Part III: What benefits from massive outflows from the USD?

Our current economic and financial systems are based on the USD and the US treasury bond as central cornerstones. Every financial asset and commodity around the world evolves around, or is tied to, the USD. Hence, to understand where the USD is heading and what implications that might have is central to any economic forecast and planning, both on a micro and macro level.

As I have previously alluded to in a couple of articles, a significant devaluation of the USD seems to be a likely major macro economic force over the coming decade. Please see Part I and Part II of this article series for some background.

In order to a) not suffer significant economic damages and b) ideally, even benefit from this tectonic shift, its critical to ask ourselves what assets will benefit from a move like this.

Firstly, a couple of high level remarks worth making. In the scenarios described in Part I and Part II of this series, we should get used to periods where we witness i) gold (and to some degree also silver) up, ii) stocks up and iii) USD down. Stocks and gold will rise as there are more USDs printed, because they both constitute real hard assets that indirectly are protected from expansion of the total pool of USDs in circulation (gold is protected because supply is tightly controlled, and stocks are somewhat protected because majority of them generate real business income from their underlying operations).

Secondly, if we double click on the topic of "stocks up" above. What stocks will go up most? Basically, the answer lies in asking the reverse question: What stocks have suffered most from the strength in the USD over the recent past?

For long, there has been this built-in gravity in the global financial system that is tied to the fact that the USD is the world's safe haven asset. This expresses itself in form of a self-reinforcing spiral which goes something along the lines of: when the USD rises, the world's demand for USD rises (e.g. governments, individuals and companies that have debt denominated in USD need to sell more assets in their local currencies to be able to afford to pay back the same amount of USD debt and with that increases the demand for USDs), which in turn leads to more USD appreciation, and so it spirals. This has historically led to an inverse correlation between the strength in the USD and emerging market (EM) equities (and many other assets for that matter, but in EM equities, this correlation is extra well-pronounced).

For example, over the past decade (since the Great Financial Crisis), the USD (in form of the USD index, DXY, or "the Dixie") has risen by c. 1/3rd. In turn this has hit EM equities particularly hard, while US stocks (the S&P500 index) have been rallying strongly. The differences are quite extreme - EM equities peaked around October 2008 (that's also roughly when the USD bottomed). Since then, EM equities have lost (!) c. 20% of their value over those 12 years. During the same time period, the S&P500 rose by a whopping +120% (!).

Now, more interestingly: can the movement be equally powerful if the USD goes in reverse and depreciates significantly?

If history is any guide, last time it did, the move was 10x more powerful in the opposite direction (please note a downward move in the red line in the chart depicts stock appreciation, as its axis is inverse in the chart). During the early 2000s (from c. 2002 to 2008), a c. 40% weakening in the USD, correlated with a c. +350% explosion in emerging market equities.

As we are anticipating a secular decline in the USD, driven forcefully (and possibly irrevocably) by the US' dire fiscal and monetary situations, it is interesting to note that historically, emerging market equities seem to have been an outstanding beneficiary of such moves. This is also an asset that the world currently is distinctly underweight, especially when compared to the future share of global economic activity that these markets are likely to constitute.

On a final note, the leading crypto currency, BTC, is also likely to benefit in this scenario as it serves the purpose of being a 'digital substitute for gold'. Ok, but why would we need a digital substitute for gold in the first place? Its primarily a question of ease of transfer and transaction. Imagine that there is a real and acute crisis in the USD and it falls, say 80% vs the price of gold. You were lucky and invested in accordance with the advice above, so you are happy you now hold physical gold worth 5x (=1/(1-80%)) more in USD-terms vs what it was worth pre-crisis. Now what? How do you access your physical gold (at the same time as everyone else in the country wants to access their gold)? How do you carry it home without being robbed or killed? Where can you safely store it? Now that the USD is no longer accepted as general payment (because the loss of confidence in the currency is accelerating rapidly) how can you use your gold for payment? How will you go about splitting your ten ounces of gold into smaller denominations to actually pay for food? And the list goes on and on... For most people living in the Western world, these questions seem foreign/ridiculous, but for people in countries that have experienced currency crises more recently, they all carry vivid memories of e.g. real estate transactions only being settled in physical gold etc.

Additional sources: Bloomberg