We open this commentary by trying to simplify a very complex trade.Think of yourself as the corporate treasurer of a midsized American company. You have your basic business activities in the United States, and you have several divisions in Europe. Over the years you have elected to avoid repatriation of the profits earned in your European subsidiaries. You did this by noting on your US income tax forms that you are maintaining those foreign sourced earnings for the purposes of permanent reinvestment and growth of your business subsidiaries in Europe. That approach enabled you to defer the US corporate tax payment on those earnings. Each year the balance grew. Each year you raised the amount of the “permanent investment” and maintained the cash reserve in Europe. You held the cash in European banks and mostly in the Eurozone, in Ireland or Germany or Italy (source: Barclays). Your company has made all this activity public over the years with notes and reports on its Form 10-K.
Most American companies with foreign operations do this. The US has peculiarities in its income tax code that create these incentives for companies to avoid repatriation. The last time those peculiarities were lifted was in 2004 when then-President Bush allowed a one-year repatriation tax break. Over $300 billion flowed back into the US. Discussions about repeating that tax break are stymied in the current administration. Estimates are that as much as $1 trillion in repatriation would potentially occur if the Congress and the White House could agree on this issue.
Let’s go back to your problem as a corporate treasurer. You keep some of your cash abroad in US dollar-denominated deposits. The deposits of your company’s cash are held in a foreign bank. That bank has a direct relationship with its US subsidiary or with some other foreign bank’s US subsidiary. That US subsidiary is able to deposit its excess reserves with the Federal Reserve (Fed) and currently earn an interest rate of 25 basis points (0.25 of 1%). The US subsidiary of the foreign-owned bank does not pay a Federal Deposit Insurance Corporation (FDIC) asset-based fee. Their American banking competitors do pay that fee. Barclays notes that US subsidiaries of foreign banks currently hold about $1.3 trillion in excess reserves sitting on overnight deposit at the Fed.
Suppose your company’s cash balance is $100 million, with half of that amount kept in euros and half in US dollars. The euros are on deposit in your Irish or Italian bank, and they become excess reserves of the European Central Bank (ECB). The dollars are routed to the Fed, as we described above.
You report your company’s financial activity in the US every quarter. Your earnings are impacted by the currency conversion to US dollars. Six months ago you had baselines in euros and in dollars. Your US dollar baseline has not changed. It earns you a few basis points payable in dollars from your deposits with your European bank. That bank pays you a small amount and eventually ends up earning a spread to the 25 basis points that is paid to that bank by the Fed.
What about your euro deposit?
You face a situation in which the euro excess reserve deposit rate at the ECB is -20 basis points. The spread between the -20 basis-point deposit cost in euros and the +25 basis-point payments from the Fed equals a 45 basis-point spread on cash. That is the gross spread. We will ignore opportunity cost and transaction costs for now. But there are costs, and your bank has to charge you to handle these activities. Costs only widen this spread.
Now you are watching the euro weaken against the dollar; and every time it does, the value of your euro deposit shrinks when you translate it to dollars. You are taking losses on your cash. All of a sudden this trend accelerates, and the ECB confirms a policy that makes greater losses more likely. As corporate treasurer you have just watched your company lose about 25% of the value of your euro deposits in a matter of weeks or at most a couple of months. You will be reporting this loss on your March end-quarter when you translate it into US dollars.
You will also have to report that loss to your shareholders. If you, as treasurer, believe that the euro will continue to weaken, you will want to change your deposit structure rapidly.
So you go to your bank and tell them to get you out of the euro, into the dollar, and not to trigger a repatriation tax to the US. You ask the bank to do an internal transaction, outside the US and within the European banking system.
What does your bank do?
Your bank sells your euros and buys dollars. It takes those dollars and cycles them into the deposit structure. That deposit structure ultimately ends up as an excess reserve on deposit at the Fed, paying 25 basis points. Your bank now has to deal with the -20 basis points it pays for the excess reserves it holds in euros. So it charges you fees, does currency swaps and hedges, and otherwise redeploys into other assets to cover the transaction. The phrase “redeploys into other assets” means buying assets denominated in euros. That is why the prices of the highest-grade, highest-quality sovereign debt denominated in euros are rising and the interest rates are falling. Even negative interest rates are acceptable is they’re not as negative as -20 basis points. Note that at the end of the day, the amount of dollars at the Fed and the amount of euros at the ECB are unchanged. The only thing that has changed is the foreign exchange rate between the euro and the dollar.
