A #U_TWO moment?

[Usd_Treasuries War Oil]

With the recent headlines on a weakening RMB, weakening Yen, a strengthening USD and oil price in USD, development of BRICS, G20 meeting in India, and top line inflation crawling back, I thought I might share some interesting thoughts and ideas on what can possible happen in the medium to longer term, and how politics play an even more important role moving forward.

US Dollar

It is likely that there could be a scenario where the US dollar can trade higher, due to an unanchored top line CPI, largely influenced by oil & energy prices. This can lead to upside pressure on interest rates and US Treasury yields, and potentially an even higher oil price that eventually will bring US and Europe into a hard-er landing, and a more severe recession if the cards are not played correctly.

Usually a worsening economy will bring down oil prices, but with the lack of investment in oil production infrastructure, sanctions on certain countries, and other countries running at tight capacity, with more oil being traded in other currencies, the West could run into a risk of being asked to pay more for the same barrel of oil using their own currency for settlement (because they can simply print more).

The West can try and do what they can to demand other countries to cut prices or increase production, but with money that's printable by Western central banks, using that printable money for settlement will be less convincing moving forward for the seller as they would ask themselves why do I want to hold onto a currency that can be forever printed ie being diluted in the longer term, especially when their govt debt is highly likely going to sky rocket within the next decade to come?

A higher USD will cause some pain in other countries who are less self-sufficient or doesnt have an alternative way to import cheap energy and goods from other countries, but it can be beneficial for those who produces and export goods to the West. Mexico, Brazil, Indonesia, China, India, Japan, Vietnam etc can be net beneficiaries from this if USD stays strong, and a weaker local currency to remain competitive on exports. BUT, the bigger question is, will these countries want to hold more onto the printable currency?

Treasuries:

It is interesting to note that some countries are reducing exposure on US Treasuries, with the likes of Saudi holding 40% less of US Treasuries since COVID, and China has been notably reducing US Treasury exposure for a long time, with Jan-21 at USD1.1tn to now at USD 870bn. There are plenty of reasons behind such reduction of UST holdings, but one thing that we know is these countries are not buying more of it. How the US find new buyers to finance its budgets (interest costs, medicare, social security, military spending etc.) will become interesting within the next 1-2 years to come.

If market turns and loses faith in US not able to put a balancing act on its budgets (very unlikely that they can), it will only shy away investors and potentially lead to de-treasurisation and de-dollarisation. When that happens, it can potentially create a bad reinforcing cycle for higher inflation (because less people trust the US Dollar/Treasuries, which results in a weakening of purchasing power in US dollar terms. [Which means people can demand MORE dollars when selling goods to the US]). However, if this scenario ever happens, equity prices might actually surprise us on the upside, especially companies with low debt, stable businesses, healthy cashflow and high cash balances (higher inflation, higher rates, which means higher interest income on cash, and wont increase interest expense burden), or companies with very strong pricing power (things that humans can't live without) and are well geographically well diversified.

But on the flip side, this issue has probably been laid out for discussion. If the think tank is smart, what can happen is a US version of Yield Curve Control, to suppress yields to a desired level. By the looks of Core CPI coming lower this week, and most upward CPI pressure coming from Energy (oil), this could work to not just bring down the interest servicing cost of Treasuries for the Government, but also avoid the US running into a recession by indirectly inducing spending and consumption.

With so much cash being deployed into Money Market Funds or deposits earning the same 5% deposit rate, if this goes on for longer, then inflation will be stuck, and will be more difficult to tame it down as everybody is making the same 5% on cash, which allows them to have the extra 5% level to purchase goods, reinforcing the inflation within the economy.?

It will not surprise us as well if 3% is the new 2% for the longer term. For now, theoretically, rates are here to stay higher for longer, but maintaining rates at current levels or hiking more wouldn't be an effective method for FED to reach its ultimate goal. They can hike or cut rates as many times as they want to control inflation, but without help from a cohesive and effective Government to achieve greater geo-politlcal ties with other countries, and resolving its internal conflicts and inflationary issues on the supply side of energy and goods, the FED’s great work will eventually become ineffective.

War:

A subject that I am probably least familiar with, but for those who read the materials published by Ray Dalio, war is never good for the fighting countries during wartime. The winning country in the end will do well, and the losing country will do very badly on both its currency and economy.?

