The wave of Fed liquidity has reversed, leaving a variety of public and private equity strategies on hold. Since the dotcom bubble, Warren Buffett’s aphorism about the rising tide revealing who swam naked hasn’t been more relevant.
On a broader level, the sudden lack of diversification and the increased correlation between bonds and equities has torn a hole in the basic theory behind most pension fund models and significantly altered the real wealth of many retirees.
After years of average returns of 6-7% for 60:40 funds, year-to-date they are down 10-15%. Meanwhile, as the RBA and other central banks keep pace with the Fed, the impact on ordinary household cash flow from rising mortgage rates is starting to weigh on the housing market.
In order to solve the inflation caused by their past policies, they are now threatening stagflation. Everything is hit, with nowhere to hide except US dollar cash and maybe very short-term bonds.
May also saw nearly every currency tumble against the dollar – including pseudo-currencies like crypto – and even gold. However, while the current strength of the US Dollar is portrayed as a flight to quality and the last place to hide, we suspect this is temporary, even if true.
In fact, dollar strength is much more likely to be part of a larger deleveraging game across all asset classes. As the Fed shrinks its balance sheet, so do most financial players doing carry trades and leveraged positions in general. A sharp swing in exchange rates – the Aussie and the yen, for example, have fallen nearly 14% in a month – means a currency mismatch is devastating, forcing a scramble to close dollar borrowing.
Beyond that, however, lies an even bigger problem, that of a weaker dollar based on the recognition that, for most of the world, the dollar is no longer low-risk.
Indeed, for investors outside the United States, there is arguably not even a common risk-free rate left to base things on. The unprecedented decision by the Biden administration to freeze and essentially confiscate the overseas assets of the Russian people has effectively destroyed the concept of the dollar and in particular US Treasury bonds as a risk-free asset.
Simply put, an asset that can drop to zero overnight can no longer be considered risk-free to anyone outside of the United States, or perhaps the wider West, but given that most of global excess savings does not come from ‘the West’, but in ‘The Rest’ it has important implications for long-term capital flows. Indeed, we don’t think it’s an exaggeration to say that this is the biggest potential systemic disruption to financial markets since Nixon pulled the dollar from the gold peg in 1971.
It also means that anyone with US dollar assets, but who fears their government will fall foul of US foreign policy at some point in the future, will now be looking to move those dollars to “safer” assets. outside the dollar. area.
Indeed, it will be interesting to see how demand for trophy properties in Sydney and Melbourne, not to mention London, Vancouver and San Francisco, holds up now that they operate as risk multipliers rather than risk diversifiers.
That said, with the dollar where it is, buying commodities or real assets outside of the US looks very attractive right now and we wouldn’t be surprised to see an upsurge in M&A throughout Asia-Pacific and Emerging Markets.
As for China, with $1 trillion in US Treasuries, it can choose not to sell, but it seems unlikely to buy much more, and indeed one angle could be to get a lot of dollar debts against them and to use them. to buy real estate.
Perhaps China could borrow in dollars against its Treasuries to pay for the next phase of One Belt One Road? Who knows? Maybe they already have.
Mark Tinker is Chief Investment Officer of Toscafund Hong Kong and founder of Market Thinking. He blogs about behavioral finance and markets at Market-thinking.com.