The European Central Bank (ECB) has said it will maintain this -20 basis-point policy rate. It also said it will buy highest-grade euro-denominated sovereign debt in Europe and do so at an interest rate down to -20 basis points. That’s right: the ECB will pay a negative interest rate on the purchase of sovereign debt assets. In fact they have just done it. See the updated G7 interest-rate chart on Cumberland’s website (here is the link: http://www.cumber.com/content/misc/G7_Table.pdf ). We are now updating it weekly for the convenience of the readers who ask us.
All this activity leads to yield-curve flattening in Europe’s highest-credit-quality debt, at interest rates trending below zero. We already see the first seven years of the German yield curve at negative interest rates. We expect that to lengthen. We expect to see similar flattening in other countries where asset quality is deemed appropriate for purchase by the ECB. In fact, the allocation system among the countries and their Eurozone weights leads us to believe that the ECB may have to purchase agency debt and even corporate bonds and other non-sovereign assets and instruments in order to acquire enough to meet their quantitative easing directive. The ECB will be buying all of the net new issuance in the Eurozone and also removing some of the seasoned bonds as it extends its QE. Its buying program could drive many yield curves below zero and do so at some very long maturities.
We are headed for an era when high-quality debt in Europe pays zero or less. We are already in an era of unprecedented deposit shifting, as those who are able to do so flee the euro. And we are in an era when US-dollar-related moves are violent and likely to continue to be so.
In the opening section of this commentary we gave an example of a corporate treasurer of a midsized American company dealing with cash balances generated in Europe. We observed how the treasurer must move funds around rapidly in order to avoid taking losses and reductions of earnings when that income is reported quarterly in the US.
Multiply that single example by millions of publicly and privately owned companies. Add to that the knowledge that as much as $2 trillion of equivalent cash is outside the US and unrepatriated. That is the estimated cumulative amount that the White House wants to tax under their proposal. Of that $2 trillion, a very large sum is not denominated in US dollars. The largest non-US-dollar holdings are in euros, Swiss francs, and other European currencies, including the currencies of those countries that are linked to the euro under the exchange rate mechanism (ERM) or that are geographically next to the Eurozone, like Sweden and Denmark.
Is it any wonder that dollar strengthening has been rapid, robust, and likely to extend? Is it any wonder that corporate treasurers worldwide are reallocating as rapidly as possible in order to limit the losses they will have to report on March 31? They have been doing so for a several months, which is why the dollar is so strong and the euro is so weak.
In 1Q2015 and 2Q2015, earnings reductions are likely to show up in S&P 500 multinational companies. Those companies that have substantial activities abroad have to redo their currency relationships and report the changes in their earnings denominated in US dollars. We will see how much each company reports when those reports are made public. The first quarter of 2015 is a key one.
Meanwhile the US stock market is experiencing its own period of adjustment and high volatility. In fact, market agents do not know how much this foreign-earnings-reporting activity is going to affect earnings. Estimates are that there will be a negative earnings shock of 4% to 5% in the first quarter and another 1% to 3% in the second quarter. We are entering a phase in which the reported earnings of American companies will be negatively impacted by the strength of the US dollar. This is likely to persist for the first half of 2015, but it may not alter the upward trend in stock prices. Remember, the most enduring valuation metric is the interest rate. It determines asset prices more than any other factor does. And it is low. In Europe it is headed lower. In the rest of the world, European policy is suppressing rates. Hence, the ECB is a bullish force globally.
Now consider the implications of these developments for additional issues involving corporate governance. You sit on the board of the corporation we cited. What do you do about borrowing? You borrow as much as you can in euros at a zero interest rate. It costs you nothing to borrow euros, and the money can be immediately converted into some other currency or asset or hedged protective device. We expect to see gradually rising loan demand in the euro system as creditworthy borrowers make rational choices to get away from the euro and negative interest rates by borrowing in euros and buying elsewhere or by buying assets in the European Economic Community.
