Cash or equity? Considerations around funding acquisitions

In acquisition transactions, the acquiring company buys out the Target company (hereinafter referred to as Target) in cash, by giving out equity or a combination of the two. The method to fund the acquisition is contingent on both parties maximizing their returns and interests. The exact process inculcates a few steps.

The Target furnishes its capitalization table for the acquiring company. This table contains the names of all shareholders, their equity stake in Target, the initial amount invested, and the dates when each investor joined the business.

The cap table lists all the shareholders who will need to be accounted for during the acquisition. Using the cap table, the acquiring company is able to determine the estimated returns made by each shareholder in the Target, after it has assigned a valuation. This helps determine if all shareholders would accept the valuation of Target proposed by the acquiring company.

As an example:

Acquiring company A is contemplating buying out Target company T and is examining T’s cap table. T’s founder and 5 investors are the equity holders and their stake in the business has been specified.

A conducts internal financial modeling exercises to determine T’s valuation and arrives at a USD 10 million estimate. With the help of the cap table, A can calculate the equity returns that T's shareholders would make to evaluate if the returns would be attractive enough for them to consider selling their share in T to A.

T’s shareholders could either accept or reject this valuation based on their estimates. If they accept A’s USD 10 million estimate, then A has a few options to buy out T at this valuation. 

1. Buy out T in cash where each shareholder gets the cash amount proportionate to their stake in T. For example, if the Founder’s stake in T is estimated at 30%, then he/she would be compensated 30% x USD 10 million = USD 3 million in cash. Similarly for other investors based on their percentage stake in T.

If A buys T out in cash, it is assumed that A will obtain full ownership over T with minimal involvement from T’s shareholders going forward. A now holds full risk and responsibility for T’s performance going forward. The advantage of an all-cash transaction for A is that equity dilution would be avoided as it would not have to offer equity stakes to T's shareholders. On the flip side, it would lose a substantial cash buffer.

An example of this method is Amazon's acquisition of Whole Foods Market in 2017 in an all cash transaction that valued Whole Foods at USD 13.7 billion. All cash transactions may be used to convince unsure shareholders in T by paying a premium on price per share. Such transactions are usually conducted by big companies with sizeable cash buffers. In this example, Amazon issued debt to generate cash for the acquisition. 

2. A buys T by issuing its stock to T’s shareholders proportionate to T’s valuation. T is valued at USD 10 million while A is valued at USD 100 million (this is an assumption). Let us consider T’s founder. Our earlier calculation valued the Founder’s equity at USD 3 million. The Founder’s equity stake in A would be USD 3 million / USD 100 million = 3%. The calculation for other shareholders would be similar if they are also being issued stock in A.

An example of this method is Pixar’s acquisition by Disney in 2006 for USD 7.4 billion where Pixar shareholders were compensated in equity. This enabled both companies to share the profits and risks from the combined animation business. The all-equity transaction made Pixar’s management — CEO Steve Jobs and President Ed Catmull — important shareholders in Disney to maintain Pixar’s creative freedom. This way, Pixar’s management would have a say in how the entity is run within Disney.

All equity transactions may be preferred when the acquiring company’s stock is deemed undervalued. T enjoys the future upside in A’s stock price by being paid in stock. From A's perspective, having T's management after the acquisition could ensure T's strong performance with the assumption that the founders know their company best and are most motivated to see it flourish. 

3. A offers part cash and part equity to T’s shareholders. A could choose to pay USD 2 million in cash and the rest in equity to T's shareholders. A would prefer this option as it could pay the rest of the amount after evaluating T's performance post-acquisition. A could add clauses in the acquisition contract suggesting that the remaining payout will be contingent on T's performance. This could include assigning a valuation to T after evaluating its performance in the initial years. 

A could opt for an earnout to fund the acquisition when both parties are in disagreement over T's valuation. An earnout involves paying the target company partially upfront and partially based on specific performance metrics achieved in future. 

For example - A could set revenue, EBITDA or profitability goals to be met after which T's valuation would be set at the desired amount. T's management would receive periodic earnouts when the financial metrics are achieved. 

A well-known example of earnouts is Mastercard's acquisition of Finicity in 2020. Mastercard paid USD 825 million upfront and offered an additional earnout option of USD 160 million to Finicity's shareholders contingent on performance targets. 

