decade, meager stock repurchases, and the drag of a cash hoard that totaled $122 billion on June 30.

“Thumb-sucking has not cut the Heinz mustard during the Great Bull Market of 2009-2019,” wrote David Rolfe, the chief investment officer of Wedgewood Partners, a St. Louis investment firm. “The Great Bull could have been one helluva of an astounding career denouement for Messrs. Buffett and Munger.” Charlie Munger is Berkshire’s (ticker: BRKb) longtime vice chairman. Buffett is 89 and Munger, 95.

Wedgewood has more than $2 billion of assets under management and oversees the $100 million RiverPark/Wedgewood Fund(RWGIX). It had held Berkshire for more than 20 years.

Rolfe cites Buffett’s investment sins of omission and commission in the past decade. Kraft Heinzstock (KHC) has been a notable loser and embarrassment for Buffett. Berkshire held a large position in International Business Machines(IBM)—about $13 billion—for much of the current decade and sold the position at close to its cost during a period when the overall market rose sharply.

Rolfe argues that Berkshire missed investing big in several major winners that “should have been in Buffett’s wheelhouse.” He cites Visa(V), Mastercard(MA), Costco Wholesale(COST), and Microsoft(MSFT).

“Buffett is incredibly well-versed in the payments-processing industry given his half-century knowledge in longtime holding American Express.These two stocks [Visa and Mastercard] should have been layups for Buffett.” Berkshire does hold both Visa and Mastercard, but the positions are relatively small and are believed to be ones initiated by Todd Combs and Ted Weschler, Buffett’s two investment lieutenants.

On Microsoft and Costco, Rolfe wrote that Buffett had “at his disposal unrivaled expert tutelage on each company in his hind pocket—but to no shareholder avail.” Munger is a longtime director of Costco, and Microsoft co-founder Bill Gates has been Buffett’s friend for 30 years and a Berkshire director for about 15 years.

Berkshire stock is are badly lagging the S&P 500 index so far this year and the stock is behind the market over the past five and 10 years, as well. Berkshire’s class A stock (traded under the ticker BRKa) has gained about 2% this year, against a 20% total return for the S&P 500—marking one of the worst years of relative performance for Berkshire during Buffett’s leadership of the company dating back to 1965. The class A shares are down 0.5% Monday to $310,970. The more liquid class B shares (traded under the ticker BRKb) are off 0.4% at $207.24.

Rolfe noted in the letter to investors that firm trimmed its Berkshire holding—once one of its largest positions—during the second quarter and sold out completely in the third quarter.

Rolfe wrote that Berkshire’s enormous cash position is becoming a drag on growth at a time when Berkshire’s economically sensitive portfolio of wholly owned businesses “have slowed considerably over the course of 2019.” Berkshire’s largest units include Burlington Northern, one of the four major U.S. railroads, and a huge utility business called Berkshire Hathaway Energy.

Rolfe wrote that he had long viewed Berkshire’s cash as a “valuable call option on opportunity in the hands of one of the most elite capital allocators extant.”

However, he grew frustrated that the cash has continued to build with Buffett repeatedly complaining that a disciplined Berkshire was losing out to aggressive private-equity firms in the hunt for deals.

Rolfe wonders why Buffett continues to play an acquisition game at which he is at a disadvantage—“very un-Buffett-like, in our opinion,” he wrote. Buffett has sought to position Berkshire as an ideal home for private companies that want to maintain their autonomy, but there have been few takers. And Berkshire also is a source of rescue capital, but there hasn’t been much need of that during a long bull market and economic expansion.

Berkshire has made only one major acquisition in the past decade, a $32 billion purchase of aircraft-parts maker Precision Castparts in 2016. That deal looks like a disappointment as the company’s revenue is little changed since then. Berkshire doesn’t disclose Precision Castparts’ profits—part of a lack of financial disclose by Buffett that irks some Berkshire holders. Rolfe views that deal as a mistake, although Buffett has spoken favorably about the company.

Berkshire did invest $10 billion recently in Occidental Petroleum(OXY) preferred stock on attractive terms—an 8% dividend plus equity warrants. But that deal was a rarity and Occidental CEO Vicki Hollub has taken heat from holders such as Carl Icahn for the sweet terms given to Berkshire.

Berkshire didn’t respond to a request for comment.

Rolfe also expressed frustration with what many Berkshire holders consider the modest amount of stock buybacks under a more-expansive program unveiled in the summer of 2018.

Berkshire bought back $2.1 billion of stock in the first half of 2019. At that pace, the company would buy back less than 1% of its shares outstanding this year. The company’s market value is $510 billion.

“Buffett seems to abhor returning ‘capital paint’ to shareholders while his Berkshire canvas is still ‘in paint,” wrote Rolfe. “Any future conviction of ours in Berkshire Hathaway shares will closely mirror that of Buffett’s own conviction in Berkshire share buybacks,” Rolfe concluded.