Saxo Bank

Q1 2017 Quarterly Outlook: The 1970s all over again


The direction of the US dollar is the key question for 2017 because a currency that is up 20% over the past year will trigger a reaction, and the incoming Trump administration can be expected to jettison the more than 20-year-old dogma that a strong dollar is in the US’ interest.

Welcome to 2017 and Trump-mania, a world where tweets set the agenda randomly across the US and where being unorthodox is the new black. For all the guess work we can do on Donald Trump and his new policies, the key questions remain the same:

What is the general direction of the US dollar?

Where is China’s currency and growth headed in 2017?

Is the double whammy of Brexit/Trump the end of a cycle, or the beginning of something new?

What’s the most important question of the three? That’s the direction of the US dollar. We have such a simplified economic world, or globalised market, that dollar represents in excess of 75% of all transactions globally.

So, when the US dollar is up over 20% year-on-year — as it is now — there will be a “reaction” to the “action”. This reaction will be a considerable slowdown in growth in the US driven by higher-than-expected interest rates (which reduce potential growth) and indirectly also by reducing global growth as the heavy burden of US-dominated debt hurts emerging markets’ ability to repay their excessive loans in dollars.

Foreign banks have lent $3.6 trillion to companies in emerging markets, and roughly 50% of that amount is to China, so questions one and two are interlinked.

The risk of recession is increasing. My good friends at NedBank, South Africa, Neels Heyneke and Mehul Daya, have the best recession model I have seen, combining monetary conditions with fundamentals. The present reading: 60% probability of recession against a market consensus of only 5-8%.

This is a big risk as we know that stock market selloffs mainly occur in recession times. The expected drawdown would be 25-40% if recession hits the US economy.

We can’t ignore the voices of populism in the US, but also shouldn’t overlook them in Europe in an election year. But rest assured, this is the end of a cycle, not a new beginning. The world will not move forward on an agenda of closed borders, anti-globalisation and trade restrictions, and against competition, but nevertheless these forces need to be respected, especially as we see a change of leadership in the global arena.

Trump taking the US “back home” on trade, overseas troops, Nato and reversing a China policy in place since the 1970s will have consequences. German chancellor Angela Merkel is now the de facto leader of the developed world, a position she never wanted and feels uncomfortable in during an election year for Germany. China will fill any vacuum left behind by the US changing course.

The Chinese leadership seems more “open” than ever before on foreign policy and investment, partly out of opportunity and partly by virtue of a desperate need to draw attention away from ever rising domestic debt and capital outflows.

China will most likely continue to weaken the CNY and CNH to the tune of 5-10% — probably gradually, but, if forced, also through another “devaluation” as retaliation for US policy.

The incoming Trump administration is, to my mind, clearly going to pursue a “weak US dollar” policy. The whole rhetoric of China’s currency being too weak, of course, implies that the USD is too strong. But – just wait – Trump will also change the dogma whereby a “strong dollar is in the interest of the US”, in place since Bill Clinton’s treasury secretary, Robert Rubin, launched it in the mid-1990s (though in fact it never was the executed strategy).

It evokes the 1970s and the Nixon doctrine of August 1971 when treasury secretary John Connally introduced a unilateral 10% surcharge on all dutiable imports, a 10% reduction in foreign assistance expenditure, closed the “gold window” (so the USD was no longer freely convertible into gold) and imposed a 90-day moratorium on wages and prices.

It seems like the Trump doctrine is adopting this as a pattern for its new corporate tax and trade policies “tweeted” so far by the president-elect.

Yes, this is very much like the ’1970s all over again – when US policy was about big business, closed borders, recession (1973-75) and a US dollar regime that could be defined by Connally’s famous words to European finance ministers at the G-10 meeting in Rome: “The dollar is our currency, but it’s your problem.” That killed the Bretton Wood system and cemented a 20% devaluation of the dollar.

The first quarter will bring us some clues, but as time goes by, expect a Trump doctrine that is a mixture of Nixon and Reagan, and watch out for big volatility.  The real conclusion, however, for all of 2017 may be that geopolitical risk matters. Welcome to the beginning of the end for the pretend-and-extend era in monetary policy.