Within the next few weeks, we will write on our outlook for 2016. Today, we are writing primarily on our outlook for the remainder of 2015. Economically, the outlook for the world is slightly stronger in the next two months. We believe that the problems so widely heralded in China and other parts of the world economy will not develop, and that fear will moderate and a combination of positive variables will start to work in Europe and parts of Asia. We anticipate the continuation of a strong US dollar, which will dampen market appreciation slightly, but we see stocks as beneficiaries between now and year end -- especially the strong growth companies that can grow in the technology, internet, and cloud spaces, retailers with a presence in China and/or online, regional banks, and credit card issuers.
The positives for the world economy are:
- Lower oil prices;
- Lower currencies in all parts of the world except the U.S. and China; and
- QE continuing in Europe, Japan and elsewhere; interest-rate declines and other economy-priming measures being continued in China.
Then what are the fears?
First, that China will devalue their currency again; in our opinion, however, a large Chinese devaluation is unlikely.
Let’s look at this claim. The Chinese yuan as of this writing has appreciated against the U.S. dollar by 7 percent since January, 2010. During that same period, the Chinese yuan has appreciated against the currencies of their average trading partner by about 27 percent. This obviously has hurt Chinese exports and strengthened the economies of their trading partners. Since the beginning of 2014, China has taken a tack of very small devaluations of their currency to keep it in at least a little in line with the currencies of its trading partners. So in early 2014, November 2014, and August 2015 the Chinese yuan was devalued very slightly: 2 to 5 percent. After each devaluation, the yuan once again rallied; the devaluations have only been meant to keep the yuan in the neighborhood of its trading partners’ currencies so that it does not rise a great deal more than the 27 percent it has already risen.
We see these devaluations as small and periodic corrections, and we expect more of them. After the devaluation in August, some analysts panicked and said that it was assured that the small devaluation would turn into a big one, and the Yuan would crash. Needless to say, that has so far turned out to be incorrect.
In the last two days, a media blitz has begun by the same analysts that the yuan will fall hard in 2016. As long as the dollar rises and the trading partners’ currencies fall, the yuan will have small corrections every 6 or 8 months. This is obviously the plan of the Chinese monetary authorities, who have now engineered three such events.
This is small potatoes. Will the yuan fall hard? We think it is unlikely, because we note that a big devaluation by China would create an equally big devaluation by its trading partners and begin a major price war. That serves no one, and the Chinese are too sharp to fall for that. In our opinion, they have decided to let their trading partners keep their 27 percent advantage, and China will just try to keep the advantage form getting larger.
A more legitimate fear, though, is that the U.S. dollar will rise too fast.
The U.S. dollar rise has been our biggest concern, and we continue to see it as a potential big problem for U.S. stocks over the longer term. In the last year, the U.S. dollar has risen by 11 percent versus the major world currencies, with the exception of the yuan, against which it has risen 3 percent. Against emerging market currencies, the dollar has risen by over 15 percent. A strong dollar is OK as long as the rate of its appreciation is measured. When the rate of appreciation becomes too steep, there has historically been a negative effect on the U.S. economy. More on this in coming letters.
The third risk we see could be a positive or a negative risk. Longer term, the U.S. has relinquished its power in the Middle East. Russia has assumed much of the power in the region. This is significant.
Russia wants higher oil prices. We believe that Russians are negotiating with Iran and Saudi Arabia to lower oil production in exchange for Iran’s leashing of the Houthi rebels it has been backing in neighboring Yemen. If this happens, Saudi fears of an attack on their oil fields by the Houthis will decline, and they may agree with Russia and Iran to lower oil production and thus raise world oil prices moderately, perhaps to $60 or $70/barrel from the current $44/barrel.
If this happens, it will (1) diminish the fear of global deflation; (2) stabilize Russian power in the Middle East as Russia, Iran, and Saudi Arabia work together more closely; (3) cause a rally in U.S. and Canadian oil stocks and strengthen the Canadian and Norwegian currencies.
On the other hand, if a major war develops in the Middle East between Iran and Saudi Arabia (which will now be without the support of the U.S.), or between Turkey (a NATO member) and Russia, Middle Eastern oil production could fall substantially, and oil prices could spike to very high levels -- above $100/ barrel. This would be bullish for oil and gold, while the oil price shock would hurt world stock and bond markets.