Acquisitions are funded in cash, equity, or a combination of the two where both parties weigh the pros and cons. 

All cash acquisition:

Advantages for the acquiring company: 

• Certainty in price being offered for the acquisition
• Equity dilution is avoided as no shares are given out 
• Provides control over the Target company
• Greater flexibility over Target's strategy and post-acquisition plans without hurdle from Target's shareholders 
• All-cash deals are quicker to be completed once agreed by the two parties 

Disadvantages for the acquiring company

• Loss of cash buffer for other initiatives / investments 
• Debt financing to raise cash could deteriorate the company's indebtedness and detrimentally impact its cost of capital and credit rating 
• Acquiring company takes on all the risk associated to the future performance of the Target company 

Advantages for the Target company: 

• Money paid upfront
• Lower risk associated to share price volatility 
• Simpler negotiation process compared to equity transactions
• May benefit from a premium price offering if acquiring company is keen on the success of the transaction

Disadvantages for the Target company:

• Lose controlling rights over own company and may result in future integration difficulties into the acquiring company without the Target's founding team
• Does not benefit from any future upside to acquirer's share price 
• Immediate tax implications on the cash amount received 

All equity acquisition:

Advantages for the acquiring company: 

• Preserves cash 
• Avoids the need to raise debt to fund the acquisition
• Acquiring company' shareholders can benefit from the continued involvement of Target's management who know their company better 
• Acquiring company can share the upside and downside with Target company management 

Disadvantages for the acquiring company:

• Equity dilution as shares need to be handed out to Target's management
• Research shows that at the time of the announcement, shareholders of the acquiring company fare worse in an all-equity transaction compared to an all-cash transaction. This may happen if the market believes the acquirer overpaid for the Target 

Advantages for the Target company: 

• Shareholders benefit from future appreciation of acquiring company stock if it deemed to be currently undervalued
• Target management benefits from synergies created between the two entities. Synergies refer to the benefits that result from combining two companies including cost savings, revenue gains, strategic synergies (e.g., by combining R&D efforts) and financial benefits (e.g., through better access to capital and improvements in credit ratings)
• Avoids immediate tax payment unlike in an all-cash transaction

Disadvantages for the Target company:

• Equity deals are difficult to iron out given considerations around Acquiring and Target companies' valuation and future management structure of the combined entity
• Target company may face a lower than justified exchange ratio between acquiring company and its stock, particularly during financial market volatility or when the estimations around synergy benefits are uncertain

The Fed's policy may just drive a recession

On 16 March, the US Federal Reserve (Fed) hiked its policy interest rate by 25 basis points and started the process of monetary policy tightening after slashing rates to 0% during COVID. This move along with its plans to hike at each of the subsequent six meetings this year was expected by the market. What surprised market participants was the Fed’s terminal policy rate expectation (the highest policy rate it expects out of this rate-hiking cycle) at 2.75% by 2023 versus the estimated long-run neutral rate (the rate supporting full employment while keeping inflation constant) of 2.35%. The Fed also plans to start shrinking its balance sheet earlier than expected and as soon as in May.

What prompted this degree of hawkishness? For one, US inflation at 7.9% in February is the highest since 1982! Second, the US labour market is pretty tight with the unemployment rate at 3.8% in February, close to the pre-pandemic rate. Additionally, job gains have been widespread across leisure and hospitality, professional services, healthcare and construction.

The Fed published its revised economic forecasts for 2022–24 after the policy meeting. It was striking to see the downward revision to its US growth forecast at 2.8% in 2022 compared to its December forecast of 4.0%. The significant increase in commodity prices and economic uncertainty are expected to drive this slowdown. Simultaneously, it projected personal consumption expenditure growth at 4.3% vs 2.6% in December. The epic level of policy stimulus undertaken during COVID both from the fiscal and monetary sides had driven inflation higher throughout 2021 in the US. 2022 added the extra layer of commodity price shock arising out of the Russia-Ukraine conflict.

Following the announcement, the 10Y-5Y US Treasury (UST) spread turned negative, in other words, the yield curve inverted, signaling that the market has started pricing in an economic recession. This was driven by expectations around a global growth slowdown from elevated commodity prices and the degree of monetary policy tightening projected by the most important central bank. Thanks to the 0% interest rate in the US over the last two years, corporate America issued copious amounts of debt to stay afloat. Non-financial corporate debt rose by USD 1.2 trillion during the pandemic. Corporates will now face higher interest rates and some are bound to go bankrupt in trying to meet their debt obligation. Although the Fed did not amend its unemployment forecast for 2023 (at 3.5%), I would assume job losses starting this year as corporates restructure to raise cash and service their debt.

