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What is Driving the US Dollar Higher and its Impact on Emerging Market Economies? Is There a Trade-off Between Inflation and Recession? Image

What is Driving the US Dollar Higher and its Impact on Emerging Market Economies? Is There a Trade-off Between Inflation and Recession?

October 17, 2022

What is driving the US Dollar higher and its impact on emerging market economies? Is there a trade-off between inflation and recession? Where are stock markets heading and which investment strategies are likely to protect your wealth in uncertain economic times?


Insightful views about the US Dollar, emerging market economies, the conundrum between inflation and recession and the type of investments including gold and silver which may protect wealth in a stagflationary environment.


What is driving the U.S dollar higher and what are the implications?


The U.S dollar is on a tear against a basket of major currencies since the start of the year. First reaching and then breaching parity against the euro.


Please see the graph below which shows the US Dollar performance versus Pound Sterling and Euros since 2000.



It has reached its highest level in over 20 years having only been higher on three separate occasions in the past 60 years.


Please see the graph below showing the US Dollar Index performance since 1970.


Although the U.S dollar is significantly overvalued based on various technical indicators given the debt dynamics, it’s difficult to determine how much further upside there is. This ultimately, although not exclusively depends on the pace of rate hikes in the U.S compared to the European Central Bank and Bank of England which have been slow in raising rates. That’s starting to change now as the Bank of England and European Central Bank focus more on inflation.


One of the main drivers is that the higher U.S interest rates have fuelled the carry trade whereby investors swap 0% yielding euros for dollars to buy U.S treasuries paying 3%. It’s a speculative and lucrative trade which has pushed the U.S dollar much higher. Another is the flight to safety arising from economic uncertainty and geopolitical tensions as well as the war in Ukraine. The U.S dollar also remains the global reserve currency and there is nothing to replace it yet which can be hugely supportive in times of crisis. There is also the marginally higher GDP growth in the U.S relative to other developed nations.


Please see the graph below the comparative GDP numbers of the major economies Pre and Post Pandemic.



The BRICS (Brazil, Russia, India, China, South Africa) economies are sounding out other partners in the middle east and elsewhere to create a new reserve currency which better serves their economic interests. Russia in particular wants to end their dependency on the U.S dollar to avoid further economic sanctions. There is a strong economic argument for this push as U.S share of global trade continues to wane over time. The BRICS want to de-dollarize their economies and create a reserve currency which is pegged to gold, possibly silver and a wider commodity base.


BRICS countries are significant producers of gold so they are justified in wanting to end their reliance on the U.S dollar when their currency can be pegged to gold which is unearthed from the ground, which no one can exert any control over, and which BRICS produce in abundance? This has been talked about for over 10 years but the political appetite to move away from the U.S dollar as a reserve currency is very strong now and likely to weaken the U.S dollar over the longer term.


What is the impact of a strong U.S dollar on emerging market economies?


Nobody seems to be talking about the implications of a strong U.S dollar on emerging market economies even though this could wreak havoc on the global economy. The possibility of bond defaults disrupting international bond markets resulting in rising yields and increasing the risk of contagion could trigger another financial crisis. This may well be the straw that breaks the camel’s back.


Please see the graph below showing emerging market currency devaluations versus the US Dollar in 2022.



What happens when the U.S dollar sees huge gains?


Foreign investment and capital flows into emerging markets evaporate due to investors preferring less risky assets such as U.S treasuries. This then forces countries to raise interest rates to stem the capital outflows which has a dampening effect on growth. The resulting local currency devaluations caused by capital outflows make servicing the U.S dollar debt more difficult leading to higher interest rates and making sovereign debts harder to pay off.


It impacts not just governments but also companies and banks, all of which have large U.S dollar denominated debt. The question is when will the international community intervene in currency markets to weaken the U.S dollar and prevent the next financial crisis?


Is there a trade-off between inflation and recession?


Despite the Federal Reserve’s efforts to tame inflation through higher interest rates, they haven’t been able to cool down prices. To drive inflation lower they will have to raise interest rates to a point which destroys aggregate demand and engineers a recession.  If the federal reserve wants to regain its credibility as a guarantor of maintaining stable prices, a recession in our view is now almost inevitable. We have been kicking the can down the road for too long, the day of reckoning has arrived and there is no magic bullet or get out of jail free card, just a hard reality.


As it stands, we have too many macro-economic imbalances with debt problems similar to the 1940’s, inflationary pressures of the 1970’s, a stock market bubble of 2000 and interest rates rising. In addition to this we have liquidity drying up with quantitative tightening in full swing and the rapidly appreciating U.S dollar causing imported inflation across the globe.


If you’re in doubt about the trade-off between inflation and recession or that we are already in the midst of a recession then you should pay attention to what FedEx, a bellwether for the U.S and global economy have to say. CEO Raj Subramaniam announced last week that they had missed earnings expectations due to weakening global shipping demand, to expect significant cost cutting and warned of a worldwide recession.


Please see the graph below which compares the Purchasing Managers Index reading for USA, Japan, Europe and UK.



Where are stock markets heading from here?


There are different methods of valuing stock markets but one of the most widely used measures, the price to earnings ratio, tells us equity markets are overvalued. We have already seen U.S equity markets drop off 30% from their highs in November 2021. Whilst the price has dropped to reflect a bleaker economic outlook, corporate earnings have proven sticky.


We haven’t yet seen a decline in corporate earnings but once higher interest rates and liquidity withdrawal starts biting; we should expect corporate earnings to decline and stock markets to trend lower to reflect the new economic reality. There is further downside in U.S equities across the board, moreso in interest rate sensitive sectors such as technology. We wouldn’t be surprised to see the S&P below 3,000 meaning a further <20% decline in U.S equity prices.


What are the investment implications and how does one go about protecting their wealth?


You need to remain calm with the mindset of a long-term investor. When risk is off the table markets are incapable of discerning the difference between good and bad investments. In a general sell off making hasty decisions is usually painful. These markets paradoxically provide the best long term investment opportunities. The smart investor focuses on pockets of value in the market adopting a contrarian approach to drive long term investment returns.


Russia is looking to launch the Moscow Wealth Standard (MWS) to compete with the London Bullion Market Association (LBMA) which systemically manipulates precious metal prices to the downside. It quite rightly seeks to normalize the functioning of the precious metals markets to enable market forces to determine the fair value of gold and silver and other such commodities. It’s no secret that some of the larger U.S banks sell gold and silver futures to drive the price considerably lower to then buy the physical metal. Basically, profiting from short term price movements in the futures markets whilst stockpiling holdings of physical gold and silver at heavily discounted prices to benefit from a long-term revaluation.


Please see the graph below which tracks the USA M2 Money Supply versus Gold for the past 50 years and suggests extreme gold undervaluation relative to money supply.



We continue to recommend precious metals such as gold and silver, other base metals such as (copper, nickel and platinum), agricultural commodities, energy, infrastructure, value stock, thematic investments with long term growth opportunities such as electric vehicles and holding some cash whilst we wait for a buying opportunity.


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