DXY &Markets:Has the link been broken?

Impact of US$ depends on intensity & macro...

Over the last two months DXY appreciated by ~5% and the yield curve startedto steepen. Whilst rising cost of capital and more expensive US$ has stoppedEM-DM equity outperformance, capped commodities, slightly widened highyield spreads and caused higher Rmb volatility, dislocation has been nowherenear levels experienced in Nov’15-Jan’16. What differentiates current period?

As discussed (here), importance of US$ as the global standard driving bothliquidity and cost of capital is so overwhelming that the link between marketsand the US$ could never be broken. However, the impact of an appreciatingUS$ critically depends on three factors: (a) duration; (b) intensity (i.e. pace ofappreciation) and (c) prevailing macro background. In some periods (’91 and’95), rising growth rates more than offset gradual and moderate US$ drift.

Whilst these periods were ultimately crushed on the rocks of slowing globalgrowth and imbalances, leading to Russian and Asia-Pacific crises in ’97-99,they were preceded by a period of gradual appreciation (and ￥ depreciation).

US$ appreciation in Nov’15-Jan’16 (~5%) occurred against a background ofstrengthening deflation and slowing growth. However current appreciation(here) is occurring when the base effect is moving headline (though not core)inflation rates up and growth was generally strengthening through most of theyear. Perhaps more importantly, investors have over the last several monthsfinally embraced the idea that public sectors are gearing up to support growththrough more expansive fiscal and infrastructure investment. At the sametime, investors are starting to believe that for the first time in two-to-threegenerations, commodities might adjust through supply rather than demand.

Gradual appreciation and more inflationary outlook is blunting US$ impact.

...in a new world spending $ trillions is viewed positively

It is an indictment of modern investment climate that China’s spending US$trillions on unnecessary infrastructure and creating rolling asset bubbles isviewed as supporting global growth and PMIs. Whilst not all investors realizeit, the underlying assumption must be that money would never be repaid andneither fiscal nor monetary policies can ever be normalized. Indeed, this hasbeen our view for years. Hence, we believe that age of ‘nationalization ofcapital’ is upon us. It is not therefore a question of whether public sectorsacross both DMs and EMs would embrace a merger of fiscal and monetarypolicies but rather its timing and size.

Fiscal ‘drift’ in ’17; need a dislocation for greater impact

A merger of fiscal and monetary policies would be an extremely potent, butalso dangerous, instrument. We therefore do not believe that the public sectorwould embrace it until there is no other alternative. We must experience amuch greater dislocation to force policy makers to coalesce around moreradical answers. Whilst it could happen in ’17, it seems more likely thatinvestors would witness fiscal ‘drift’ rather than a substantive lift in spending.

At the same time, monetary policies are likely to remain in abeyance. In ourview, this could be a recipe for stalling rather than rising growth and return ofdisinflationary pressures. However, it is also true that ultimately, a mix of fiscaland monetary policies would shift both economic and inflationary outcomes. Itis just a matter of time. At this stage, we continue to prefer a ‘bar-bell’ strategyto country selection rather than betting on cyclicality whilst maintaining“Quality Growth’ and ‘Thematics’ tilt to stock selection.