Weekly market recap: the dollar’s delayed demise

After weeks of strength off the back of rising inflation expectations, gold succumbs to investor pressure and fell from its recent highs.

FacebooktwitterlinkedinmailFacebooktwitterlinkedinmail   by Tertius Bonnin, 14th August 2020

The US Department for Energy has proposed changes to rules around water efficiency requirements for shower heads following multiple complaints from President Donald Trump about how low water pressure is hindering the leader of the free world’s ability to maintain the ‘perfection’ of his hair.

Japanese equity traders were gushing with excitement last week as the index rose 5% in local currency. Asset class returns are below; after weeks of strength off the back of rising inflation expectations, gold succumbed to investor pressure and fell from its recent highs.

Figure 1: Asset class total returns, local currency

 

    

 Source: Bloomberg, EQ Investors

Figure 2: Asset class total returns, GBP currency

Source: Bloomberg, EQ Investors

A few months ago, we looked at gold’s unique status (gold blooded markets) within markets and touched on how it is seen as both a commodity and a currency. We also discussed the recent rise in the gold price, in part driven by an increase in the global money supply as policymakers have responded to the coronacrisis with large volumes of debt issuance and quantitative easing. But with governments now laden with debt, the question on investors’ minds is whether policymakers will attempt to inflate their way out of this crisis or whether governments will be unable to service their debt and default on what is supposedly a risk-free asset (i.e. government bonds). While the latter will have devastating consequences for confidence in the global economy, what would the former mean for cash?

Even before the start of the US-China trade war back in 2018 there were near constant murmurings at the fringe around the role of the US Dollar as the world’s reserve currency. The importance of this topic was accelerated somewhat as the two superpowers, China and the US, have squared up to one another in recent years. In particular, we look at China’s launch of a yuan-based oil contract (taking a huge step away from the established USD-dominated petrocurrency system) and the US beginning to weaponise the dollar by targeting enemies through the global payments system SWIFT.

Figure 3: Though far from mainstream, trading in yuan-denominated oil futures has already grown to a near 10% global share Figure 4: The US Dollar remains by the dominant currency for global transactions, followed closely by the euro
Source: Bloomberg, EQ Investors Source: SWIFT, EQ Investors

 

One major concern for investors is likely to be the several trillion dollar stimulus packages passed through US Congress and the multi-trillion dollar programmes announced by the US Federal Reserve. A weakened US dollar under threat of inflationary pressures is therefore starting to prompt some investors to question what it would take for the greenback to lose its status as the world’s reserve currency – and more importantly what could replace it?

Among the major economies, there are potentially two other options: China’s yuan or the euro. Though the yuan has certainly become more prevalent in line with China’s economic rise, use of the currency within the international payments system remains low at less than 2% meaning broader uptake in the short-term is unlikely. Even the euro which commands far wider use (34% of global payments) has its own credibility issues, ranging from the eurozone’s lack of a unified banking system to the sovereign debt crisis still blotting recent memory.

Once these are discounted, the two remaining options banded around most are either gold or bitcoin. Taking the latter first, bitcoin itself has been at the centre of several controversies ranging from major hacks of cryptocurrency exchanges in which millions of dollars have been stolen, to the implicit association of financing criminal activities using the currency. Add to that the high price volatility and the fact that a large proportion of bitcoin in circulation is closely held by a small number of people, it’s clear that there are many short comings. Meanwhile, gold – which has historically been an inflation hedge amongst investors due to its ability to hold its real value through inflationary periods – cannot be ‘printed’ by central banks, carries intrinsic cultural value globally, and is widely seen as a safe haven asset.

Figure 5: Gold’s price has rocketed in recent months as inflation expectations have spiked Figure 6: Inflows into the SPDR Gold Trust ETF in the US have made the ETF one of the top ten largest holders of gold in the world
Source: Bloomberg, EQ Investors Source: Bloomberg, EQ Investors

 

Unfortunately, there are a few reasons gold is unlikely to take the dollar’s spot as the world’s reserve currency, least of which is the fact that an increasing number of transactions are done electronically. So, while there may be real concerns that are beginning to emerge around the longevity of the US dollar as a reserve currency, the lack of any viable alternative in the short-run will surely help prop up the importance of the US dollar for now.

STAT OF THE WEEK: 55% – the proportion of the world’s population that live in urban areas (Out World in Data).

DATA CORRECT AS AT: 14/08/2020

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About the author: Tertius Bonnin

Tertius joined EQ in 2016 and is responsible for covering investment ideas within US, Global and Thematic equities. He sits on the fund selection committee and also supports the portfolio managers across a range of other responsibilities.

He passed Level I of the CFA exam in 2018, holds the Investment Management Certificate and has a BA in Business with Finance. He enjoys a variety of sports including skiing, cycling and running – and when not in the office he experiments with Asian cuisine.

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