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Most US economic indicators point to a continued deterioration due to America’s failure to control the Covid-19 pandemic.
The US will continue to need massive government stimulus financed by the Federal Reserve’s balance sheet, which is up by $3 trillion to $7 trillion since February. It is expected to grow to $10 trillion by year-end to maintain consumption levels, according to Bank of America Global Research. Congress has so far failed to agree on a new stimulus package.
Consider the gloom and doom data:
- A 1.1% decline in June personal income following a revised -4.4% decline in May (vs. 4.2% initially reported);
- A fall in the University of Michigan Consumer Sentiment Index to 72.5 in June from 101 in February, that is, to the lowest level since early 2012;
- Initial jobless claims for the week ended July of 1.43 million and continuing claims of 1.7 million;
- Durable goods orders at 10.8% below year-earlier levels;
- Johnson Redbook same-store sales at 8.7% below year-earlier levels as of July 25.
This portends a long and deep US recession. In theory, a falling dollar should help restore equilibrium to the economy by cheapening dollar assets and encouraging investment. This has been true for homebuilding, the strongest sector in the economy, although housing starts in June remained below the previous year’s level.
But it does not appear to have helped investment in productive plant and equipment. If precautionary savings remain high and consumers retrench, US GDP will remain depressed. 70% of US GDP is household consumption, compared to an OECD average of 60%.
The dollar will continue to fall as its fundamentals, namely debt and current account, deteriorate and the economy searches for but fails to find a new equilibrium.
We continue to examine the investment implications of prolonged dollar weakness.
The star performers to date have been the FAANG group (Facebook, Apple, Amazon, Netflix, Google), as well as Tesla, Nvidia, Alibaba, Twitter and Baidu, up a remarkable 50% during the year to date despite falling revenues. The tech monopolies are trading on aggressive analyst profit forecasts and we believe are vulnerable to disappointment.
Some mainstream forecasters have aggressive price targets for gold. Bank of America sees $3,000 in 18 months, up from $1,968 on the morning of July 31, while Goldman Sachs forecasts $2,300 by year-end. Peter Schiff of Euro Pacific Capital is talking about gold at $15,000. His target isn’t necessarily wrong, although we disagree with his logic.
The price of gold is like the price of life insurance on the Titanic after a close encounter with an iceberg. Treasury Inflation-Protected Securities also provide an insurance policy against extreme moves in the dollar. The trouble is that buying TIPS is like buying insurance from the captain of the Titanic.
TIPS pay off against the Consumer Price Index (CPI), which may not compensate investors for the impact of a dollar crash. That’s why gold broke from its longstanding relationship with TIPS yields.
How far can gold rise? It’s instructive to compare gold to another asset that is outside the financial system but useable for payments, namely Bitcoin. Gold and Bitcoin have traded in the same direction this year, although Bitcoin is considerably more volatile.
Bitcoin’s huge initial returns followed the market’s gradual familiarization with the asset. It has scarcity value like gold, and the advantage that it can be used directly as a means of payment. It has two great disadvantages, though.
The first is that countries may ban its use, and the second is that the cryptography which underlies its scarcity value may be compromised by new technologies, notably quantum computing. By contrast, gold is held as a monetary reserve asset by most of the world’s central banks and is used as a store of value by billions of people.
There is no technology that would drastically change its scarcity value.
A statistical technique known as Principal Components Decomposition shows the degree to which returns to each asset in a portfolio are determined by a common factor, and how much of the variance is explained by each of these factors. We looked at daily returns to a portfolio of dollar hedges: the Euro, Yen offshore RMB (CNH), Swiss Franc, gold and Bitcoin.
The first Principal Component is clearly a “currency factor,” to which gold as a small exposure and Bitcoin none at all. This explains 42.5% of overall variance.
The Second PC is an “insurance factor” to which Gold and Bitcoin are heavily exposed and – significantly – CNH is somewhat exposed. That indicates that CNH is acting to some extent as a form of insurance against a dollar crash.This explains an addition 24.3% of overall variance.
The third factor is common to CNH and gold, another statistical measure of the extent to which CNH has become a form of insurance against the dollar.
The factor loadings are shown graphically below:
To summarize the remarkable result of this exercise:
- The dollar’s weakness places a premium on assets outside the financial system such as gold and Bitcoin, although we think gold far the more reliable of the two; and
- To some extent, the Chinese currency is acting as a form of insurance as well.
To be sure, there is quite a difference between a national currency and an asset like gold. If a currency appreciates too much, the deflationary effect on its home economy will depress economic activity and put a brake on the rise of the currency. There is no limit to how far gold may rise.
This view of the relationship of the increasing gold-like role of China’s currency has implications for equity investment.
CNH dropped from 6.92 per dollar on March 4 to 7.15 on March 19 under the impact of the Covid-19 epidemic in China and took another hit to 7.18 per dollar at the end of May when US President Donald Trump banned a US government fund from investing in Chinese securities.
But is has been solid as a rock ever since and today, August 3, is trading at 6.98. The vast difference in ability by the US in comparison to China of coping with the coronavirus pandemic and its economic consequences accounts for recent CNH strength and will only become more pronounced in coming months as the economic disparity persists.
However, CNH is not an ideal dollar hedge. The People’s Bank of China ties the CNH’s onshore cousin, the CNY, loosely to the dollar by setting CNY central parity every morning and only permitting a +/- 2% move relative to parity.
Still, CNH can function as indirect protection against further dollar weakness by shifting from US dollar assets into Chinese equities or – mainly for longer-term instiutional investors – into Chinese debt securities.
Banks have been the big underperformers in China’s equity boom. The H-shares of the big four state banks plus the largest private bank, China Minsheng Bank, are shown below on a normalized scale.
China Construction Bank, the best-managed of the group, is trading at a forward P/E of 4.7, more than a standard deviation below its 7-year mean.
It is instructive to compare CCB’s performance to the European bank index (SX7E). In the first phase of the COVID-19 crisis CCB fell in Hong Kong from $6.8 to $5.9 before recovery to $6.4.
During the March equities slaughter, it was little changed while the European bank index fell from about 90 to about 50. Then CCB fell from around $6.4 on July 15 to $5.7 on July 31 while the European index was barely changed.
China’s economy is growing while Europe’s is shrinking, and the Chinese yield curve is still in positive territory, which means that banks can make money by taking deposits and making loans.
Moreover, China’s growth edge will prove an advantage in regard to potential credit losses. We attribute the plunge in Chinese bank equity prices to the prospect of US sanctions against Chinese banks designed to restrict their access to dollar funding markets.
The first news of prospective sanctions emerged around July 8, when CCB was trading at around $6.6, before plunging to $5.7 while the European bank index remained almost unchanged.
That warrants a buy recommendation for Chinese banks. We do not expect that the Trump Administration will use the nuclear option against Chinese banks at a point when the dollar’s reserve status is facing severe doubts. Indeed, such a move could prove to be a nuclear option against the dollar.
Even if the Trump Administration did so contrary to expectations, China could weather the problem without much difficulty. In case of need, the People’s Bank of China would sell US Treasuries to provide dollar funding to Chinese banks.
The total dollar liabilities of Chinese banks are probably below $600 billion, or about a fifth of China’s foreign exchange reserves. China moreover has longstanding plans in place.
If Chinese banks, for example, are excluded by sanctions from the SWIFT system, the principal mechanism for cross-border interbank payments, China’s Cross-Border Interbank Payment System could take up most of the slack.
Chinese official and semi-official sources issued solemn warnings in July that Chinese banks should prepare themselves for such sanctions. This apparently depressed bank shares—without justification, in our view.