War in Iran : US Blunder & Grumpy Dollar

Description

In this new episode of ThinkMacro presented by Babak Abrar, Vincent Chailley (CIO of H2O AM Group and H2O Monaco S.A.M), discusses the macroeconomic fallout from the conflict in Iran and its implications for global growth and markets. Behind the immediate shock, the discussion dives into the growing vulnerabilities of the US economy - from constrained fiscal and monetary buffers to softening consumer confidence - and explores whether the dollar’s long-standing dominance as the world’s reserve currency might finally be challenged. A timely and in-depth analysis of shifting global dynamics and what they could mean for investors.

This podcast is distributed for informational purposes only and does not constitute advice, an offer or solicitation by or on behalf of H2O AM to buy or sell any securities, related financial instruments or other products, or to engage in any trading strategy in any jurisdiction. The analyses and opinions contained in this document represent the views of the author(s) referenced as of the date indicated and are subject to change without notice.
Before investing in any product, investors should fully understand the risks, including the market risk associated with the issuer, the financial benefits and the suitability of such products, and consult their own advisors. Investors should be aware that the value of an investment and the income derived from it may fall as well as rise, and that past performance is not a guide to future performance.

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Transcription

Speaker #0
Hello everyone and welcome back to Think Macro. Today I'm back with Vincent Chahier, CIO of H2O Asset Management. Hello Vincent. Hello Babac. Great to see you. We've got a lot to cover in this episode. What are the macro consequences of the conflict in the Middle East? What does it mean for growth, for the consumer, and for the US in particular? And on the long term, what's the impact to the US dollar? So Vincent, let's dive in. My first question,
Speaker #1
isn't it above all a shock for Asia and European countries rather than the USA? Yeah, indeed. Europe and Asia are oil importing countries. So they suffer more from the shock than the US that exports oil. And it's a serious shock. 40% increase in prices from roughly $60 to about $100 today for these countries is probably the largest shock we have seen in more than 50 years. So by its magnitude, it's already a big shock. And it could become an even bigger shock by its length. It's been two months so far, and we know that it's going to take months before we reopen the Strait of Hormuz and before the oil flows. back to normal levels and take the price down again. So the combination of the magnitude and the length makes it a serious economic shock. Now, Asia and Europe have means to weather the shock. You're talking about regions that have saving buffers. Consumers have large savings they can use to absorb the shock. there are Political means to absorb the shock as well. We've seen that countries like Korea, Germany recently implemented measures, fiscal measures to help the consumer and companies absorb the shock. You have leeway there. And even over the medium term, if the shock was to last longer, central banks have some leeway to cut rates down the road. You mean… Cut rates, because I think the first two elements,
Speaker #0
the cushion with the saving on one side and the help from the government on the fiscal side, I think everybody and the Senate can see that happening. But you mentioned cutting rates. Well, everything that we read on news is that the increase of the price of the oil barrel has a direct impact on inflation. And on the contrary, we see that central banks want to fight the inflation. So they rather want to increase the rate than cutting it.
Speaker #1
Yeah, yeah, of course, they are in the role there. They need to keep control of inflation and particularly the ECB or the Bank of England that really target inflation first. But in this stagflationary shock we are facing now, the flation... component is now and is actually small compared to the stagnation component that comes right after. We are not in 2022. We're not in a world of strong demand that can take a higher oil price, energy shock into an inflation spiral as happened in 2022, when out of COVID, we all wanted to travel, go to the restaurant and spend. Demand was not very strong at the start of this year in any of these countries, actually anywhere in the world. So the risk of morphing this inflation shock, this supply shock into some sort of inflation spiral is pretty small. Now, yet central banks do communicate on inflation first because that's part of the game. In doing so, they prevent that from happening. the anchor inflation expectations. They're telling companies, guys, don't do like in 2022, don't pass on prices because I will hike. And right after, because I just hiked, you're going to face recession. So please don't do it. Stay calm, absorb the shock by yourself and avoid getting into that inflation spiral. So that's essentially a communication exercise. And when you look at numbers, so far it works because of the lack. of demand at the start of the conflict. And this communication, you don't see in any country, whether Europe, Asia, or the US, any de-anchoring of inflation expectations. Companies do not price so far, oil prices into their end. good price and there's no such spiral as we observed in 19 in 2022 so wait that's the difference between a supply and a and a demand uh shock uh but everything you said uh on europe is it also valid for the usa it's it's quite different in the us uh we already mentioned it in our previous discussions uh the us economy is is in a more fragile position okay the shock is smaller. at the economy level. But because of the fragilities of the economy, the shock could morph into something more serious. First thing, okay, it's smaller at the level of the economy, but the consumer himself faces as big a shock as in any other region. At the pump, it may even be bigger in the US because the tax component, the tax part of the price is smaller. than in other countries. So when the market price rises 40%, the impact of the pump is actually bigger. In the US, you're talking today 20-25% already, and rising. So for the consumer, which is the weak part of the US economy, the impact is already very significant. And the US economy needs the consumer. It needs consumption to run. It's based on that. It's fueled by consumption. So anything that takes that consumption down is a serious matter for the U.S. economy. And so they don't have this leeway on the fiscal side and also on the saving side in the U.S.? Yeah, absolutely. I mean, these are the