Where do you go with the loan proceeds? You buy assets and divisions of other companies elsewhere in the world, expanding your holdings; or you raise your investment in what you now hold. Your acquisitions are financed at zero interest. You do not go into the Eurozone’s debt market for financial assets; you let the ECB do that. You may go into the equity markets or acquire real estate, patents, or research and development assets in euros. But you do get away from cash. The euro is poison to your earnings, your balance sheet, and your future. Run from the euro. How long do you run? Maybe until the euro reaches 80 cents to the dollar. We do not know where this repricing of currencies will end.
Where else do you go?
You go where you find the most reliability, the strongest property rights, and the world’s largest and most steadily growing economy. That place is the United States. The US dollar is going to get stronger for good reasons. Markets are rapidly and robustly adjusting, because agents in those markets are making rational decisions to invest in the dollar and the US.
We believe that portfolios need to be realigned to capture these changes. That must be done quickly. Classic asset allocation models, consisting of those old multicolored pie charts that depict distributions of worldwide investment assets, are failing miserably. We see clients complaining about their pensions, charitable foundations, and personal portfolio holdings. They are trapped in the ancient pie chart paradigm. Those classic pie chart asset allocation mechanisms are flawed. They were designed by looking backward, to that period when the old normal was in force. The new normal is being defined and will continue to be defined for more years to come.
To deal with ongoing change requires careful thought. It begins with the admission that we are now navigating uncharted waters. The challenges are enormous.
At Cumberland Advisors we have been rapidly realigning portfolios to capture J-curve effects. We will write more on that topic in the near future. J-curves are important, and we will probe them in depth.
We have been reflecting on the currency changes and their implications, since they are now the biggest force at work. Our bond portfolios reflect these changes in the US with spread product and selected sectors. Our stock portfolios are heavily reorienting towards domestic US when it comes to US allocation. Our international portfolios are more than half currency-hedged. The part that is not currency-hedged selects places in the world that are doing well on their own and do not require the currency hedge. We are again fully invested.
The bull market in assets is NOT over.
About The Author
Images: Flickr (licence details)
About the Author
David R. Kotok cofounded Cumberland Advisors in 1973 and has been its Chief Investment Officer since inception. He holds a B.S. in economics from The Wharton School of the University of Pennsylvania, an M.S. in organizational dynamics from The School of Arts and Sciences at the University of Pennsylvania, and a masters in philosophy from the University of Pennsylvania.
Mr. Kotok’s articles and financial market commentary have appeared in The New York Times, The Wall Street Journal, Barron’s, and other publications. He is a participant in Bloomberg radio programs. He is a frequent contributor to CNBC programs, including Morning Call, Power Lunch, Kudlow & Company, Squawk on the Street, Squawk Box Asia, and Worldwide Exchange. He co-authored the book Invest in Europe Now!
Mr. Kotok currently serves as a Director and Program Chairman of the Global Interdependence Center (GIC) (www.interdependence.org), whose mission is to encourage the expansion of global dialogue and free trade in order to improve cooperation and understanding among nation states, with the goal of reducing international conflicts and improving worldwide living standards. Mr. Kotok chairs its Central Banking Series, and organized a five-continent dialogue held in Philadelphia, Paris, Zambia (Livingstone), Hanoi, Singapore, Prague, Capetown, Shanghai, Hong Kong, Rome, Milan, Tallinn, and Santiago, Chile. He has received the Global Citizen Award from GIC for his efforts.
Mr. Kotok is a member of the National Business Economics Issues Council (NBEIC), the National Association for Business Economics (NABE), serves on the Research Advisory Board of BCA Research, and is also a member of the Philadelphia Council for Business Economics (PCBE).
Mr. Kotok has served as a Commissioner of the Delaware River Port Authority (DRPA) and on the Treasury Transition Teams for New Jersey Governors Kean and Whitman. He has also served as a board member of the New Jersey Economic Development Authority and as Chairman of the New Jersey Casino Reinvestment Development Authority.
Mr. Kotok hosts an annual Maine fishing trip, where, it is rumored, most of the nation’s important financial and economic decisions are actually made.