In his latest note released this morning, JPM’s head quant, Marko Kolanovic, reiterates his recent tactical call that the “unprecedented outperformance” of US equities vs. the rest of the world is over, and again recommends “gradually tilting towards Emerging Markets”, a trade which in recent weeks has generated profits as beaten down EM have found a floor and have indeed outperformed the developed world (whether or not this trend continues will depend on the Fed, the trade war with China, and various other intangibles).
For now, Marko is sticking to his conviction, and writes that “markets are likely sensing that the tide may be turning in the trade war” and “the tables are turning as a stronger USD, higher yields, and trade tariffs start impacting US profit growth, and YoY earnings comparisons soften.” Echoing his latest note from late August, Kolanovic says that “while we think that US equities will drift higher, the days of rampant outperformance vs. the RoW are likely over.”
Whether Kolanovic’s attempt to bottom tick the EM/DM trade will be successful will be revealed in due course.
What we found far more intriguing, however, was the second part of Kolanovic’s report, in which the JPM strategist shares his thoughts on a topic that has fascinated many in recent days – including politicians in both the EU, Iran and the US – namely Europe’s ongoing desire to circumvent SWIFT and Trump’s ability to “weaponize” the dollar, in order to maintain commerce with Iran in a narrow sense, but more broadly, to bypass Washington’s “veto” on global commerce and transactions that involve the world’s reserve currency: the US Dollar.
As a reminder, yesterday we reported that Europe has unveiled a “Special Purpose Vehicle” to do just that, which not only would bypass SWIFT, but potentially jeopardize the dollar’s reserve status. As we explained, “given U.S. law enforcement’s wide reach, there would still be a risk involved, and European governments may not be able to protect the companies from it. Some firms will be tempted to try the new infrastructure, however, and the public isn’t likely to find out if they do. In any case, in response to Trump’s aggressive foreign policies and “weaponization” of the dollar, it is worthwhile for Europe, Russia and China to experiment with dollar-free business.”
This brings up the bigger point: no currency’s international dominance has lasted forever, and there’s no reason for the U.S. dollar to be the exception to this rule.
Trump’s confidence in his ability to weaponize the dollar against adversaries and stubborn allies alike could eventually backfire for the U.S. as efforts to push the dollar off its pedestal grow ever more serious.
Today, Kolanovic picks up on this theme and begins with a generic analysis of fund flows, and – in the context of the most successful US “export” – he writes that one can look at the US Trade deficit “as a trade surplus in which the US is acquiring goods in exchange for USD bills.” According to the JPM strategist – and many others – this “exchange of natural resources and labor for inherently worthless fiat currency, as well as broad USD ownership has many benefits for the US” such as the following:
USD acquired in trade is often deposited in reserves (e.g., treasuries or other US assets) thus reducing the cost of capital for the US government and businesses. In this way, global trade and related ownership of USD keeps domestic inflation low, and is helping finance the US government (e.g., military, foreign policy, etc.).
Hardly groundbreaking, Kolanovic notes that this “exorbitant privilege” was recognized a long time ago by geopolitical rivals – such as China and Russia – that don’t enjoy this benefit. It was also summarized by former NATO secretary general, Javier Solana, who said that “the power of the U.S. today is not military, it’s the dollar.”
And, as Kolanovic rhetorically asks, with the current US administration policies of unilateralism, trade wars, and sanctions increasingly affecting both friends and foes, “the question arises whether the rest of the world should diversify away from the risks of the USD and USD-centric finance?“
And this is where the risk emerges, because as Kolanovic expands “recently, there are developments that suggest such a diversification could take place, and is being catalyzed by policies of the current US administration.”
In other words, if faith in the greenback is failing, blame Trump.
To underscore that point, the JPM strategist brings up the story we discussed yesterday, in which EU foreign affairs chief Federica Mogherini and Iran’s Foreign Minister Zarif announced the creation of a ‘special vehicle’ for trade despite US sanctions, while noting that a similar idea were promoted last month by Germany’s foreign minister, Heiko Maas.
To Kolanovic, it is the threat of Trump’s “unilateral policies” that are the biggest risk of bringing major powers of China, Europe and Russia closer, an alliance which “could profoundly impact the USD-centric financial system.” But it’s not just Trump, however:
while the current US administration may be a catalyst for long-term de-dollarization, such diversification may be prudent even if Washington policies change. For instance, currency/rate diversification might be in the best interest of Emerging Market economies, time and time again left at mercy of US Federal Reserve rate cycles.
So if indeed the US Dollar finds itself at a “tipping point” with a growing risk for a USD-centric system, how should investors protect themselves? To Kolanovic, one possible hedge against the secular risk of de-dollarization is “by shifting into non US
assets (e.g., RoW stocks and bonds)”
But his preferred trade appears to be going long gold, not only for strategic but due to tactical reasons as “the current positioning in gold is extremely short.”
Figure 2 shows aggregated investment in gold ETFs and futures as fraction of the S&P 500 price. It is currently near the lowest point in a decade, and there were only two historical instances this low level was reached. One was shortly before the market crash in 2008, and the other shortly before the market rally in early 2016 (led by Emerging Market stocks and Value). Being long gold worked well in these entirely different scenarios (one being risk off, and another risk on).
Whether or not buying gold would truly hedge the collapse the US-centric world, a process which would entail the ascent of either the Euro or the Yuan to the status of global reserve currency, and one which the US would not allow to happen without a major war, is debatable. However, what is most remarkable is that we now have reputable bankers in the face of none other than Marko Kolanovic, one of the most respected strategists at JPMorgan, contemplating a world in which the US Dollar is no longer the reserve currency, a “thought experiment” which until recently was relegated to the fringes of financial commentary. That this line of thinking is becoming increasingly more mainstream – and accepted – is perhaps the most troubling observation from Kolanovic’s latest note…
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