War in Iran : US Blunder & Grumpy Dollar

[MUSIC] >> Hello, everyone, and welcome back to ThinkMacro. Today I'm back with Vansar Cheye, CIO of H2A State Management. Hello, Vansar. >> Hello, Babak. >> Great to see you. We've got a lot to cover in this episode. What are the macro consequences of the conflict in the Middle East? What does it mean for growth, for the consumer, and for the US in particular? And on the long term, what's the impact to the US dollar? So Vansar, let's dive in. My first question, isn't it above all a shock for Asia and European countries rather than the USA? >> Yeah, indeed. Oil, Europe, and Asia are oil importing countries. So they suffer more from the shock than the US that exports oil. And it's a serious shock. 40% increase in prices are from roughly $60 to about $100 today for these countries is probably the largest shock we have seen in more than 50 years. So by its magnitude, it's already a big shock. And it could become an even bigger shock. By its length, it's been two months so far. And we know that it's going to take months before we reopen the straight of almost and before the oil flows back to normal levels and take the price down again. So the combination of the magnitude and the length makes it a serious economic shock. Now, Asia and Europe have means to whether the shock. You're talking about regions that have saving buffers. Consumers have large savings they can use to absorb the shock. There are political means to absorb the shock as well. We've seen that countries like Korea, Germany recently implemented measures, fiscal measures to help the consumer and companies absorb the shock. You have leeway there. And even over the medium term, if the shock was to last longer, central banks have some leeway to cut rates down the road. You mean cut rates? Because I think the first two elements, the cushion with the saving on one side and the help from the government on the fiscal side, I think everybody understand and can see that happening. But you mentioned cutting rates while everything we read on news is that the increase of the price of the oil barrel has a direct impact on inflation. And on the contrary, we see that central banks want to fight the inflation. So they'd rather want to increase the rate than cutting it. Yeah, yeah, of course. They are in their role there. They need to keep control of inflation. And particularly the ECB or the Bank of England that really target inflation first. But in this stack flationary shock we are facing now, the flation component is now, and is actually small compared to the stag stagnation component that comes right after. We are not in 2022. We're not in a world of strong demand that can take a higher oil price, energy shock into an inflation spiral as happened in 2022. When out of curvy, we all wanted to travel, go to the restaurant and spend. Demand was not very strong at the start of this year in any of these countries, actually anywhere in the world. So the risk of morphing this inflation shock, this supply shock, into some sort of inflation spiral is pretty small. Now, yet central banks do communicate on inflation first because it's part of the game. In doing so, they prevent that from happening, they anchor inflation expectations, they're telling companies, guys, don't do like in 2022, don't pass on prices. Because I will hike and right after, because I just hike, you're going to face recession. So please don't do it, stay calm, absorb the shock by yourself, and avoid getting into that inflation spiral. So that's essentially a communication exercise. When you look at numbers, so far, it works. Because of the lack of demand at the start of the conflict. And this communication, you don't see in any country, whether Europe, Asia, all the US, any de-anchoring of inflation expectations companies, do not price so far, our prices into there. They're the end good price. And there's no such spiral as we observed in 2022. So that's the difference between a supply and a demand shock. But everything you said on Europe, is it also valid for the USA? It's quite different in the US, we already. mentioned it in our previous discussions. The US economy is in a more fragile position. Okay, the shock is smaller at the economy level. But because of the fragilities of the economy, the shock could move into something more serious. First thing, okay, it's smaller at the level of the economy, but the consumer himself faces as big a shock as in any other region. At the pump may even be bigger in the US, because the tax component, the tax part of the price is smaller than in other countries. So when the market price rises 40%, the impact at the pump is actually bigger in the US. You're talking today, 2025% already, and rising. So for the consumer, which is the weak part of the US economy, the impact is already very significant. And the US economy needs the consumer. It needs consumption to run. It's based on that, it's fueled by consumption. So anything that takes that consumption down is a serious matter for the US economy. And so they don't have this leeway on the fiscal side, and also on the saving side in the US. Yeah, absolutely. I mean, these are the fragilities of the US economy. You don't have such safety nets. You have in other regions, no excess savings. Very little fiscal room because of the large deficit the economy is running. Little money to be leeway as well. We remember the Fed over the last year also has focused on growth more than inflation. So they already low compared to their sort of neutral rate. So that of course reduces the leeway they may have in case of pressure on growth. And now more locally, we have to bear in mind that before the conflict, you already had some pressure on consumption in the US because of tariffs last year. And you already had some pressure to the upside on inflation. Inflation was actually going up into the conflicts before it happened. So you already had sort of a squeeze to the consumer's purchasing power. Now the shock only magnifies that. So you're not risk there, no safety nets, and pressure on the consumer that has no real savings to absorb the shock may morph into something more serious. And there's this notion in the US of stall speed. You know, the US economy is a leverage economy. And that's a strength. That's what makes it outgrow other economies when things do well. And they do that through markets. You know, markets accelerate the engine. It's a jet. The US economy when we are more like running an Airbus. So we slow in Europe. Now the good news is that we can fly at a slower speed. Now the US jet is faster. But if it slows down too much, then it falls below stall speed and immediately falls into recession. That's the difficulty of this leverage economy. Now