So what was your rationale for the high levels of market volatility suffered in the past month or so?
Popular theories include the slowdown in China’s economy, a deceleration in global earnings, or complacent investors ignoring inevitable market risks. For me the glue that not only binds many of these theories but also helps inspire such moves in the first place is the US dollar.
Or, more specifically, the strength of the US dollar.
The US dollar is still the premier player in global cross-border financial flows, but its widespread adoption as a denomination for equity, debt and commodity products over the past few decades has left a problematic legacy if the currency goes up in value.
In the few years after the global financial crisis of 2008-9 the value of the US dollar broadly went sideways, reflecting a general period of low foreign exchange rate volatility. However, over the past year the value of the US dollar has risen by more than 15 per cent and this reality, combined with a few other factors, has helped create a perfect storm for a number of key financial market groupings.
For companies and countries highly exposed to commodities and resources denominated in dollars, the prices of these goods have gone up because the dollar is stronger against the local currencies of these firms and countries.
This sounds like good news but higher prices usually lead to lower demand too. Mix in the added burden of institutions or individuals having to repay corporate, personal or government debt, which is often US dollar-denominated, and before long you have a crisis for commodity producers and any firm or country outside the US with debt predominately in US dollars. In short, one or other of these descriptions covers most of the emerging markets.
And of course this is dynamic. As the credibility of an emerging market’s economic policy starts to wane, this tends to feed through into its currency, accentuating the burden of the strong US dollar and inexorably leading to lower growth and possibly recessionary forces. That is why there was such a furore after the value of the Chinese yuan moved in late August.
In combination, this explains why emerging markets have struggled so much over the past year or so.
And the developed world is not immune too. First, the impact of an emerging market slowdown hurts a good source of export growth. But the biggest effect on the developed world is that a higher US dollar helps cover up structural issues.
Take a look at the eurozone and Japan, two regions that have struggled to post economic growth rates akin to the US over the past few years.
Unsurprisingly this is a reality that is worrying for policymakers in both regions. And what have been their policy responses? Apply quantitative easing… and quietly hope their respective exchange rates slide against the US dollar to help boost growth and price competitiveness.