Despite the degree of interest rate hikes forecasted, the Fed does not expect a recession. In fact, Fed chair Jerome Powell cited three historical instances in 1965, 1984 and 1994, where the Fed was successful in cooling the economy through interest rate hikes without causing a recession. The market disagrees and between you and me, the market usually pre-empts and forces the Fed’s actions.

In this stagflation scenario — with growth slowing and inflation remaining persistently high — how should an investor think about portfolio construction? Consumer staples are an obvious beneficiary as higher prices force buyers to cut back on discretionary spending. Utilities and healthcare are other defensive sectors that could protect the portfolio. Loading up on blue-chip names is another good move. You may have come across the argument that ESG investment is inflationary as it penalizes investment in fossil fuel and metals and thereby creates an uneven supply for important commodities. I would take this prompt and add green metals that are needed for renewable energy generation to my portfolio. These include lithium and cobalt (used in batteries), copper (wind, solar PV) and zinc (wind, solar, hydro, energy storage) among others.

Some regions such as Asia have relatively dovish monetary policies compared to the West as inflation is not out of control. Here, ASEAN stocks continue to benefit from their disproportionate exposure to financials, real estate, materials and construction sectors that outperform during inflation. Please check my piece on ASEAN as an inflation hedge for this topic.

Central banks globally are struggling to juggle high inflation and easing growth. At the moment, containing inflation appears to be the number one priority. However, as monetary policy tightening weakens growth, central banks may disappoint the market’s rate hike expectations in order to protect the economy. This would create a good environment for bond investments to thrive, particularly next year.

Conclusion:

The Fed’s aggressive interest rate projections coupled with elevated commodity prices suggest the rising probability of a recession in the US and global economy.

Portfolio construction during stagflation periods should tilt towards defensive sectors such as consumer staples, healthcare and utilities.

Green metals that are used in renewable energy generation and select sectors that benefit from inflation are a good fit in the current environment.

Please consider contributing to humanitarian efforts in Ukraine. Refer to this or this website for organizations undertaking humanitarian efforts.

Using macro signals for equity investing

Investing in the equity market can seem daunting, particularly to those of us who are risk averse and worried over a lack of finance knowledge. However, history tells us that market performance can be anticipated by following macroeconomic signals and paying attention to the political and geopolitical changes in the economy.

Following the financial crisis in 2007-08, the global economy witnessed a recession where growth collapsed, interest rates were slashed and inflation was subdued. Despite the gloomy atmosphere, some stocks performed better than others given their defensive quality. Think discount stores and medical services providers that benefit from demand inelasticity. You need these goods, recession or not. Or recall India between 2010-11, when consumer price inflation rose to double digits. With input prices shooting up and hurting profit margins, commodity, industrial and bank stocks did reasonably well. These examples suggest that you can (and should) pick stocks or themes based on the macro environment.

Hard core finance professionals rely on bottom-up company analysis to select companies with good balance sheets, cash flow and rising profitability. However, bottom-up stock analysis is time consuming and arcane for individuals outside the field of finance. On the other hand, keeping track of economic changes through the news and the power of observation is more relatable. Macroeconomics can help you pick and choose investment themes and the companies that fit them. Exchange Traded Funds (ETFs) are widely available in the market and investors can access the companies within the ETF index, its investment style and historical performance. Finding the right ETF suitable to the current economic environment is relatively simple given the information available today at your fingertips.

In addition to macroeconomics, geopolitical and regulatory changes also influence stock prices. Think US-China trade war that disproportionately hurt US automakers, chip makers and electronics manufacturers. Or the regulatory crackdown in China in 2021 which hammered Chinese tech companies. Following these developments and their impact could have guided you on where NOT to invest!

Let's take a look at the different macroeconomic scenarios and the sectors that outperform and underperform in them, to assist you in your investment journey.

