LONDON, Nov 30 (Reuters) - “Buy dollars, wear diamonds” goes the decades-old foreign exchange market maxim.
But not everyone feels the reflective glow when the sun is shining on the world’s most important currency. Across the world certain countries, assets and corporate sectors will feel the heat.
A stronger greenback and rising U.S. bond yields squeezes dollar borrowers, diverts capital from countries that need it most towards the United States, and hits companies whose cost base is in dollars. Even within the United States, holders of riskier high yield corporate bonds will be nervous.
The dollar and Treasury yields have soared since Donald Trump’s presidential election win as investors have bet that his proposed $1 trillion fiscal package of spending and tax cuts will give a huge boost to the U.S. economy.
The dollar has hit a 14-year high on an index basis, and the benchmark U.S. 10-year yield its highest in over a year. The 10-year yield had its second biggest weekly rise in almost 30 years.
Below is a look at some measures of how far the dollar and U.S. yields have come, and some of the potential losers from continued appreciation in the value of the pre-eminent currency for global trade, banking, finance and business.
Dollar's 7-year cycles: tmsnrt.rs/2g7ph8E
U.S. 'eurodollar' rate futures: reut.rs/2gEwhJM
Dollar vs G10 FX spec positions: reut.rs/2gDWVCq
All EM assets - stocks, bonds and FX - are vulnerable to a certain extent. These countries are sitting on $3.3 trillion of non-bank borrowing in dollars - a figure which has doubled since 2007 - and many depend on overseas capital to balance their books. Those with large current account deficits.
Turkey and South Africa are among the most dependent on foreign capital to balance their national books, as this chart of the so-called ‘Fragile 5’ current account gaps shows:
Morgan Stanley is “cautious” on EM equities. Its estimate of aggregate earnings per share for stocks on the MSCI Emerging Markets index at the end of 2018 is $77, “significantly” below the consensus $82. The most vulnerable regions are Latin America, South Africa, Turkey, Indonesia and possibly India, it says. Relief could come if the dollar rally abates.
JP Morgan turned further underweight EM currencies, sovereign and corporate credit and local currency bonds. “LatAm and EMEA EM currencies are no longer cheap, with Asia FX still expensive due to rate cuts,” JP Morgan said, adding that EM bond fund inflows will likely slump next year to $20 billion. So far this year, inflows have totalled $49 billion.
The Turkish lira hit a record low last week even though the central bank jacked up interest rates. The lira is down 15 percent this year and the country’s main stock market is lagging most of its EM peers, up only 4 percent year-to-date.
As issuing bonds in dollars becomes more expensive, some EM borrowers could be tempted to raise more cash in their own currencies. JP Morgan forecasts EM local bond issuance to rise by $42.5 billion, or 9 percent on average, in 2017 versus 2016 to $517 billion. More than 80 percent of that will be in Asia.
Emerging market debt issuance: reut.rs/2gE2qRR
“The property bubble is the most important macro issue in China.” So says Deutsche Bank, adding that it is spreading to more and more cities across the country. This will force Beijing to put further pressure on property developers in the coming months by tightening broad credit growth. As the sector weakens and heaps the pressure on Beijing to keep policy loose, the yuan’s losses against the dollar will accelerate.
Deutsche has one of the most bearish calls of all on the yuan, and expects the dollar to rise to 8.10 yuan by the end of 2018 from around 6.90 currently. That’s a yuan depreciation of 17 percent. A lower yuan makes interest payments more expensive for Chinese property firms, already in the crosshairs of a government trying to cool the overheating real estate market.
Chinese land valuation growth: tmsnrt.rs/2fQgKsC
U.S. High Yield
As the Fed raises rates, so the return on so-called safer assets increases and narrows the premium offered by riskier bonds. In this environment, all bonds come under pressure, but high yield or “junk” bonds are particularly exposed.
Morgan Stanley favours U.S. investment grade (IG) bonds over high yield (HY), forecasting a -0.9 percent excess return for IG and a -2.4 percent excess return for HY next year. “As election euphoria fades and late-cycle risks become more apparent, we expect spreads to again widen.”
U.S. high yield graphic: tmsnrt.rs/2gDVkg7
Unlike EM assets, developed market equities are negatively correlated to their currencies. This could be most visible next year in Britain, where sterling has been clobbered by the Brexit uncertainty and the runaway dollar. Analysts at Societe Generale reckon Brexit isn’t fully priced in yet, but will have to be next year.
Sterling will remain weak, boosting the large-cap FTSE 100 index, where around two thirds of earnings come from abroad. But the mid-cap FTSE 250 more driven more by domestic factors won’t be so lucky. Long FTSE 100/short FTSE 250 is one of the bank’s top equity market trades for 2017.
UK large cap vs mid cap stocks: tmsnrt.rs/2gwc21D (Reporting and graphics by Jamie McGeever and Vikram Subhedar; Editing by Robin Pomeroy)