Strength of the Dollar: Will the Dollar become really Strong

Strength of the Dollar: Will the Dollar become really Strong 

The most anticipated trade of 2016, Trump or No Trump is over and Wall Street and other markets have moved on to the second most anticipated trade on how strong would the Dollar become. With the pre-election mood of made in America for America by Americans, the Dollar looks to become very strong but how strong would it really become and how strong would the Trump administration like it to become is the question that would be guide the world markets in 2017. This would be the Trump trade 2.0.

The first trade was about a sudden swing away from positioning for deflation and an economy dominated by monetary policy, in favor of readying for inflation and an active fiscal policy. Having grown slightly excessive, that Trump trade has been corrected somewhat and a second Trump trade starts.

This trade will last and dominate a major portion of the way, markets trade in 2017.  I suspect, until markets have learnt how to interact with a novel means of policy communication. It will involve increasing volatility, and the critical variable will be the dollar.

The fluctuations so far have given the clearest taste of what lies in store. Donald Trump, provided the fuel in an interview recently where he described the Dollar as “Too Strong “.  This was obviously dollar negative.

Also, more importantly he gave an idea on the border tax,  the idea that taxes should be based on cash flow, rather than income or profit, and be applied on a destination basis. This would mean products exported outside the US would not be subject to US tax, while imports would be taxed wherever they were produced. This is a radical notion, supported by many Republicans in Congress, and very much in line with the wishes of Mr Trump’s core electoral support.

After banks and investors across Wall Street had published copious research on the possibly profound effects of a border tax on both equity and foreign exchange markets. The president make a few statements that a border tax would be complicated and he himself would love it.

Most Analyst on Wall Street and in other markets are of the consensus that border taxes are complicated. Any version would create winners and losers among equities, dealing a potentially critical blow to businesses whose model revolves around imports, such as retailers, whose shares have been under pressure so far this year. It would also have a direct impact on the dollar.

Market Pandits at Wall street feel that dollar would go up one-for-one with a border tax, which was “short-term right, long-term very wrong. The rise in the dollar would counteract the higher cost of imports.

The border tax would strengthen the dollar, at least until it stimulated US businesses to substitute imports with goods built at home. While markets have moved to discount some of the risk, positioning even before it actually happened.

                                                        

 There was enough interest on border tax for the president’s comment to push down hard on the dollar, whose trade-weighted index is down 3.44 per cent from its high two weeks ago, and back to a level it first reached a week after the election.

Antipathy to a strong dollar would make it harder to raise rates and the federal funds futures market has pegged back the odds on three rises this year, as projected by the Federal Reserve, to where they were before the Fed’s statement last month. The yield curve, expressed as the gap between 10-year and two-year Treasury yields, has tightened and is flatter than it was at the beginning of 2016. These are corrections to the first Trump trade.

Meanwhile financial stocks, despite earnings figures solidly ahead of expectations so far, have suffered in line with the shifting picture on rates and the dollar.  The value stocks have had a rotten start to the year, for a similar reason, while dividend earners have recovered slightly.

Progress will depend on what gets passed in Washington — and investors will have to put up with plentiful confusion and conflicting starts. Expect rising volatility and reduced correlation between stocks as traders react to Mr Trump’s specific comments as they arise. Investors will have to put up with plentiful confusion and false starts.

_ Farzan Ghadially

The Trade for 2017 @ Wall Street

The Trade of 2017:

The three most recommended trades for 2017 with market consensus are that most brokerage houses are recommending …

The first possible trade is buy US banks this year and it will bring you great wealth. The second possible trade of 2017,  is to sell short overvalued consumer staple stocks.  But the single most compelling trade that I feel would work out very well   is to buy German government bonds.

 Why could you possibly want to buy debt that offers a minuscule or negative yield? Surely only a fool would pitch such an idea is what most people would think.

Conventional wisdom has it that to buy German government debt is at best unimaginative and at worst brainless. Bond yields are low because growth in the Eurozone and inflation expectations are subdued and interest rates are likely to remain low for many years to come. To buy fixed income securities that offer such a poor return is viewed as a sad admission of investment defeat, as though the best that can be hoped for is to get your principal back more or less in one piece.

Looking at it in a different way, the apparently dull investment is one of the most mispriced opportunities on offer. The investor who buys Bonds today is in fact taking out a compellingly priced and highly asymmetric bet on the break up of the Eurozone at some point before the bond comes to maturity.

The logic behind this trade is as follows. Although it is impossible to quantify, there is a risk that the single currency will split, whatever form the break-up would take. What can be stated more certainty is that in such an event a future German currency, call it the Deutschmark 2.0, would trade at a far higher level against rivals than the euro.

