The global economy is remarkably decoupled, with the US and China out-performing Euroland, Japan, and much of the rest of EM. Will the world ‘converge up’, i.e., the weak parts of the world recovering, or will it ‘converge down,’ i.e., the strong parts of the world being dragged down? Much of the angst in the financial markets lately may be related to the fear of the latter scenario. But is this fear justified? We suspect not.
The previous two episodes when big blocs of the world significantly under-performed the US were in the 1990s: with Europe under-performing the US after the EMS Crisis in the early-1990s and Asia under-performing the US after the Asian Crisis in 1997.
In both cases, the US economy managed to power ahead, and we witness the ‘converge up’ case in both episodes. In fact, historically, the US economy almost always led the rest of the world, in recoveries and in recessions.
While the US economy has become relatively less influential over the years, due to globalization and the rise of EM, and the US’ leading role may have become less dominant and absolute, we believe as long as China remains stable, the US should have a good chance of continuing to recover.
In our view, the recent volatility in the financial markets is more of a result of years of financial repression by central banks and inflated asset prices, rather than a genuine reflection of the downgrade in the prospect of the global or the US economy. The cumulative recovery achieved in the US has been sufficient to justify the termination of QE3, in our view. In this sense, a strong Main Street was always going to be the main threat to a strong Wall Street. We believe the dollar is in a great position to perform well. Either the world converges up, led by the US, or if it converges down, which should be accompanied by very volatile financial markets, the dollar should perform well. In short, the dollar is in a win-win asymmetric situation. We continue to expect substantially lower EURUSD, NZDUSD, and the ‘Southern’ EM currencies.
The bottom line
The remarkably divergent global economy can be resolved either through ‘balancing up’ or ‘balancing down.’ History suggests that the former scenario is more likely than the latter. The Fed might retain the ‘considerable time’ for a little longer, because of the weak global demand. However, we believe the lower interest rates and oil prices should be sufficient to offset the effects of a stronger dollar, and the US economy ought to be able to continue to recover. Such a scenario should in theory be positive for the dollar. On the other hand, the ‘balancing down’ scenario could generate so much fear in the markets that safe haven flows could also support the dollar. We believe the dollar is likely to be in the early stages of a secular appreciation. The EUR, NZD (and other commodity currencies), and BRL (and other high-yield but currency account deficit currencies) should remain vulnerable.
The above article is an extract from our research paper “A Decoupled Global Economy and the Dollar” published on October 16, 2014.
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