Monday, August 10, 2020

The dollar and the "dominant currency paradigm" - There is good news from a dollar decline

When thinking about the dollar investors should understand current thinking about currency economics. There is a new view that has emerged that should drive thinking about global growth and trade, the Dominant Currency Paradigm (DCP). 

Most who have been taught any international trade and finance are familiar with stories of concerning the law of one price, or some version of stick prices which will impact terms of trade and competitiveness. The law of one price means that a depreciation will raise the price of imports relative to exports (terms of trade) and thus increase competitiveness. This has been referred to as the PCP or producer currency pricing paradigm. The alternative or local currency pricing (LCP) paradigm says that sticky prices in the currency of the destination markets leads to lower price of imports relative to exports and reduces competition. The problem is that research on invoice pricing shows neither economic story represents reality.  

Reality can be explained by the DCP, whereby exports are priced with a few dominant currencies and change prices infrequently. In a more complex world of trade with intermediary production, global commodities, and financing in dollars, the DCP can explain the current trade environment and show how the dollar moves can spillover to trade around the world. In a dollar DCP, the Fed is not the central banker for the US, not the financier of the globe,  but the arbiter of profits and trade flow across the world. 

The DCP paradigm can be described through the following stylized facts that have strong empirical support, (See "Dominant Currency Paradigm" American Economic Review March 2020):

  • Firms set exports in a dominant currency and change currencies infrequently. Invoicing in the dominant currency will affect terms of trade and the quantity traded in a manner not expected in traditional models.
  • In the short and medium term, the terms of trade are insensitive to exchange rate changes. It is hard to change the terms of trade when a large proportion of traded goods are priced in the dominant currency.
  • For non-US countries, the exchange rate pass-through into import prices should be high and driven by the dollar fluctuations and not bilateral exchange rates. For the US, the dominant currency, pass-through into import prices will be low. 
  • For non-US countries, import quantities will be driven by dollar fluctuations and not bilateral exchange rates. US imports will be less sensitive to dollar exchange rate changes. 
  • When the dollar appreciates (depreciates), there should be a decline (increase) between countries in the rest of the world. 

Large changes in the value of the dollar will have a major effect of global trade and growth and its move extends beyond US interests; nonetheless, a dollar decline may have positive spill-over effects. A dollar decline will be good for trade across other countries and may be a good signal for increasing non-US equity exposure.

Commodity markets and the long-run - Follow industrial production and inflation

Commodities have been suffering from the continued downturn of the current super-cycle. Commodity super-cycle can last for more than twenty years although individual markets and commodity sectors may follow their own cycle paths that can be shorter.  The question is whether this is the time to get increase exposure to commodities.  

Clearly, after the shock in March and April, there has been a rebound. Energy prices are off their lows, precious metals have seen significant increases in demand, and selected industrial metals and agriculture markets have moved from lows. For example, copper is above highs from a year ago and have retraced all of its earlier loses this year.  However, the real question is whether macroeconomic conditions are right for commodities.

To answer the question of whether to hold commodities, we can look back to data over the last century.(See "Predictability in Commodity Markets: Evidence From More than a Century") The researchers attempt to answer a number of question and look at individual markets and not indices, but their conclusions with respect to macro factors are clear. Industrial production growth and inflation are predictive variables for commodity prices both in-sample and out-of-sample. The researchers find that these predictive variables are more predictive during market expansions. 

They also find that the introduction of futures markets generally increases the efficiency of commodity markets, but that means that macro factors are less predictive, and volatility actually increases.  

For the investor the key is making an assumption about growth and inflation. If both those are expected to rise, holding some commodity exposure makes good sense for both return and diversification. Both these factors may grow at a slower rate than expected two months ago, so there is time to make any appropriate portfolio adjustments.

Saturday, August 8, 2020

Skyscrapers and alternative data - An example of correlation not prediction

Everyone wants to use alternative data. Use something different and create an edge. Some data are very interesting, tell a good story, and are predictive, yet novel does not mean better. Some original and eye-catching data may just be correlated with the some would regard as bland and mundane. The skyscraper index is a good simple example of alternative data.

The concept is easy and catchy. When there is a topping of a new tallest skyscraper, it is a sign that we are at an economic top and ready for a collapse. Construct the tallest building and rest assured that the economy is ready for a downturn.  

Look at today. We may not have had a new tallest building, but by the measure of super-tall skyscrapers in New York at the end of 2019, it seems like we were at an economic top. China, by the number of mega-skyscrapers competed in the last few years should also be ready for  downturn. Growth has had a for some time. I will note that after the fact, many can usually find a tall building that was completed that should have provided that elusive economic top signal.

A more careful analysis of the skyscraper index shows that it, at best, just correlates with the credit cycle. (See "Skyscraper Height and the Business Cycle: Separating Myth from Reality".) When there is cheap credit, big speculative buildings will be built. Given there is a lag between planning, construction, and completion, the tallest buildings may be finished when the credit cycle will turn. There is a lot of thinking with the skyscraper index for a phenomenon that derives from excess credit but may not be a leading predictor of economic doom. 

This may be same with a lot of alternative data. Data may be fascinating, catchy, and informative, but these alternatives may not be more predictive than other conventional variables. The standard for alternative data should be clear. It has to add more explanatory power, serve as an improved predictor, and be cheap to create. Still, I will follow the skyscraper index because it is great cocktail conversation.  

Friday, August 7, 2020

Belief superiority and belief confidence - Watch out if you think you are superior

"Markets are crazy and there are a lot of panicked investors... Thank god I'm not one of them!"  

We have heard some variation of that comment. "Markets are crazy. I am not. Those other investors are irrational and don't know what they are doing." Yet, believing that you are superior to your peers is a recipe for disaster. Traders and investors need to be confident with their decisions, but superiority will generate bad behavior. This is the conclusion of some recent work in experimental psychology. (See, "Is belief superiority justified by superior knowledge?")

There is belief confidence which is an absolute measure, and belief superiority which is a relative measure. Both confidence and superiority can be problematic for effective decision-making. In the case of belief superiority, someone who perceives their views are superior to others will have a greater gap between perceived and actual knowledge. Those that feel less superior will either have a smaller gap or even a negative gap. The person who has belief superiority will also seek out stories and news that are belief congruent or consistent with their own views. 

Belief superiority is consistent with the Dunning-Kruger effect which finds that the least skilled often overestimate their abilities. Many want to be around the guy who exudes superiority relative to others; the one who is not just confident but seems to be better than the pack, yet that can be a recipe for disaster given the knowledge gap. That analyst or talking head who seems so confident may be wrong. You don't want to be that guy who thinks he his beliefs are superior to other. Still, there is hope. 

Those who think of themselves as superior but are given strong feedback to show their short-comings will respond and seek out alternative views. A splash of cold hard reality will lead to change. Be a skeptic and if confronted with the person who believes he is better than his peers, make sure he has to face reality with strong truthful feedback.