High growth: Periods of economic boom are ripe for equity investing given strong consumer spending, corporate optimism and credit disbursal to fund unique business ideas. In order to select the sector or company that can generate high returns, turn to the details of GDP growth in that country. What is driving growth? Is it the consumption boom? If so, what are consumers spending on? Is it corporate investment into R&D, machinery or factories? Export boom led by specific products? Think semiconductors in Korea and Taiwan, electronics in Singapore and automobiles in Japan. The details help spot the growth generating sectors and investment themes that could give you your next big investment.

A study conducted by Morgan Stanley Capital International (MSCI, provider of equity indices such as MSCI World, MSCI Emerging Markets among others) showed that industrials, consumer discretionary, financials and informational technology are the most cyclical sectors. This implies that companies within these sectors closely follow the business cycle. On the other hand, consumer staples, healthcare and utilities are the most defensive i.e., least correlated with growth and the economy.

High inflation: MSCI's research shows that high inflation lowers future growth and adversely impacts small cap companies in the medium term. Higher inflation could also take away from sectors that depend on stable cash flow over the long term such as utilities. On the other hand, sectors that act as effective inflation hedges including energy (through rising commodity prices), financials (through higher central bank policy rates that lift banks' interest income) and real estate investment trusts (REITs own real estate assets which benefit from rising rent and property prices during periods of inflation), outperform.

Emerging market equities have historically performed well during inflationary periods given the dominance of the commodity sector in their economies and / or export baskets. Examples include oil and gas in the Middle East, soybean, crude oil in Brazil, copper in Peru, petroleum, coal and coffee in Colombia and oil and gas in Indonesia.

MSCI Emerging Market Index (MXEF) vs Commodity Research Bureau Index (CRB RIND)

Extracted from 'Emerging market equities in an inflationary environment', Man Institute, August 2021

High interest rates: A high interest rate environment usually arises during periods of growth and / or inflation boom, when the central bank tightens liquidity conditions to prevent excesses. The central bank hikes the policy rate, thereby raising borrowing cost and in the process slowing economic activity. This is the environment we find ourselves in today with global central banks raising rates and tightening liquidity conditions.

Financial stocks thrive in a rising rates environment as banks and brokerage firms can charge higher interest on loans and earn higher income. Insurance firms' profit margin improves in this environment as insurers reinvest premium in long-term instruments like bonds, which earn higher interest income when rates are hiked. An analysis conducted by CI Global Asset Management showed that Canadian and US life insurers generated on average 19.36% and 27.27% return respectively during periods of interest rate hikes over the past twenty years.

Rising rates have also benefited real estate stocks such as REITs as interest rate hikes are led by robust growth and inflation which are positive for real estate prices. An analysis conducted by S&P Dow Jones research concluded that between 1970 and 2006, there were six periods with rising bond yields in the US, of which four saw US REITs produce positive total return. In two instances, REITs outperformed the S&P 500 index.

In 2021, several emerging market central banks including Bank of Russia, Banco Central do Brasil and the Hungarian National Bank among others raised their policy rate to combat inflation. Latin American central banks were among the most aggressive last year. Amidst rising rates, the LATAM sectors that produced positive returns on average were communication services, consumer staples, energy and materials. Communication services firms such as telecom as well as materials firms benefit from growth boom.

Political uncertainty: Numerous examples come to mind when contemplating the impact of political developments on equities. Taking a current example - the military standoff between Russia and Ukraine sent stocks crashing in Europe and US while also elevating commodity prices. Back in 2018, diminishing confidence in Spanish Prime Minister Mariano Rajoy's government sent Spanish and Italian stocks tumbling.

Amidst ever changing political dynamics, investors should pay attention to the sectors tied to these economic and political developments. Particularly during election period, having a quick read through candidates' election manifestos is a great tool to anticipate stock market winners and losers.

Catalyzed by the potential sanctions against Russia, oil, wheat, aluminium and palladium (key Russian exports) prices rallied. Markets fear a hit to the supply of these commodities if Western economies slap sanctions on Russia. Blue chip stocks, US treasuries, Japanese Yen (JPY) and Swiss Franc (CHF) tend to perform better in such scenarios, as they are considered safe haven, whereas companies and /or assets linked to sanctions or sanctioned entities underperform. Given the adverse supply shock on Russian natural gas, Dutch natural gas stocks rallied.

During the political uncertainty in Spain, market sentiments were tied to Spain's relations with the EU. Strong relations would signal policy continuity and boost investor sentiment. When PM Pedro Sanchez formed the government, the market rallied and bond yields fell given his commitment to standing by the Euro as well as follow sound government policies. In this case, the persona of the potential prime minister, signalled by his/her comments and election mandate determined market reaction.

