The US president's agenda is stuck in Washington swamps, his business councils have been dismantled and investors have pretty much said goodbye to their hopes of wide sweeping reforms that would provide a kick to the ageing business cycle.
This ageing business cycle is proving particularly problematic for consumption. The US's job machine is still running at full speed thus supporting domestic consumption; this means the point of labour scarcity is fast approaching. Once this point is reached, it will trigger a slowdown unless productivity and wages pick up. Indeed, if consumers have continued to spend, they have done so by depleting household savings (which have dropped from 5.4 per cent to 3.6 per cent of disposable income in the past year) and borrowing money – to the point that consumer credit has hit an all-time high.
At the same time, the likelihood of large-scale tax reform, in particular, is looking more unlikely than ever. The Republican Congress will manage at best to pass a 2018 Budget including temporary tax cuts which, while certainly welcome, will be inadequate to the task of countering the cyclical slowdown currently unfolding.
On a higher level the US's geo-political credibility has been penalised by the more isolationist tone and the unpredictability of the White House. By pulling out of the Trans-Pacific Partnership (TPP), by hinting that the US nuclear umbrella might not continue to protect NATO’s European member states and by turning the strategic decision-making process into an improvised, incoherent jumble, the current president has led the US’s grip on global leadership to be questioned – and offered Europe and China a golden opportunity to bolster their own.
This can be seen by looking at the relative weighting of the dollar. Currencies have a universal influence on prices and so, have traditionally been one of the purest ways to view a country’s outlook, politically and economically.
Key Points
- The likelihood of large-scale tax reform in the US is looking more unlikely than ever.
- The euro’s steady appreciation versus the US dollar has continued unabated in August.
- The new paradigm for the euro–dollar pair has emerged as a potential source of market disruption.
It makes sense to view the euro–dollar exchange rate in 2017 as the mirror image of what it was in 2014, when the US enjoyed a much rosier economic outlook than the eurozone, though it goes deeper than mere economic comparisons. In an era where quantitative easing has pushed interest levels near to zero, thus ensuring rate differential which is far smaller than usual, currency traders have been forced to become far more attuned to political developments.
The euro’s steady appreciation versus the US dollar since the start of the year has continued unabated in August. This trend reflects above all the weakness of the US dollar, which is even starting to see its safe haven status questioned, as demonstrated by the accelerating rise in Europe’s common currency following the recent geopolitical tension sparked by North Korea. It is also worth noting that the price of gold – the ultimate reserve ‘currency’ – has also benefited from that trend since the start of the year.
As a consequence, fund managers are adjusting their positioning to reflect their doubts about whether President Trump can push through a large enough infrastructure spending and tax reduction programme to shore up this ageing business cycle. While President Trump initially showed promise, the so-called “reflation trade” of the fourth quarter of 2016 has now been mostly unwound. Investors who are recognising the current dangers should continue to reduce the weight of cyclical stocks in their equity strategies.
Stocks of companies offering high visibility and structural growth drivers such as those of the technology sector remain the most appealing. The challenge of the market concentration risk in that only a few mega-capitalisation companies dominate can be addressed by leveraging bottom-up grass root research that will allow managers to invest in some of the smaller mid-cap tech players.
In the medium term, the new paradigm for the euro–dollar pair has emerged as a potential source of market disruption. An acceleration of the US dollar weakening could boost US inflation, at the very moment where visibility on the Fed policy is shrinking due to the many members soon to be appointed soon by President Trump. If we get a more politicised Fed, where the next chairman ignores inflation, it may cause the market to begin to price bonds to take account of an “uncertainty premium” which would increase their cost. This will also necessarily affect the equity risk premium and may potentially unsettle equity markets as well.
If at the same time president Mario Draghi is forced to gradually taper the European Central Bank quantitative easing program, despite a strong euro being a source of tougher financing conditions for the eurozone, this could be a very unsavoury cocktail.
While in the US the recent hurricanes could provide a silver lining in that the need to coordinate relief efforts has allowed a Budget to be swiftly pushed through, this will do very little to allay longer term concerns on US credibility. A protracted weakening of the US dollar would be a headache for European investors as European companies earnings per share will have to be cut by 5 to 8 percentage points for every 10 per cent gain in the euro. There is nevertheless one region which stands to benefit from a weak dollar, both on the economic and political front: emerging markets. The good news is that emerging equity markets are even richer in technology holdings than in the US.
Jean Medecin is a member of the investment committee of Carmignac
