The force that’s reshaping the global economy has big implications for the US dollar
Dramatic historical juxtapositions that highlight the extent of today’s technology revolution are easy to find. The chip inside a singing birthday card has more computing power than the Allied forces had in World War II, according to Professor Michio Kaku’s Physics of the Future (2012). The old A7 chip inside the (now outdated) iPhone 5S is 1,300 times faster and has 16 million times more memory than the guidance computer used in the early Apollo spacecraft of the mid-1960s, an article in thedailycrate.com (February 1, 2014) contended.
Today’s profound technological changes are transforming various industries and sectors, and they hold a massive influence on cash flow dynamics at every level of the economy. Further, many of these changes are not adequately reflected in traditional economic measures, so they are underappreciated by many in financial circles. Yet we think investment success in the decade ahead will largely rest on a sophisticated understanding of how secular changes such as these are unfolding.
Technological change comes in many forms, and while some of the most dramatic examples of recent years are in areas such as robotics, artificial intelligence, and self-driving vehicles, we think the innovation that has had one of the most profound influences on our economy today, despite being less glamorous, is hydraulic fracturing, or “fracking.” That novel method of oil and natural gas extraction has delivered a veritable “energy revolution” in the United States in recent years, which allowed more oil to be produced domestically and therefore resulted in less need to import the commodity.
Indeed, the nearby graph displays how dramatically the petroleum component of the U.S. trade deficit has lessened. Of course, in recent years the petroleum trade deficit has been reduced both as a result of lower volume imports and because of the dramatic oil price declines witnessed. In the end, though, we believe lower oil prices are largely the result of lower volumes imported, and are emblematic of the over-abundance of global oil supply relative to demand, partly a consequence of this novel technology.
Fascinatingly, this dynamic has created a shortage of U.S. dollars in certain oil-exporting parts of the world, which can stress financial markets to the extent that some of these countries are also funding themselves via USD markets, thereby requiring a steady supply of USD into their financial system to meet obligations. In our view, this shortage of global dollar liquidity was a primary culprit behind the market volatility seen in the back-half of 2015 and early 2016. Many commentators lay blame on the volatile oil price itself for the broader market’s gyrations, but accepting that explanation is to miss the forest for the trees.
Further, since the financial crisis we have seen robust auto sales in the U.S., which has expanded the trade deficit somewhat, as autos are one of the largest single-product drivers of the trade balance, and many are imported. Still, if not for robust auto sales in the U.S., the global dollar shortage would be far worse, so interestingly global financial stability may be much more tethered to U.S. car sales figures than many would imagine. Most of the remainder of the trade deficit falls into the “consumer goods” category, which ranges from apparel to toys and furniture, but we surmise that the growth in this segment of the deficit is largely cyclical in nature, and has also been influenced by the tremendous strengthening of the USD in 2014 and 2015. Thus, today we see the trade deficit has settled in a $40 to $50 billion range, rather than the $60 to $70 billion range of the mid-2000s, which has had the effect of creating a persistent shortage of USD in certain regions, and there are reasons why we believe that problem might grow worse in the years ahead.
It is well known that many factors can play into changes in currency valuations, and that the relative importance of these factors can themselves change over time, but we believe global capital flow dynamics have been vital to recent USD appreciation, and this move has decidedly not been a case of mere monetary policy divergence, as many have contended. Where does this leave us today?
Despite plummeting rig count levels, domestic oil production has proven to be remarkably resilient in the face of oil price declines and therefore oil imports have only edged up modestly. Also, given the newly accessible domestic oil resources, due to fracking technology, if the oil price rises substantially higher, domestic production will again crowd out import volumes.
Moreover, if the oil price declines further, the resultant higher import volumes should be offset by the lower unit prices of those imports. At the same time, it’s quite likely that U.S. auto sales have peaked, which suggests that this segment of the trade deficit could begin contracting again, thereby providing a longer-term boost to the USD by constricting supply via this channel. In fact, both these factors strongly suggest that the trade deficit is likely to structurally improve in the years ahead, which implies that the global USD shortage may get worse and the currency’s value longer-term may remain strong.
In our view it’s difficult to see how the USD would weaken substantially over the medium term, barring extreme central bank action, a U.S. production collapse, or an oil price surge. Of course, further dollar strength would hamper global growth, so ideally currency stability (or modest weakening) would be a favored outcome, as the global economy today is fairly fragile and is very vulnerable to a persistently stronger dollar.
Fortunately, various monetary policy factors, such as: the Federal Reserve’s near-term dovishness, the Bank of Japan’s lack of policy movement, and the European Central Bank’s (a region that runs a current account surplus) difficulty in impressing markets from here, are all likely to help keep the USD softer in the short-run, which is a positive for financial stability. That suggests to us that investors should exercise a good amount of caution around their dollar positioning today, as near-term softness may eventually give way to the technologically-inspired tailwinds driving a stronger dollar longer-term.
Rick Rieder, Managing Director, is Chief Investment Officer of Global Fixed Income for BlackRock
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