Stock market investing can seem daunting. However, simple tools such as tracking the economic changes, reading through government budget documents and election manifestos go a long way in determining equity market winners and losers. You don't need a finance degree to grow your money. Just some good observation and daily reading.

Economics for bond investment

Good investors understand the importance of diversifying their portfolio by balancing risky and safe investments. Government bonds are generally considered to be among the safest investment assets as governments are less prone to default than corporates. Given the lower risk profile, government bonds offer lower interest payments compared to corporate bonds. However, adding government bonds to one's portfolio is a good hedge against investment volatility.

In this note, I will discuss the various macroeconomic variables to assess when considering investment into government bonds. One formula to familiarize yourself with is the opposite relationship between bond yields and prices. When bond yields go up, bond prices go down and vice versa. Rising bond yields therefore, lower the investment return of bonds.

Are we in a high growth and high inflation phase?

Periods of strong economic growth are generally driven by consumer spending, corporate investment, government spending and/or strong trade performance. Strong economic activity may generate inflationary pressures that force the central bank to hike interest rates and raise bond yields. Moreover, during economic boom, equity investments tend to outperform bond investments as investors are generally optimistic about the business outlook.

As economies are emerging out of the COVID-induced lockdowns, economic growth and inflation have been rising since late 2020. In such an environment, investors would wait until interest rates have peaked (and bond prices have troughed) before re-entering the debt market.

Debt market capital flows in Asia turned negative earlier this year as bond yields and inflation rose. In several economies such as India and Philippines, negative real yields (nominal yields less inflation) dimmed the attractiveness of government bonds.

Quarterly growth and monthly inflation data can be accessed through local statistics agency websites, central bank websites or the International Monetary Fund (IMF).

How is the fiscal profile likely to evolve?

A country's fiscal profile refers to the government's debt and budget deficit to GDP. A highly indebted government may face difficulties in servicing its debt as investors require higher interest payments to hold that debt. A poor fiscal profile deteriorates a country's sovereign credit rating and raises the investment risk of holding government bonds. During the pandemic, India, Malaysia and Philippines among other Asian countries found their sovereign credit rating or outlook downgraded by the rating agencies. This raised concerns among investors and weakened capital inflows into their debt markets.

Having said that, bond investors should concentrate on the trend of fiscal profile rather than absolute levels. For instance, several governments announced medium term fiscal consolidation plans post COVID, to bring their debt under control. Examples include India, Indonesia and Malaysia, where ministries of finance announced medium-term debt and deficit targets to soothe concerns. Fiscal improvements, ceteris paribus, lead to lower yields and better bond returns over the medium term.

Investors should also study the average debt maturity and currency denomination of government debt. Longer maturity profiles reduce the exigency of debt repayments and give governments the time to bring finances in order.

Foreign currency denominated debt is more vulnerable to exchange rate volatility during crisis periods. Indonesia and Philippines have higher proportion of foreign currency denominated debt. During periods of risk-off, these markets are more vulnerable to capital outflow driven by exchange rate depreciation. In this regard, although India's debt and deficit levels are generally higher than Asian peers, long average debt maturity (exceeding 10 years) and largely local currency denominated debt provides important cushion to investors.

Data on fiscal metrics is available on the websites of the ministry of finance, budget office and the IMF.

What are the demand and supply dynamics?

In Econ 101 we learnt that the price of a good is a function of its demand and supply. Similarly, bond prices depend on demand and supply. If demand for bonds is higher than supply, bond price would increase and improve the investment return.

I admit that gaining this information is slightly tedious, but not impossible. You simply need to know where to look.

Bond supply is easier to determine as the budget office or ministry of finance provides this data while promulgating the annual budget. Governments often discuss budget financing through surplus cash reserves and/or additional bond issuance.

Bond demand is onerous to determine as each country differs in its bond holders. Common sources of demand include 1) local insurance firms, 2) local pension funds, 3) local banks, 4) foreigners and 5) the central bank. For instance, in South Korea, the local pension fund called National Pension Service (NPS) is an important investor in Korea Treasury Bonds (KTBs). NPS often discusses its allocation into KTBs and its medium-term plans, which can be accessed on its website. In recent years, NPS announced its intention to raise overseas allocation in search of higher yields. With the Korean population rapidly ageing, NPS has been seeking more lucrative investment opportunities for its depositors. Greater allocation overseas implies lower allocation towards domestic assets such as KTBs. This is long term negative for KTB returns.

