US Monetary Policy Impact: Here Comes The Squeeze

The February payroll data has shocked the Federal Reserve and financial markets.

With 295,000 new jobs in a single month and a fall in the unemployment rate to 5.5 per cent, Janet Yellen must respond with monetary tightening, possibly as early as in the June FOMC (Federal Open market Committee) meeting even though inflation is well below the American central bank’s two per cent inflation target.

While a 150 point rise in the fed funds rate is possible, the ECB and the Bank of Japan battle deflation risks via money printing (sovereign bond purchases).

This is the reason the US Dollar Index has spiked from 78 to 100 in the past year. The breakout in the US Dollar, in turn, accelerated the collapse in energy and commodity prices. The ten-year US Treasury note is only 2.15 per cent but it is still ten times the yield on the ten year German government bond yield, now at a century low of 0.20 per cent.

Fed monetary tightening, ECB money printing, Abenomics in Japan, Russia’s recession, the commodities bear market and 25 year lows in Chinese GDP growth will determine the next strategic themes in the international financial markets.

GCC economies have a huge stake in the US central bank’s monetary policies, due to the region’s pegged currencies.

This is all the more true since the GCC’s revenue from its 17 million barrels a day oil production has been cut in half since June 2014. The 16 per cent rise in the US Dollar index since June 2014 is also hugely negative for tourism and speculative property demand in the region, particularly from Russia and the EU.

Six years after the failure of Lehman Brothers, the US has the most stable and well-capitulated banking system in the world. The Bernanke Fed literally saved the world from another Great Depression and a daisy chain of bank failure and sovereign default that would have not spared GCC economies.

After all, Brent crude fell $100 in six months in 2008 until Saudi Arabia engineered a 4.2 million barrels OPEC output cut, the largest in the history of OPEC. Back in 2008, unlike now, Saudi Arabia was black gold’s swing producer, the de-facto central bank of oil.

What will be the investment implication of higher US Dollar interest rates? One, the Dollar could rise even further against the Yen, Euro and emerging market currencies. I can easily envisage the Yen at 130, the Euro at 1.02, the Chinese Yuan at 6.40 and the Indian Rupee at 65 by year-end.

Two, we know that stock market valuations compress during times of rising interest rates. Wall Street equities are expensive at 17.5 times earnings at a time when earnings growth/margins are vulnerable to a stronger dollar and European/Chinese growth declines.

Three, the commodities bear market will continue due to the strong US Dollar, overcapacity and lack of Chinese demand. Goldman Sachs even expects Brent crude to fall to $40.

Four, higher US Dollar rates and weaker global growth are negative for gold and silver prices, which could both easily fall by another 10 per cent.

If Goldman Sachs is right about $40 Brent, GCC equities could experience a significant correction this summer. Saudi Arabian equities were bid up by retail buying in expectation of an opening to foreign investors that are fully priced in.

In the UAE, the biggest beneficiary of lower jet fuel prices is Air Arabia. The leading low cost carrier in the Middle East, Air Arabia trades at 12 times earnings and a 6 per cent dividend yield. With 10 per cent passenger traffic growth, 80 per cent load factors and 20 per cent EPS growth, Air Arabia is a natural hedge against lower oil prices.

Egypt, a net oil importer, is a beneficiary of the oil crash. The UAE, Kuwait and Saudi Arabia have pledged a fresh $12 billion to Egypt at the Sharm Al Sheikh conference. This will further stabilise the Pound and attract FDI to Egypt.