the problem is, at the turn of the year, you were already close to that stall speed. Where this consumer purchasing power is squeezed, you had or slowed down, you had into the year. The new shock, yes, not as big as elsewhere, may be sufficient to take us below that stall speed and morph into some negative loop. That loop that usually takes the US economy further up, could loop the other way and take it down, accelerating it down. If confidence falls, takes consumption down, then you just not have less consumption for the economy. You also have less performance of assets. And both the economy and market start to learning the wrong way and that's what takes you into recession. So we need to be very careful on the US economy because of that proximity of the growth we had into the conflicts and the stall speed it needs to keep on growing. But you are talking about the economy and the market and if we just look at the market for a minute, which is not necessarily the point of this podcast because we like to have views on macro. But what we've seen from the beginning of the year is that the US market is beating records even now. Last week we had new records on the S&P 500. So how do you reconcile this view of potential recession in the US while on the other side in the market mainly driven by this AI boom? We have those new records. Recession is always a risk. It can never be a given and the US has this remarkable ability to generate confidence and avoid falling below that stall speed. AI is such an answer to that question. Last year you had pressure from tariffs. You had also pressure on the US economy and then comes the AI investment theme that brings both investment to the economy and confidence. A new theme with productivity gains down the road pushing markets up that adds to the confidence end to wealth. All that participates in that positive loop the US economy likes to use to outgrow and keep it going above a stall speed. Now it's one thread and it relies a lot on confidence. When you are facing a shock like this, the one we're facing now with high oil prices, potentially for an extended period of time. It can't really dump confidence. It can't tell investors, hey guys, I'm already giving free capital investing in AI in these big companies, hundreds of billions of dollars in the hope of good profits in three, five, maybe more years. Shall I continue to do that? If now I'm facing a serious shock, where my purchasing power is at stake and I'm a bit squeezed now. In this kind of environment, you may say, "Well, five, seven years is a bit too far away. Let me just refocus on the present." You may have a situation where investors and consumers are a little bit less keen to provide free capital to these companies and you start running a market pressure that potentially takes stock market prices down a bit. That's a risk premium to the theme and then you start looping the wrong way because you have then pressure on stock markets. That affects confidence, confidence affects consumption, consumption affects profits and the market goes down again and you start looping the wrong way. We need to be very cautious with this theme. It's not physical, fundamental economy where you've got money in the buckets. You spend. You spend on the basis of herbs in a theme. Make sense, but it's a far away theme that is always, always relies, always holds on confidence. One topic we discuss also with many clients is in their portfolios, some are starting to lose confidence in a portion of their portfolio on par with asset. Do you think that can be also a trigger that they will be more careful on their overall portfolio and the investments they will make? To some extent, yes, because again there you are in the mindset of US consumers and participants. But it's not systemic. It's not similar to what happened in08 with the CDOs and subprimes. It's not systemic. It's more like a lot of US investors have exposure to private assets, but in a way that is quite small proportions, say, with many different actors. You have a system where liquidity is well managed with restrictions but well organized. It's hard to see something systemic there that takes prices down and accelerates to the downside. But investors are taking a loss there, at least a market loss. 20, 25% liquidity discount because there are some redemptions that's psychologically never good. The risk here is not systemic but is a accumulation of confidence shocks. You starting from a not so strong position, there are question asks on AI, there are question asks asked on private assets and then comes an oil shock on top of all this. Another you may have enough to turn confidence down and take the economy below stall speed and then you start to be the wrong way and end up with a recession. And your jet stops or speed is not fast enough and it falls. And it falls. If we extend our horizon, if we look for the red on the US economy down the road five years, what will be your predictions? Well, for assets we had 30 plus years of total superiority of the US economy and US assets, the US exception. Now over the last four, five years now, investors have started to observe and account for a change in that performance. There's been now about five years that US assets are more volatile than others, new regime because of maybe potentially excessive leverage. I mean, the way this model has been pushed further than others, it's already been more volatile. More recently, performance also has been challenged. We've had 30 years of steady out performance of US equities of steady performance of US bonds as well as a safe haven. More recently, it's a lot less the case and curves have steepened a lot. So investors are a lot more cautious to lend to the US over the medium or long term. And more recently equity performance as well. Has not has been maybe at par if not below other markets. Not by much, but that's a change after 10, 15 years of regular out performance of US assets, it's no longer the case. So for investors, from a return and risk perspective, US assets have changed or at least are in question. Now there was always another big reason for investors to hold US assets and to keep that link with the US economy under dollar. This first security, a lot of countries need the US for their security and that links them to the US assets, to the US economy and its assets. And the payment of oil for at least the Gulf producing countries you have in the Gulf. In these two reasons with the conflict now also now getting challenged. Because of these reasons and security oil, these countries had to recycle their dollars in the US or in US assets. It's going to come in question now. Security countries in the Gulf realized that maybe the security was not as guaranteed