The U.S. dollar is on a strong trend, as the expectation of the Fed’s tightening is driving deleveraging of dollar-financed carry trades. On the other side of the strong dollar are a weak pound, euro and yen.
The decline of commodity currencies is the clearest trend. The Australian dollar, Canadian dollar and the currencies of several commodity-export-dependent emerging economies have declined sharply. The trend is likely to continue throughout the year.
Stocks will remain volatile on conflicting news regarding liquidity and growth. Fueled by asset inflation, the United States’ growth rate is picking up, and dollar liquidity is receding in anticipation of higher interest rates ahead. The growth outlook for Europe and Japan remains fragile. Their quantitative easing is likely to remain intact through 2013. Most big companies are global in their sales and earnings. Hence, their stocks will fluctuate with mixed news on growth and liquidity.
A limited crisis in emerging markets is still possible. As hot money is leaving them, they are facing difficulties in adjusting to the tighter liquidity environment. The recent political disturbances in Brazil, Egypt and Turkey amplify the uncertainties.
Gold is likely to perform well in the second half of 2013. While the rising U.S. dollar keeps downward pressure on the price of gold, rising global uncertainties support its role as a safe haven. Further, gold pricing is shifting to the East from the West. The Shanghai market is likely to overshadow London or New York within five years. Hence, the price of gold will increasingly track China’s monetary policy rather than that of the United States.
The Dollar’s Long Shadow
A rising dollar is the most important trend in financial markets. Its importance is in the role of dollar liquidity in carry trades since 2008. Since 2008, the Fed has communicated its intentions clearly to the financial market. It decreased the risk to using the dollar to fund speculation. Based on the surge in the forex reserves of emerging economies, it appears that trillions of dollars of hot money have flowed into emerging economies. A strong dollar is triggering a reversal. The full consequences are yet to be felt.
The U.S. economy is recovering. Without fiscal consolidation, it could be growing at 4 to 5 percent now. I believe asset inflation is driving the U.S. economy. Its current net household wealth has surged 45 percent to US$ 70 trillion from the low of US $48 trillion in 2009, and significantly above the pre-crisis peak of US$ 63 trillion. The Fed’s tightening is primarily to prevent a full-blown asset bubble. Its burst could bring another financial crisis.
As the global tide of hot money recedes, the chances are that the United States’ asset markets will be resilient. Much of the hot money will just vanish due to deleveraging. Some money will be reallocated to the U.S. market from others. Hence, the United States’ asset prices are better supported than others.
In the medium term, the U.S. dollar’s outlook hinges on the continuing rise of the U.S. stock market. It is a self-fulfilling expectation. If most investors believe in the U.S. economy, the money will flow into the country’s stock market. Its rise creates enough wealth effect to sustain the economy. The strong economy justifies the optimism. The money keeps coming.
In the longer term, if the fundamentals improve sufficiently, the bubble element in the economy could be digested through flattening out asset prices while letting the economy grow. Energy and agriculture are bright spots for the U.S. economy. They are not sufficient to carry the economy. The key to the U.S. dollar’s future, in my view, is in improving the quality of the U.S. labor force. Without major progress there, the dollar will collapse again.
The United States’ virtuous cycle depends on lack of competition for money. The main alternative is China. Since China joined the World Trade Organization, global money flow has favored it. This was a major factor triggering the weak dollar between 2002 and 2012. After 2008, the flow to China at the expense of the United States accelerated.
When international money flows to an economy and is used to enhance its competitiveness, the optimism is validated, and the money inflow will receive its appropriate reward by sharing in the growth. However, the money could be used to finance an asset bubble. It creates paper gains for the capital inflow in the short term. The optimism is validated too, which encourages more inflow. But, this is an unsustainable dynamic. When the bubble peaks, everyone realizes that the optimism is misplaced. Capital flight follows, and with it the bubble bursts.
China’s economy was mismanaged after 2008. Instead of learning from the bubble disaster of the United States and embarking on structural reforms to improve competitiveness, China merely used fiscal and monetary stimulus to amplify an existing bubble, creating a feeding frenzy of getting rich overnight. As the U.S. economy improves and attracts more money, China’s bubble bursts.