By looking at the actions of US supplying depleted Uranium missiles to Ukraine, North Korean leader meeting Putin in Russia, and both Japan and Korea changing its cabinet (appointing Military representatives that are closer to US), these actions are definitely not de-escalating any tensions in Ukraine or in between countries. Although it is something that most of us want to avoid, it is not up to us to decide what the outcome is, and we as asset allocators would want to be prepared for such scenario as it can be detrimental to prices of many asset classes.

Oil:

With ongoing production cuts from OPEC+ and more countries buying oil using other payments away from USD, China being one of the largest users of oil is benefiting from cheaper oil imports?from countries like Russia, and Iran. Petrol prices at the pumps are lower in China, which is not having that big of an impact on its CPI, unlike the West.?

How they transact is most likely done via the exchange of RMB with oil. China’s imports from Russia have doubled since COVID (largely oil), and most of these trades are done outside of the US Dollar system. This is important to note as China is buying oil at a discount to the dollar price, and as a result of that, China is largely unaffected by inflation from energy prices, and India is also benefiting by buying cheap energy from Russia as well. India’s import from Russia on oil was 2%, and recently has gone up to 20% of its total imports on oil.

With Middle East countries joining the BRICS alliance, if I recall correctly, BRICS now jointly produce more than 60% of the world’s oil, and IF more countries trade outside of the US Dollar system (trade in Rupee, RMB, gold, or other currencies etc), this would probably have an impact to the West, especially to Europe (who largely depend on imported energy from others), and USA (whos SPR reserves are at a 40 years low). When other countries rely less on the US Dollar to trade oil, as a businessman, it would not be surprising to see the seller of oil demanding for more USD or EUR for the same barrel of oil (because more of these paper money can be printed out of thin air!)

What gets more interesting is the strengthening of the US Dollar is not weakening the Oil and other commodities prices. In fact, oil stayed strong as a result of the lack of investment in oil production within the past decades due to ESG requirements implemented at a global level, also, with more global warming impacts, Hurricanes affecting the Gulf, causing disruptions to the offshore oil rigs. With Strategic Petroleum Reserve (SPR) being at 40 years low, there are potentially limited oil that the US govt can flood the market with to push down oil price for its country for long. IF the figure is correct, there is approximately around 46 days worth of supply in the US from the SPR.

By looking at this week's US CPI figures, Oil and energy are the key components causing a rise in CPI on a YoY basis, and its something that cannot be ignored as it clearly has a direct impact on inflation, which affects interest rates policy. And with the West less willing to use dirty fuel to produce electricity, and nuclear (dangerous), with the Russian natural gas being cut off, it will be interesting to see how the West can really tame its inflation and survive in the long run, without causing too much disruption to people’s lives and pockets, and to its economy.?

Either way, looking into or beyond 2024, there are too many different scenarios that can play out that will have material impact on how assets are allocated. Politics, policies, are becoming more intertwined with markets. With elections happening in Taiwan, and US in 2024.

Summarising on what has been shared from the above:

There are a lot to digest from the above, and perhaps a lot of scenarios that can play out, but based on all possible scenarios, it seems like:

i.) Oil should perform well under all scenarios (something happens or nothing happens scenario) as there is a real disruption in supply to the rest of the world (sanctions on Russia and Iran, and ), and with production capacity reaching its limit due to under investment over the years from meeting ESG standards.

ii.) Stay short term on US deposits and Govt bonds would probably be a better strategy as we do not know whether yields might go higher (due to an implosion of US budgets or lost in trust in the dollar[which can take a while]), or YCC [which essentially is a way of cutting rates] will be performed on the US Treasury yield curve (cannot bet on any sides as the impact is too great if the opposite scenario does happen…but maybe a YCC has a slight higher chance of happening…)

iii.) US Dollar CAN trade a lot higher, and equity markets CAN go a lot higher and yields can go a lot higher if a bad scenario plays out…!

iv.) Emerging Markets could be a good place to allocate like Mexico, Brazil, South East Asia. Most of these countries produce their own energy, and are generally well tucked away if any tensions rises between US and China. These countries with better foreign reserves (diversified) will perform better than others that have a more fragile economy and reserves.?

v.) Europe is most likely going to be the lesser winner out of all scenarios.

vi) Dedollarisation is already happening, its not something new. When China buys a barrel of oil using RMB, and its consumed, more RMB will be used to buy more oil.

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