Similarly, the Employees Provident Fund (EPF) in Malaysia is a key sources of demand for Malaysian Government Securities (MGS). Amidst the COVID pandemic, the Malaysian government allowed citizens facing economic hardships to withdraw their EPF contributions. These withdrawals reduced EPF's assets under management and affected its MGS investment.

As the pandemic shuttered businesses across nations, banks became risk averse to lending. Rather, they preferred increasing their allocations towards the safety of government bonds. This created additional demand for government bonds and boosted prices. Banks provide data on their government bond investments during quarterly results filing.

For information into government bond holders, I would also recommend going through central bank publications. Central banks often produce deep dives on country bond markets and major bond holders.

Is the central bank assisting the bond market through QE?

Prior to COVID, quantitative easing or QE as a policy tool was used mostly in developed economies facing prolonged periods of low growth and inflation. For further information on QE please refer to this article. The Bank of Japan (BoJ) and European Central Bank (ECB) implemented QE measures to revive growth and inflation amidst demographic decline. Post the global financial crisis in 2008, the US Federal Reserve (Fed) performed QE to stimulate the economy and bank lending.

QE opens up an additional source of demand for bonds in the form of central bank bond purchases. The COVID pandemic forced several developing economy central banks to implement QE measures. These were aimed at 1) easing liquidity conditions for consumers and businesses affected by the pandemic and 2) financing governments' stimulus measures by lowering bond yields.

Several Asian central banks undertook QE measures including the Reserve Bank of India, Bank Indonesia, Bangko Sentral ng Pilipinas and Bank of Thailand among others. Central banks publish data on asset purchases on their websites.

As fiscal stimulus deteriorated government' fiscal profile, central banks mollified bond investors by purchasing government bonds and assisting government finances.

How is the currency outlook?

In a previous post, I touched upon the importance of currency return in the overall return of an asset. Foreign investors must incorporate the currency outlook when investing overseas. Suppose you are a US based investor and have invested in Indian government bonds. Over a period of time, the investment returned 15% through capital gains. However, over the same period, the Indian Rupee depreciated 10% against the US Dollar. In that case, your total return would be 15-10 = 5% from this investment.

Therefore, having some idea about where the currency is headed will add to the thoroughness of your investment analysis. Please refer to this post for case studies on currencies.

Conclusion

Government bonds are safe investment bets and considered to be good portfolio diversifiers. In order to assess the pros and cons of investing in this asset class, you can examine readily available economic variables. These include

1) Economic growth and inflation - higher growth and inflation raise government bond yields and lower bond prices.

2) The country's fiscal policy - improving fiscal outlook through lower fiscal deficit and debt over the medium term, ceteris paribus lower government bond yields.

3) Demand and supply dynamics - knowing the major holders of government bonds by country is a great first step in comparing demand and supply for bonds. Information on bond demand and supply can be found on central bank or ministry of finance websites.

4) Central bank asset purchases or QE - Another source of bond demand is the country's central bank. In Japan, the BoJ holds over 40% of outstanding Japanese Government Bonds (JGBs). This policy is aimed at lowering interest rates to boost bank lending, growth and inflation.

5) Currency outlook - investors should incorporate currency views into their investment analysis when investing overseas. Refer to my previous posts on currency discussions.

Currency case studies

This post is a follow-up to my previous article, which laid out the economic framework to forecast currency performance. In that note, I had emphasized on the importance of currency evaluation in the investment decision making process. Currency returns need to be accounted for in the overall investment return and simple economic variables can be utilized to make an assessment about a currency’s direction over the investment horizon.

We identified 7 economic and policy variables to guide the currency outlook. In this note, we will apply the variables to forecast actual currencies. These case studies will assist you in building your thought process around currencies, when to buy and sell them and how to apply economic variables to understand the market. Please note that currency forecasting based on economic fundamentals is appropriate for medium to long term forecasting and identifying currency cycles.

The US Dollar is likely to weaken:

The USD is the most traded currency in the global economy. In 2019, the USD was involved in 88% of all FX transactions. Additionally, as the global reserve currency, the dollar is held by almost all central banks and institutional investment firms. Given the importance of the USD in the global FX market, we start applying our economic framework to forecast its direction.

