— 2023 Q1 UPDATE —
Market Returns:
Quarter 1 Returns:
Source: Y-Charts
See important disclosures at the end of document
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A Quarter in Review:
The first quarter of 2023 had its fair share of drama associated with it. Some of that included the collapse of 3 banks which spurred panic of a potential banking crisis, which you can read more about here “Banking Crisis Update | K2 Financial Partners”, to news headlines saying that the US dollar was not going to be the reserve currency anymore, which will be covered at the bottom of this market update. (1)(2) While those news headlines deserve attention, they are like waves in the ocean, fleeting.
The main current of Q1 was still the direction of interest rates and the two variables that highly influence the direction of interest rates: inflation and unemployment.
Inflation Update: continued to decelerate during Q1 as measured by CPI, going from 6.34% year-over- year in January, to 5.99% year-over in February, and finally to 4.99% year-over in March.
Source: FRED
Unemployment Update: The labor market has remained relatively resilient. Although labor force participation has not fully recovered to pre-covid levels, even when normalized for those numbers we are not at a recessionary level of unemployment. In March, the labor force participation rate had climbed back to 62.6% and unemployment was still at 3.5%.
Source: FRED
With inflation still 2.5 times higher than the Federal Reserve’s target inflation rate of 2% and unemployment staying strong but showing some signs of being ready to increase, there is general encouragement from market participants that the Fed should stop interest rate hikes now because interest rate hikes have a lagging effect on the economy. Therefore, the general worry of a lot of market participants is that the Fed will overshoot interest rate hikes which will squash demand too much by increasing unemployment and causing a credit contraction which could lead to a recession and deflationary pressures.
While this worry is valid in theory and might be the short-term base case in the market, there are structural forces in the global economy that the Fed understands it is fighting against which puts asymmetric upside risk to inflation. (3) These include perpetual fiscal deficit spending (i.e. large government budgets), fractured energy markets that are partially at OPEC’s mercy, major supply chain shifts away from China, and a general trend toward deglobalization (spurred by a multipolar world). (4)(5)(6)(7) These forces are all counteracting the Fed’s push to bring inflation down to 2%, and while we may get there this year, it may prove harder than the 2010’s to keep it at that level. It is difficult to see a multipolar world where there is not an asymmetric upside risk to inflation, which if true, means higher interest rates for a longer period of time.
This viewpoint is different than what the market is currently pricing in. The market is currently pricing in interest rate cuts beginning in the summer of 2023, and a linear interest rate decrease from that point forward. (8) This is partially why there has been a rally in the equity markets in the first half of the year, because interest rates are being priced in to drop as inflation reaches the 2% target, if that viewpoint does not hold true, and interest rates stay higher for longer, we could see a reversal in the equity markets. However, if that does hold true, then we could see a continuation of this current trend.
Based on my research, the current highest probability scenario is for inflation to continue to decelerate as liquidity is reduced in the economy through credit contraction by the banking sector and higher interest rates. This will lead to a short term pause in interest rate hikes and a drop in commodity prices, with a rally in equity prices. Followed by another energy price shock due to OPEC’s control over the energy markets as they do not have to battle with Russia over the west any longer any longer since 90% of Russian oil is purchased by China and India. (9) Another reason energy prices might stay higher for longer is there is a fundamental disconnect between supply and demand in the oil markets due to have decades of underinvestment in oil due to the hopes we would be able to move to renewables, but we are simply not even close to replacing fossil fuel use. (10) Finally, over the past year we have drastically drawn down our strategic petroleum reserve to help control oil prices, this trend simply cannot continue ad infinitum, with there being some talks of the U.S. government looking to reverse the drawdown and begin to restock the petroleum reserve later in 2023. (11) Either an energy increase or even just a persistent new high will pass through into the millions of businesses that rely on oil for either continuing their operations or through making products with oil derivatives. This would continue to put pressure on inflation throughout the global economy, which would cause the Fed and markets to rethink lowering interest rates. If this scenario plays out as stated, then markets will be forced to wake up to the reality of a secular shift.
US dollar:
As you keep up to date with the news, you might have heard that China and Brazil started transacting in their currency rather than the US dollar (USD). (12) It is not uncommon to hear claims that the USD is not going to be the reserve currency anymore. While it may be true that in our lifetime the USD could fall out of favor as the world's reserve currency, the probability of this happening anytime soon is exceedingly unlikely. There are a few items on a checklist a country needs to even be in the conversation of becoming a reserve currency, and no other country besides the US comes close to meeting the requirements as of now.
First, to be a reserve currency, you need your currency used in global trade, which the yuan is starting to be used a bit more, but it's a tiny fraction of global trade. Therefore, on the first test, it already fails. As of 2022, some estimates put the US dollar at being on at least one side of a trade in over 85% of global trade transactions. (13)
The second thing you need to be a reserve currency is a giant liquid underlying bond market. There needs to be investable high-quality assets that are liquid, and China doesn't have a big enough bond market to pull this off, only the US really has it.
Third, you need a free-floating currency (no capital controls), and China manages its currency. Therefore, it fails on the third test.
Fourth, debt needs to be issued in your currency in other countries. The US has around $12T worldwide in outstanding liabilities issued within other countries that are priced in US dollars. (14) The whole world is essentially leveraged up using US dollars, and there is a demand to have US dollars to be able to pay these liabilities back. Not China, nor any other country comes close to this.
For example, if a company takes a loan out to open a factory in Africa and it's priced in US dollars, they must pay the bank back in US dollars, which means they need US dollars. The whole world would have to simply decide to stop paying back debts denominated in US dollars for the reserve status to be taken over, which would only happen through defaults on a level we have never seen in the modern world or through massive world war where America loses.
Therefore, it is important to remember that it's going to take much more than a few commodities being traded between countries in something other than the US dollar for that to happen the United States to have its reserve status threatened. This does not mean there is not a general trend away from the dollar and that we could not see a global de-dollarization over the course of time, but it will either be over the course of decades or through a major world war where America loses. Last, if another country did become the world’s reserve currency, it would have to be a country that did not peg its currency to another currency like China does.
Conclusion:
While it's important to stay informed and up to date with current events, it's equally important to approach news with a level head and avoid sensationalized headlines. It is always advisable to look at the bigger picture, to have a sound understanding of economic and financial systems, and to make informed decisions based on this understanding.
Here at K2 Financial Partners, our main mission is to help you reach your financial goals. If you have any questions or concerns, please don't hesitate to reach out to your financial advisor here at K2 Financial Partners. We are here to help you!
Sources:
De-Dollarization Is Happening at a ‘Stunning’ Pace, Jen Says - Bloomberg
Oil Prices Jump After Surprise OPEC Production Cut - The New York Times (nytimes.com)
Global Trade Faces a Stagnant Decade With Higher Inflation - Bloomberg
Russian Oil Exports Hit Prewar Level As China and India Buy 90% (businessinsider.com)
U.S. energy secretary says it could take years to refill oil reserve | Reuters
Why the dollar keeps winning in the global economy | Reuters
Dollar-Denominated Debt Outside U.S. Hits $12.6 Trillion | Barron's (barrons.com)
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