May 31 2024

Feeling The Heat

You know one thing that is strong right now? The US dollar, and it is likely to get stronger. Wait, what? aren’t we supposed to be in a peak rate environment, and a likely decline in rates should make US Government debt less attractive?

First of, there is no decline in rates to speak of. From 7 cuts predicted this year, we might have only one, if we can get it. The Fed is subjecting its rate decision on inflation and jobs. Both have cooled but remain hot, US core PCE was at 2.8% (above the 2% target) in Apr24 and unemployment rate is stubbornly low. So rates are staying elevated for now.

In contrast, Europe is likely going to cut the ECB rate, currently at 4.5%, for the first time in 2 years. Inflation has cooled down to 2.7% in Apr24, but economy is forecast to grow at a mere 1% for 2024.

Europe like many other countries are not as fortunate as the US, and are now forced to cut rates before their economy stalls to a halt. They’ll most probably do so sooner than the US.

By doing so, their currencies are at risk of continuing to slide vis-a-vis the US dollar. Since Jan21, the USD appreciated by 17% against a basket of world currencies. Nowadays, The Japanese Yen and the Chinese Yuan are feeling the heat of sharper depreciations.

Now, let’s run a couple of scenario. The good first: the US outperformance marches on driven by lavish Government spending and super-charged corporate profits. It is likely going to buoy markets, and rates should stay restrictive. USD stays strong. The bad now: The US economy stalls, as credit defaults spread and the consumer feels the pinch of high prices. The Fed should be forced into decreasing rates, while equity markets likely sell on the news, boosting attraction of USD-sovereign debt as safe haven. USD strengthens. It is a head-you-lose, tail-I-win type of situation.

What about the ugly scenario, of a tailspin of combined high prices and economic stagnation, a stagflation of sort. The Government throws in support measures, increasing spending and national debt, even as interest rates are maintained artificially high to lure in US treasuries buyers. Besides BTC and gold, there is no other hard currency beyond USD that you’d like to hold at this stage.

Talking about BTC and gold, they’ve taken note of such a possibility, rising by 64% and 17% so far this year. Thank you very much.

The cheeky strength of the USD is reflective of a broader asynchronism between the US and the other major world economies. China’s economic engine is only slowly restarting, with the IMF upgrading its growth forecast to 5% for 2024, but manufacturing activity reverting back to contraction in May24. Japan is in a come-back-maybe mode. Europe is at the mercy of energy supply scarcity, and has a warring nation on its doorstep. And the UK…well, you know, it’s complicated.

While the rationale part of investors’ brain expects a switch of the pendulum out of highly valued US equities, the crazy reality is that it is hard to stop that train. Large cap tech reclaimed leadership in May24, and even shined on Utilities supposed to thrive in an energy-hungry-AI environment all the more than rates are expected to decrease. The reasonable portfolio manager in me recommends to rebalance into fairly-valued EM assets, and short duration bonds, but ever so slightly.

Total return performance 5M24 – Bloomberg, 360 Advisory LLC

Taking a longer-term view, we are likely to feel the heat quite literally in the coming months and years. Heat waves are already impacting India, with temperatures as high as 50C in Delhi this week. Extreme weather conditions is likely to stress further agriculture, and waterways essential in supply chains.

So far this year, unexpected weather conditions have impacted the price of cocoa, and orange, and the same is happening for wheat. While the 2015-2019 period was characterized by a 30% fall in commodity prices, the 2020-24 period saw a 75% increase, as per Bloomberg Agriculture subindex.

Droughts have compounded geopolitical issues at Panama, and Suez. Besides, “The Rhine River — Europe’s busiest commercial waterway, which moves everything from diesel to coal inland from the giant port of Rotterdam in the Netherlands — has seen record-low water levels in recent years“, as per Bloomberg.

Taken apart, this is not solely the climate itself that creates a crisis, this is where it adds up to pre-existing vulnerabilities. For the US, the MIT has done a nice job issuing the STRESS platform that harnesses big data to visualize where climate tensions overlap with economic fragilities, or infrastructure bottlenecks.

Here is the rendering of combined stress from high particules air-concentration, water stress, high temperature, and poverty. While it is a handy map to choose where to buy your real estate, it highlights severe risk factors for the US South West, and the corridor from Texas to the Great Lakes.

data extract from Stress Platform 30May24 – MIT

Soon enough, we’ll be able to do the same for one’s own portfolio of stocks with the aim of managing sustainability risk. Bear with me on that.

Stay safe out there !

About –

360 Advisory LLC is a Boston-based RIA managing investments