1. US trade balance is likely to worsen: The United States has historically seen trade deficits (where imports > exports) since 1992. It is a consumption-based economy, relying on imports to fulfill domestic demand. As the US economy is exiting the pandemic, pent up consumer demand is likely to boost imports and worsen the trade deficit. This should weaken the USD.

2. US capital account balance is likely to worsen: The United States is the largest source of private sector capital in the world economy. As a response to the economic shock from COVID-19, the US Federal Reserve (Fed) slashed policy interest rates to 0% in 2020. With domestic interest rates at record low, US based investment firms have the incentive to allocate capital overseas in search of higher yields. This is likely to worsen US’ capital account balance and weaken the USD.

3. The Fed will allow inflation to run high: In August 2020, Fed Chair Jerome Powell announced an important shift in the Fed’s monetary policy. Since 2012, the Fed had been targeting 2% inflation. In August 2020, Chair Powell tweaked the Fed’s inflation targeting mandate from long-term inflation targeting to average long-term inflation targeting at 2%. Quoting Chair Powell – “following periods when inflation has been running below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time”.

This shift in monetary policy is important because it suggests that the Fed will let inflation exceed 2% in some time periods, as long as inflation averages 2% over the long term. With pent up demand in the US coming back, higher US inflation is likely to weaken the USD.

4. US money supply growth is at a historic high: In response to the COVID-19-induced economic shock, the US government and central bank unveiled massive stimulus programs. These were aimed at boosting consumer spending and private investment. At the same time, the stimulus measures pushed M2 money supply growth to a historic high of 24.8% y/y in December 2020!! To provide you some context, M2 money supply during GFC peaked at 10% y/y in March 2012. Such high money supply growth is likely to weaken the USD.

As per our framework, the USD is likely to weaken.

In the subsequent case study, we will assess the currency’s direction relative to the USD.

Korean Won’s fundamentals have been improving.

1. Korea’s trade balance is improving: Semiconductors comprise ~20% of Korean exports. Semiconductor prices are cyclical in nature, with each cycle generally lasting 2 years. The last cycle bottomed out in August 2020 and the pandemic has simultaneously boosted demand for electronic products made using semis. This suggests that semiconductor prices are likely to rise over the next 1-2 years and boost Korean exports. This will strengthen the KRW.

2. Korean inflation is below US inflation:

Ageing demographics is an important driver of lower Korean CPI. In 2020, Korea's fertility rate fell to 0.84, the lowest globally. This compares against 1.73 in the US and 1.42 in Japan. Korea's population fell for the first time in 2020, suggesting a downtrend in consumption and inflationary pressure in the economy over the coming years.

Relative to the US where the Fed may let inflation run high, Korean CPI is likely to be weak due to structural factors. This will weaken the USD against KRW.

3. US money supply exceeds Korean money supply: Against 18% y/y M2 money supply growth in the US (after peaking at 25% last year), Korean money supply peaked at 11% y/y. Lower Korean money supply is likely to strengthen the KRW against the USD.

4. The Bank of Korea is likely to hike the policy rate soon: To provide you some context here, the BoK is a conservative central bank. By conservative, I mean that it has hawkish tendencies and is averse to extra loose monetary policy conditions. Such conditions lead to macro prudential risks such as asset bubbles. The BoK is especially concerned about rising house prices in Korea and household debt being over 100% to GDP. With the economy reverting to normal post the 2020 crisis, the BoK sounded hawkish at its last policy meeting. An eventual policy rate hike will strengthen the KRW.

Currency forecasting is simpler than we think it is. Sure currencies are volatile and prone to swings due to everyday events. But economic fundamentals can guide the medium to long term currency outlook and help look through the daily, weekly or even monthly volatility. Moreover, economic analysis can help enhance the investment decision making process for trading FX and other asset classes across economies.

Key takeaways:

1. Our analysis of the US Dollar (USD) based on the economic variables indicates that the USD should weaken in the medium term.

2. On the other hand, the same variables suggest Korean Won (KRW) appreciation.

3. Similar analysis on currencies can be utilized to identify attractive currency pairs where one currency has strong fundamentals and one weak. FX traders often use such analysis to go long (buy) and short (sell) currencies to make gains.