by Asset Allocation Committee | PDF

In June, we published a WGR on the EU’s decision to issue a Eurobond, a financial instrument backed by the full faith and credit of all the member states of the European Union.  One of the reasons the U.S. dollar remains the global reserve currency is because the world financial system works on a dollar/Treasury standard.  The U.S. has open trade and capital markets.  Because of America’s willingness to accept persistent trade deficits, foreign countries can acquire dollars through trade and easily hold those dollars in reserve in the deep American financial markets.  The premier reserve instrument has been the U.S. Treasury; in fact, it could be argued that the Treasury is America’s greatest export product.

The attractiveness of the dollar as a reserve instrument is relative; American management of the reserve currency is far from ideal.  When the world shifted from the dollar/gold to dollar/Treasury, Europeans complained that the U.S. was exporting inflation through a weaker currency.  Treasury Secretary Connally noted that the dollar “is our currency but it’s your problem.”   Volcker’s anti-inflation policies of the early 1980s was a major contributor to the Latin American debt crisis and the “lost decade” of the 1980s for South America.  Since 9/11, the U.S. has used financial sanctions as a foreign policy tool.  Restricting access to the U.S. financial system has proven to be very effective in crippling foreign economies.[1]  But, these sanctions are not popular with foreign governments.  Dissatisfaction with dollar management has not reached a level adequate to overcome the network effects that keep the dollar as the reserve asset.

It is important to note that we view the introduction of a Eurobond as a catalyst for a change in trend but the primary reason for a new dollar bear market is valuation.  Against most major currencies, the dollar is deeply overvalued.

Our primary valuation model for currencies is purchasing power parity.  This model uses relative inflation to value currencies.  It is not a trading model; exchange rates tend to vacillate around the forecast parity level.  But, at extremes, it can signal that the exchange rate is vulnerable to a reversal.  In general, dollar bull markets tend to end with a catalyst.  The 1970s dollar bear market began with the closing of the gold window.  The 1985 bull market ended with the Plaza Accord.  The 2002 trend reversal began with statements pressing for a weaker dollar from the U.S. Treasury secretary.  As is true of many markets, valuation alone doesn’t cause reversals, but it creates conditions where a reversal is more likely.

Perhaps another way of thinking about the dollar is that the exchange rate creates winners and losers.  A strong dollar adversely affects exporters and industries that compete with imports.  It supports importers and solely domestic industries.  A weak dollar has the opposite impact.  Thus, over time, when a sector is harmed a political reaction will follow which leads to a reversal in trend.  With the dollar, the cycles tend to be long, meaning that the level needs to be extreme to trigger a policy response.

This chart shows the JP Morgan Dollar Index, which is adjusted for inflation and is trade weighted.[2]  Bull markets are colored in green, and bear markets in mauve.   For a U.S. dollar investor, the path of the dollar’s exchange rate is a critical component of foreign investing.

This table uses the dollar cycle dates and compares the MSCI U.S. Index with the MSCI World ex-U.S. Index.  We use the yearly change in monthly data, averaged over each cycle.  On average, the latter index outperforms the U.S. in dollar bear markets, whereas the U.S. outperforms during dollar bull markets.  There are two other characteristics of note.  First, cycles last a while; the average dollar bear market lasts 111 months (just over nine years) and dollar bull markets last 88 months (eight years).  Second, dollar bear markets tend to have higher levels of volatility.

If our postulate is correct and the dollar is about to enter a bear market, the outlook for foreign stocks relative to domestic stocks improves.  Although there is no certainty that our position is correct, the combination of an overvalued currency, a lengthy bull market, and a Eurobond catalyst increases the odds that a reversal is likely.  If so, the outlook for foreign equities should improve.

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[1] Iran can attest to this assertion.

[2] Countries that conduct more trade with the U.S. are weighted more heavily in the index.

by Asset Allocation Committee | PDF

(NB: Due to the Labor Day holiday, the next report will be published on September 18.)

The U.S. economy is driven primarily by consumer spending.  In 2019, for example, personal consumption expenditures on goods and services accounted for 67.9% of U.S. gross domestic product (GDP).  For the economy to grow, consumers simply must boost their spending.  But what allows consumers to do that?  Generally, consumers need to fund their spending out of income, so one key to sustained growth in consumer spending is sustained growth in consumers’ income.  The Commerce Department tracks the total volume of personal income in the economy, including wages and salaries (the large majority of income).  It also counts proprietors’ income, dividends, interest, rent, and the like.

The problem is not all that income is available to be spent.  As the saying goes, there is nothing certain in life but death and taxes.  Since one can’t easily avoid paying the government’s take, economists typically focus on personal income after taxes, commonly referred to as “disposable income.”  The graph below shows how the total volume of disposable income has grown at a slower and slower rate for most of the time since the mid-1980s.  The slowdown reflects many factors, such as slower population growth, globalization, declining inflation, and changing tax policy.  The slowdown in disposable income growth goes far toward explaining why U.S. economic growth has moderated over the last few decades.

We think it’s also useful to dive a bit deeper into the personal income story.  Note, for example, that once a person takes on debt, they have an obligation to make debt service, i.e., interest and principal payments.  That debt service might not be as hard to avoid as taxes but getting out of the obligation is onerous.  Debt service limits how much discretion people really have over their spending, so we pay close attention to a measure that we think is a better gauge of truly discretionary income.  Our measure consists of disposable income less debt service (in other words, total personal income after paying taxes, interest, and principal).  To better approximate how discretionary income has grown from the perspective of an individual, we calculate it on a per-capita basis.  In the chart below, the red line shows the rolling five-year rate of change in per-capita discretionary income based on our calculations.

Rising prices can take a bite out of people’s purchasing power, so we also compare how our measure of income has changed versus the consumer price index (CPI), which is shown by the blue line in the chart.  Over the period shown in the chart, per-capita discretionary income has grown by an average of 1.56% over the rate of inflation.  When the gap narrows—because of slowing income growth, accelerating inflation, or both—recessions often follow.  More broadly, the big story here is that since the late 1980s, when per-capita discretionary income was growing almost 3% faster than consumer prices, income growth has generally exceeded inflation by a much narrower margin.  Much of the reason was the dramatic rise in household debt and debt service as consumers struggled to maintain their lifestyles during the 1990s and early 2000s.  In the midst of the Great Financial Crisis of 2008-2009, consumers were saddled with all the mortgage debt they took on during the housing boom, so the growth in per-capita discretionary income barely exceeded inflation at all.  The disparity remained weak in the years immediately following the crisis until consumers were able to work down their debt.

The good news is that discretionary income accelerated far beyond inflation in the late 2010s.  In the five years ended in December 2018, per-capita discretionary income grew at a rate 2.69% higher than CPI inflation, almost matching the best figure in the late 1980s and reflecting improved wage and salary growth, falling debt service costs, tax cuts, and stagnating population growth.  Consumer finances looked very good before the coronavirus hit.  Now, however, the pandemic is seriously pushing down income, and many people may take on increased debt to tide them over.  That means that even if prices fall a bit more or remain stable, the disparity of discretionary income over inflation could weaken again and discourage spending growth.

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