To reverse the situation, China must embark on structural reforms to improve competitiveness. It has a major advantage over the United States. With per capita income of US$ 6,000, its growth potential is far greater. If the reforms can convince the market that China’s potential can be realized, the money will return.
The competition between China and the United States for money is a key global dynamic. The yo-yo dynamic between the two will dominate the global economy for decades. It amplifies the up-and-down cycle in either. As the composition of growth is quite different between the two, other economies will float up or down depending on their relationships with either.
The yo-yo dynamic now is in favor of the United States. Hence, the economies that have benefited from China’s boom are suffering. Commodity exporters are the most exposed. Their currencies are adjusting to reflect the new reality.
The Australian dollar has declined nearly one-fifth from its peak. There is much more to come. The most vulnerable commodities to China’s down cycle are industrial minerals. Since China joined the WTO, the price of iron ore rose nearly ten times. Australia has benefited enormously from the trend. It suffers most on the way down too. The Australian dollar’s adjustment is not half done, in my view.
I thought that oil would be resilient compared to industrial minerals because it cannot be recycled. It has performed even better than I expected. China’s electricity production has slowed two-thirds. The price of oil should have halved. But Brent crude remains above US$ 100 per barrel, down less than 20 percent from the last year’s peak. Its strength is probably due to Saudi Arabia managing supply and the turmoil in the Middle East.
The uniqueness of the energy story suggests that the currencies of energy exporters like Canada and Russia perform better than that of mineral exporters like Australia and Brazil.
Emerging economies as a whole are facing difficulties. They suffer declining export prices and hot money leaving. To stop a vicious spiral of currency depreciation and inflation, they have to tighten monetary policy in an economic downturn. If they try to protect growth by easing monetary policy, the vicious spiral could lead to another emerging market crisis like in 1998.
Gold Moves East
There is a negative correlation between the U.S. dollar and gold in recent history. In light of the strong dollar, huge amounts of short positions have been built up in gold and gold stocks. I suspect that the correlation will not work in the second half, and such short trades will turn out badly.
At the beginning of the year, I expected that a strong U.S. dollar would pressure the price of gold in the first half. But it would perform better in the second half as the U.S. stock market slows, diverging less money away from gold. A new factor strengthens the case for gold. The physical demand has been extraordinarily strong in response to the slide in the price of gold. This could be a turning point in gold history. The pricing of gold may move permanently to the East from the West.
China and India account for roughly two-thirds of global demand for gold. Other emerging economies account for most of the rest. But, the price of gold is fixed in London or New York and driven by U.S. monetary policy. This is obviously wrong. But inertia is a powerful force. Financial markets continue with what has worked in the past.
The tension between where gold is priced and where demand is located is manifesting itself in two ways: first, gold shops in Asia have no physical gold to meet demand; and second, the price of gold set in Shanghai is consistently higher than in London or New York. Physical gold is likely to flow from the West to the East due to the pricing gap. It is only a matter of time before the warehouses of London and New York are emptied. When the stock is all shifted to the East, the price fixed in Shanghai will become the real price. The gold exchanges in the West will wither.
China lost gold to the West from the mid-19th century onwards. Domestic uncertainties drove waves of immigration financed by gold. The trend has reversed over the past decade. And the trend is likely to accelerate in the coming decades. India has the most gold in the world. The Fed has the most gold reserves among all central banks. China is likely to surpass both in the coming decade.
Gold is a substitute for money. Gold production is about 3,500 tons per year and is worth US$ 154 billion or 951 billion yuan. China’s M2 is likely to rise by 14 trillion yuan or 16 times the gold supply. Within five years, Chin’s M2 could rise by 2 trillion yuan per month, while the supply of gold will remain the same. Gold should trade with China’s money supply, not with that of the United States.
In addition to China, India will remain the second largest source of demand. Even if its economy grows at 5 percent per year, proportionally, its gold demand will increase by 28 percent in five years. As the Bank of Japan targets 2 percent inflation, the Japanese have become a force in gold demand too. Looking beyond the shadow of the strong U.S. dollar, gold has a very bright future. I believe that the price of gold will top US$ 3,000 per ounce in five years.
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