Wall Street Journal: US Dollar and Global Market Malaise

The Wall Street Journal: When money gets tight, greed turns to fear and investors retreat from the riskiest assets. Already, bets on low volatility have blown up, money has fled from Turkey and Argentina in particular and from emerging markets more generally, stocks of the biggest banks are under pressure and Italian bonds have been in turmoil. For the next domino to fall, follow the debt: The banks in highly-indebted China, Australia, Sweden and Canada and then on to investment-grade corporate bonds everywhere.

That, at least, is the theory of Ian Harnett, chief investment strategist at Absolute Strategy Research. What may seem like unrelated events – including the bursting of the Bitcoin bubble – are symptoms of tighter money, most obvious in Federal Reserve rate rises and the recent jump in the greenback, he says.

The theory stands in contrast to the mainstream explanation: The events are mostly not connected, and where they are, mostly the dollar is not the cause. The dollar rose a lot in a short period, which surely hurt some of the most vulnerable emerging markets. But the rise in the dollar was not the cause of slower growth in Europe and China—indeed its strength against the euro was clearly the result of the deceleration in the European economy. Some economies may be going through a soft patch, and a trade war is a true danger, but much of the fall in asset prices reflects hope disappointed.

Mr. Harnett’s theory chimes with historical patterns, however. Long periods of easy money have frequently led to excessive risk-taking and large debt build-ups, ending with a bang when monetary conditions start to return to normal. It is not that a stronger dollar caused Italy’s political ructions, for example, but that the rise in the dollar has made investors more sensitive to risks, prompting them – belatedly – to pay attention. One sign that the problem is global: stocks of the big banks rated as globally systemically important are, on average, down more than 20% from their peaks of the past 12 months. “The happy-go-lucky great synchronized recovery is coming to an end,” said Mr. Harnett. “You’re seeing the shares of many of the [systemically important] institutions being tonked at the same time.”

Mr. Harnett thinks investors are starting to put China under pressure and will dig out the playbook from 2015, once again worrying about the level of Chinese debt. Chinese stocks have tumbled more than 20%, putting them in a bear market amid talk of economic deceleration and U.S. tariffs due to take effect on Friday. There is a fair amount of concern among investors about the falling value of the yuan, but but as yet there is little sign of financial panic.  

A Chinese slowdown typically drags down the price of the commodities heavily used in Chinese construction. Already, copper, which is highly sensitive to the Chinese economy, has nose-dived, dropping 12% in the past four weeks for its biggest fall over such a short period since 2015. The knock-on effects on big commodity producers and exporters to China can ripple across emerging markets and into other major exporters such as Australia, too.

A separate but parallel threat comes from banks. The fall in bank stocks has yet to be reflected in weaker bank bonds. If and when bonds fall too, it could drag down investment-grade corporate bond indexes due to the heavy weighting of the bank sector – and hurt the large numbers of investors forced out of government bonds by central-bank bond-buying programs. Investors losing money on what they regarded as the safest corporate bonds would naturally rein-in risk taking, contributing to market weakness, while bank executives are less likely to extend credit when their shares are plummeting. Weak banks can weaken the economy, which in turn weakens banks.

Not all is doom and gloom. Mr. Harnett thinks it is too early to be sure that the dominoes will keep falling and recommends keeping some risk—with the U.S. best placed to withstand a return of global caution, reflected in the outperformance of U.S. banks compared to those elsewhere.

“We’re not saying hit the red button and get max defensive, because it could be that China reflates, the dollar comes down again,” he said. “But if the Fed continues to tighten, the dollar continues to strengthen—we think you will see more points of weakness.” That means an end to the strategy of buying the dips in stock prices that has worked so well for the past nine years.

Hopefully, Mr. Harnett is wrong. The European economy may be merely in a soft patch, as the European Central Bank argues. China has had a run of bad economic data, but debt has been more restricted recently and trouble might be avoided if Donald Trump’s trade war comes to a quick end. Bank stocks might merely be reversing their rapid ascent from the end of last year when everyone started to believe in a synchronized global recovery—not sending a signal of much worse to come. Hopefully.