A Big Tail Risk In Strong Dollar Environment

The media has been focused on the Turkish economy which has been sputtering lately, leading to a currency crisis. The word ‘contagion’ has become overused by the media since Turkey is such a small part of the economy. Turkish stocks are only 0.05% of the MSCI all world index. The media has been missing the elephant in the room which is the Chinese economic slowdown. The advancement of America and the decline of China has pushed markets to the brink of major volatility.

As you can see from the Economist chart below, the CSI 300 has cratered while the S&P 500 has increased to near record levels. 

Source: Economist chart

While the chart makes it look like the tariffs caused the issues in China, it’s mostly a cyclical problem. However, the weakness does put China in a bad place to negotiate trade deals. In a game of chicken, the loser will be the one in the position of weakness which will crack because the pain is too harsh.

Yuan & Shanghai Composite Crater

Chinese weakness and American outperformance have caused the dollar to rally which is hurting commodity prices. Furthermore, other emerging markets are feeling the pain. Even though America is the largest economy in the world, because it grows slower than China, it can’t make up for China’s weakness. China will make up 31% of global GDP growth in 2018, while America only makes up 11% of GDP growth. The chart below shows the sharp decline in both the Chinese Yuan and the Shanghai Composite index. 

Source: Bloomberg

The Shanghai Composite is down 23.46% since January 26th. You can say the American economy has caused a wide divergence because it is outside the loop of the global cycle. America extended its cycle with fiscal stimulus through the tax cuts and spending boost.

The strong dollar could be the undoing of America because it hurts export growth and international profits. The chart below shows that the increase in the trade weighted dollar has been the biggest reason the Goldman Sachs financial conditions index has become more stressed.