April 2023 Market Outlook
Starting in the first century, Roman Emperors needed more money to fund the Empire’s military and government budgets. Over the next 200 years, five emperors starting with Nero (54 – 68 AD) and ending with Gallienus (253 – 268 AD), debased the realm’s currency – the denarius – by almost 99% as 100 denarii in Nero’s day only retained the equivalent purchasing power of 1 denarius by the time Gallienus enacted his desperate massive depletion of precious metal content in the coin.
Even the United States has its own history of currency debasement. Ninety years ago, this month on April 5, 1933, President Franklin Roosevelt signed Executive Order 6102 which forbade ownership of quantities of gold coin, bullion, and gold certificates in an amount greater than $100 (approximately $10,000 in current dollars). All persons were required to deliver gold amounts above the limit to the Federal Reserve at $20.67/troy ounce. The next year the U.S. government changed the statutory gold content backing the USD to $35/troy ounce, an effective 40% debasement of the USD and a nice mark to market on the prior year’s trade!
Why do we include such upbeat historical reminders about currency debasement as the lead in this quarter’s newsletter?
First, we believe currency values matter when considering investment strategies and establishing financial plans. Inflation, when driven by the printing of excess money relative to GDP growth, effectively functions as a form of currency debasement. Second, the USD is facing an evolving trend of global de-dollarization. While we do not expect the USD to be replaced as the global reserve currency any time soon (USD remains at the heart of world finance, participating in 88% of foreign currency transactions), sustained momentum in de-dollarization will undoubtedly impact financial assets and U.S. markets. More on this trend follows below.
In the context of taming inflation and the impact of Fed policy on the economy, it is important to note that the Federal Reserve has hit the brakes rather hard with respect to M2 growth. March 2023 M2 yr/yr growth was -4.1% which represents a drop in M2 growth from March 2021 when M2 was up over +24% yr/yr. The negative -4.1% decline represents the largest year-over-year decline since 1934. Since the peak of M2 in July 2022, the annualized decline through March is -6.1%. The withdrawal of over $1.5 trillion in M2 since early 2022 is why we believe a recession awaits our economy in the second half of this year. This is certainly consistent with the inverted shape of the U.S. Treasury yield curve where longer term yields are well below those of short-term Treasury Bills.
How might the de-dollarization trend impact U.S. inflation and interest rates?
As of February 2023, the U.S. debt stood at $31 trillion – just $25 million below the official debt limit. When you add the present value of government entitlements, the current level of U.S. debt is almost $74 trillion – which is over 275% of forecast 2023 U.S. GDP. Through quantitative easing, the Federal Reserve helped purchase a staggering $5 trillion of U.S. debt in recent years which introduced an unprecedented increase in the money supply which we believe to be the root cause of current inflation.
However, there has been a notable shift in the global pattern of foreign government purchases of U.S. debt. In 2017 foreign ownership of U.S. Treasury debt outstanding was approximately 43% (approximately $6 trillion of $14 trillion debt). At the end of 2022, foreign ownership of U.S. Treasury debt had fallen to about 30% of outstanding issuance (approximately $7.3 trillion of $24.6 trillion debt). Since we run a trade deficit with the rest of the world, most notably China, where are foreign governments investing the USD earned from exports?
Historically, surplus USD earned through trade would be retained as part of a country’s foreign reserves and invested in U.S. Treasuries. However, for various reasons, foreign central banks have been diversifying their foreign reserves away from USD. Global reserves held in gold have risen from approximately 10% in 2017 to just under 12% as of September 2022. French President Macron has called for “a reduction in the extraterritoriality of the USD”. China is now buying oil and LNG from energy producers denominated in CNY (Chinese Yuan), and the Chinese are exploring settlement of trade invoices with non-aligned African countries with e-RMB (digital renminbi).
Recent U.S. sanctions on Russian reserves have further incentivized China to denominate invoices in CNY when able, combined with a willingness to settle balance of trade surplus via gold contracts. Furthermore, the European Union is scheduled to pass the European MICA Act (Markets in Crypto-Assets) in May which could possibly pave the way in time for Stable Coin settlement of trades, adding yet another competing currency with USD.
Therefore, while the global reserve status of the USD is unlikely to be displaced any time soon (4Q 2022 IMF data suggests the USD represents 58% of global reserves), we may be witnessing a de-dollarization trend which could lead to a “balkanization” of global trade markets in time.
If this trend continues, it will likely further reduce a drop in demand for U.S. Treasuries from foreign institutions and quite possibly a growing demand for gold as a “neutral reserve currency.” If foreign governments do not roll their maturing treasuries into new issuance, then yields will likely rise in order to attract U.S. investor capital. We are already seeing a current “crowding out” effect of U.S. treasuries on bank deposits.
Rising yields do not create a pro-growth environment over an extended period and monetization of the debt (central bank purchasing of government debt) is the pathway to currency debasement which has plagued past governments and empires.
We might complete our “dark cloud” macro forecast by noting the war in Ukraine, the possible lurking intentions of a Chinese invasion
of Taiwan, and an A.I. supercharged 2024 U.S. Presidential election. However, we believe the current focus for allocating assets in 2023 should remain on the likelihood and severity of recession and the stubbornness and longevity of inflation. While the de-dollarization trends discussed above are important to consider in the context of achieving long-term investment and planning objectives, they should not weigh as heavily on the markets in the near term.
On the positive side, the US continues to be the global leader in terms of entrepreneurial ingenuity, efficiency of capital markets, and free enterprise, which are important “rays of light” shining through a cloudy forecast. How market innovations and earnings growth interact with the larger macro-economic trends noted above is hard to predict. We recommend staying invested, diversified, and appropriately allocated based on individual risk tolerance as the post pandemic economy and Fed strategy normalize.