Germany’s current account surplus as a percentage of gross domestic product has risen steadily since the adoption of the single currency it was 8 per cent last year and its current account has strengthened relative to that of the US. A standalone Deutschmark should trade at a significant premium to the euro when priced in US dollars.

In the event that a German currency was set free from the artificially low single currency, the value of the redenominated German government debt should appreciate significantly. This means anyone buying Bonds today is in fact buying an embedded option on this potential future appreciation.

The question is how aware is the wider market of the existence of this embedded option, and what value can be ascribed to it?

Unlike a regular option, buying German government bonds does not involve paying an expensive premium and losing money to time decay. A 10-year Bond can be purchased today at a yield of 0.3 per cent, meaning that a position can be held for a decade with a positive cost of carry, at least in nominal terms.

A second advantage is the asymmetry of the risks involved in holding the position. You are unlikely to lose money but retain the possibility of a significant pay-off should a Eurozone break up occur. Provided you keep faith in the creditworthiness of the federal German government, the greatest risk is a sharp rise in Eurozone inflation, which erodes the value of your principal.

You also risk a mark to market loss should German yields rise from your purchase price, but holding the position to maturity would negate this.

The final advantage to the trade is tactical the position is highly liquid and cash like so there is little opportunity cost in holding it. In the event of more attractive investments arising over the duration of the bond, it can be easily sold and the proceeds reinvested.

Many smart investors have over the years come up with complicated ideas to bet on the break-up of the single currency, with mixed results. It may be that the simplest and most effective has been staring them in the face all along.

The big risk of this embedded option trade is if inflation jumps in the block.

_ Farzan Ghadially

No Short Term Crisis coming in 2017 in the Chinese Markets

Western Concerns Justified on the Chinese Markets, but no Short Term Crisis coming in 2017.

When the direct trading link between stock markets in Shenzhen and Hong Kong opened last month the international investors ready to take advantage of what was billed as a big opportunity to buy into Chinese equities.

The link offers foreign investors greater access to shares on the Shenzhen stock market, home to some of China’s up comming technology companies. However, flows reached just a fifth of their daily limit on the link’s debut and have failed to match that since.

Judged by the money, international interest in Chinese stocks remains anemic. Yet talk to strategists focused on the country and many think the worlds second-largest capital market could be on the brink of another bull run.

 A lot of international investors still like the China  market . There’s incredible dispersion in this market and a lot of change, whether it is driven by regulation or reform, but also change driven by technology and within that we can find some fantastic opportunities is the overall call on a broad basis.

The skepticism of international investors is understandable. It has been more than a year since Chinese stock markets were synonymous with anything other than headaches. The last big bull market in early 2015 was eye-popping in scale and it caught most fund managers off-guard. The bust that followed was brutal and those whose money was trapped when about half the listed market suspended trading still bear the scars.

Since then, angst about China’s currency policy has triggered two episodes of global market turmoil and concerns about its weakness are growing once more.

Small wonder that Hong Kong-listed Chinese companies still the broadest means of gaining exposure are trading on a soggy 8 times expected earnings, compared with a ratio of 15 times for the MSCI Asia-Pacific.

Yet leading brokerages like Morgan Stanley recently upgraded China to “overweight” for the first time in 18 months, looking for a rally led by earnings growth.

Others have focused on potential misunderstandings by western investors of changes in China.

There is a lot of concern about the financial systemic risk for the whole banking system; the second is the big concern about the property tightening related downside risk this year. And, thirdly, a lot investors and analyst underestimate the China reform process.

The economy’s debt mountain is a long-running concern for China watchers. Overall debt has risen to more than 250 per cent of gross domestic product from about 150 per cent 10 years ago a very high increase.

But the bulls argue this may be peaking and in key areas, beginning to ease.

 I do acknowledge that the overall gearing level is high but I do not believe there is an imminent risk of a short-term crisis, in my opinion.

One of the biggest risks for China, however, may be outside its control namely the action of US president Donald Trump. Mr Trump has threatened to label China a currency manipulator and impose 45 per cent tariffs on Chinese imports.

In my opinion if this danger does play out, which could take more than a percentage point off Chinese growth by some estimates but think the likelihood of Mr Trump making good on his threats is slim since it would hit the US too, raising the prices of everyday items.

This year the Shanghai Composite and its Shenzhen counterpart are down 12 per cent and 15 per cent. Crucially, however, neither has broken below its average valuation of the past five years, implying sentiment this time has not been so thoroughly crushed as it was in the four-year bear market to 2014.

China’s bulls are counting on it and I do not believe there is an imminent risk of a short-term crisis.

_ Farzan Ghadially