as they thought. Or all that they were promised. So they may end up first need to rebuild and number of infrastructure. They may not do that entirely in dollars as they did in the past. They may wish to diversify that away a bit from the US saying it's not as perfect as I thought, maybe I should think of not necessarily an entirely different solution but some more diversified or more a broader solution for my infrastructures and potentially reinforced that defense where potentially other systems coming from elsewhere in the world. So you start from countries that were a hundred percent dollars that may progressively decide to take a bit of that out of the dollar world and spend it with different countries. That means potentially medium to impression on US assets. And on the dollar. Now the second element is oil. Oil is, is, is to really paid in dollars. That's the reserve currency of the world. That's the commodity currency. Now we've seen with the conflict that in what, a week into the conflict, you had almost immediately China providing the ability to pay for roll in yuan in Renmin B. And they offered that regularly over the last two months to countries that were struggling to get access to oil. That's a major signal to the world that tells particularly Asian economies India, Korea, Japan, all benefited from this facility offered by China. So there's an option. There's an alternative to the dollar when you want, when you need to buy oil. And if the US is constrained, and the dollar is constrained to get your oil, then you may turn to China to get access to it. So that's, that's a major change that also participates in this sort of rebalancing of the world. Rebalancing of the world's reserve currency, telling the world, you may need less dollars and you do have an alternative with the Chinese Renmin B. So we've seen all, and I think everybody is following news on the impact on the petro dollar and also on the security side. But if there are less demands globally for dollar, now how come that the dollar has appreciated those last two months versus the other currencies? You're catching me there. Yeah, well that's due to the phenomenon that is directly linked to the US exception. And when we call the dollar smile, dollar is strong in two situations, in the two extremes, when the economy is running hot. So on the right of the smile, the dollar is strong because that's typically where a leveraged economy like the US economy outgrows everyone. In this situation, you got better economic performance in the US, better performance of US assets. So people, investors all want to hold these assets and the dollar is strong. And the dollar is also strong on the other side, when things turn sour, hard lending, external shock. Why that? Because as the reserve currency, the world is essentially dollarized. The majority of the world's countries and investors are dollarized. And what do you do when there's a shock? You tend to take the money back home. First, you immediately need dollars to fund your oil in the case of an oil shock. Your mountain calls if markets tend to fall. You need immediately dollars for funding and you need right after that dollars because you want more dollars because you want to secure your portfolio and take the money back in your own currency. So that's the two big reasons why the dollar is strong also on the far left of the growth spectrum. Now, the dollar is weak in the middle when growth is okay, there's not much volatility. And then investors, what do they do? They just diversify away from the dollar. The whole dollar is they want to seek risk premium here and there because it's not too volatile. So it makes sense to diversify your portfolio away of US assets. That's the middle of the smile. Now, what's happening now is actually challenging that dollar smile, that the shape of smile. It's been challenged on the right with the higher volatility. And say, less superior returns you had on US assets recently over the last three, five years. So you have less reasons to hold dollar on the right side of the smile. And the US economy also is now is now more struggling to outgrow others. Now, the conflict is a hit to the left of the smile. Now, to look at numbers, the dollar was not that strong in the recent period. Yeah, you're right to say it's been quite strong, it went up. But now, you're talking about 40% oil shock. Historically, when you have such a shock, the dollar is a lot stronger than that. Today, we're talking two, three percent dollar appreciation. And it's now coming back down again. For 40% appreciation, historically, it would have been more like seven, ten percent appreciation of the dollar. So you can already see that the left of the smile did not function as much as it did in the past. And what's happening may challenge it further. If countries are saying, I shouldn't not be a hundred percent dollars for my security. I should not rely a hundred percent on the dollar for my old payments. Of course, that means diversification away. And that means the very reason why that left of the smile was so strong, so protective, fades, and the smile basically flatters. That's what's happening now, and we would expect that to continue in the conflicts to only accelerate this phenomenon. So that's for you and for H2S measurement, that's a sign of the end of the U.S. exception. The fact that the dollar smile is not anymore working as it used to work in the past. Yes, the conflict in essence accelerates the end of the U.S. exception in taking the economy, the U.S. economy back to say normal. We already had U.S. assets back to normal. It's now telling us the dollar as well as to get back to normal. It will become a more normal currency and no longer the unique reserve currency of the world that shows strength where others don't because of its inicity. It's now in competition with other currencies for that status. And the Chinese U.N. now is in a position to already to compete with the dollar. And now is in Asia, essentially in the future it will continue to grow. Its share will continue to grow and better balance the world's monetary system in competing with the dollar as a reserve currency. And possibly later on, why not as well the euro? So you are now entering a world of no longer a single currency as a reserve, but a multiple currency reserve currencies for investors and countries. So euro will be a topic of one of our future podcasts. Thanks for joining into this episode of Sting Micro, Vassa, all with the pleasure. Thank you. Thanks, bye-bye. If you have any question, please do not hesitate to contact your H2A M6 Rep or visit our website at www.h2.am.com. And finally, if you enjoyed this episode, don't forget to subscribe. Thank you all and see you soon.