fragilities of the U.S. economy. You don't have such safety nets you have in other regions. No excess savings, very little. fiscal room because of the large deficits the economy is running, little monetary leeway as well. Remember, the Fed over the last year or so has focused on growth more than inflation. So they're already low compared to their sort of neutral rate. So that, of course, reduces the leeway they may have in case of pressure on growth. And now more locally, We have to bear in mind that before the conflict, you already had some pressure on consumption in the US because of tariffs last year. And you already had some pressure to the upside on inflation. Inflation was actually going up into the conflicts before it happened. So you already had sort of a squeeze to the consumer's purchasing power. Now, the shock only magnifies that. Thank you. You are at risk there. No safety nets and pressure on the consumer that has no real savings to absorb the shock may morph into something more serious. And there's this notion in the US of stall speed. You know, the US economy is a leveraged economy. And that's its strength. That's what makes it outgrow other economies when things do well. And they do that through markets, you know, markets. accelerate the engine. It's a jet, the US economy, when we are more like running an Airbus. So we're slower in Europe. Now, the good news is that we can fly at a slower speed. Now, the US jet is faster, but if it slows down too much, then it falls below stall speed and immediately falls into recession. That's the difficulty. of this leveraged economy now the problem is at the turn of the year you were already close to that stall speed with this consumer purchasing power squeeze you had or slow down you had into the year the new shock yes not as big as elsewhere may be sufficient to take us below that stall speed and morph into some negative loop that that that loop that usually takes the us economy further up could loop the other way and take it down, accelerating it down. If confidence falls, takes consumption down, then you just not have less consumption for the economy. You also have less performance of assets. And both the economy and markets start turning the wrong way. And that's what takes you into recession. So we need to be very careful. on the US economy because of that proximity of the growth we had into the conflicts and the stall speed it needs to keep on growing. But you were talking about the economy and the markets.
Speaker #0
And if we just look at the market for a minute, which is not necessarily the point of this podcast because we like to have views on macro, but what we've seen from the beginning of the year, is that the US market is beating records even now. Last week, we had new records on the S&P 500. So how do you reconcile this view of potential recession in the US while on the other side in the market,
Speaker #1
mainly driven by this AI boom? we have those new records. Yeah, but recession is always a risk. It can never be a given. And the US has this remarkable ability to generate confidence and avoid falling below that stall speed. AI is such an answer to that question. Last year, you had pressure from tariffs. You had also pressure on the US economy. And then comes the AI investment theme that brings both investment to the economy and confidence. A new theme with productivity gains down the road, pushing markets up, that adds to the confidence and to wealth. I mean, all that participates in that positive loop the U.S. economy likes to use to outgrow and keep it going above. above stall speed. Now, it's one thread, and it relies a lot on confidence. When you are facing a shock like this, the one we're facing now with high oil prices, potentially for an extended period of time, it can really dump in confidence. It can tell investors, hey, guys, I'm already giving free capital, investing in AI in these big companies, hundreds of billions of dollars, in the hope of... good profits in three, five, maybe more years. Shall I continue to do that? If now I'm facing a serious shock where my purchasing power is at stake and I'm a bit squeezed now, usually in this kind of environment, you may say, well, five, seven years is a bit too far away. Let me just refocus on the present. And you may have a situation where investors and consumers a little bit less keen to provide free capital to these companies, and you start running a market pressure that potentially takes stock market prices down a bit, adds a risk premium to the theme, and then you start looping the wrong way because you have then pressure on stock markets that affects confidence, confidence affects consumption, consumption affects profits, and the market goes down again, and you start looping the wrong way. So we need to be very cautious with this theme. It's not physical, fundamental economy where you've got money in the pockets, you spend. No, you spend on the basis of hopes in a theme. Makes sense, but it's a faraway theme that is always, always relies, always holds on confidence.
Speaker #0
And one topic we discussed also with... with many clients is in their portfolios, some are starting to lose confidence in a portion of their portfolio on private assets. Do you think that can be also a trigger that they will be more careful on their overall portfolio and the investments they will make?
Speaker #1
To some extent, yes. Because again, there you are in the mindset. of US consumers and participants. But it's not systemic. So it's not similar to what happened in 2008 with the CDOs and subprimes. It's not systemic. It's more like a lot of US investors have exposure to private assets, but in a way that is quite small proportions, say, with many different actors. You have a system where liquidity... is well managed with restrictions, but well organized. So it's hard to see something systemic there that takes... prices down and sort of accelerates to the downside. But investors are taking a loss there, at least a mark-to-market loss, 20%, 25% liquidity discount because there are some redemptions. That's never psychologically never good. So the risk here is not systemic, but is a accumulation of confidence shocks. You're starting from a... not so strong position. There are questions asked on AI. There are questions asked on private assets. And then comes an oil shock on top of all this. Together, you may have enough to turn confidence down and take the economy below stall speed. And then you start living the wrong way and end up with a recession, yes.
Speaker #0
When your jet stops or its speed is not fast enough. And it falls. And it falls. If we extend our horizon, if we look further ahead on the U.S. economy down the road five years or ten years, what will be your predictions?
Speaker #1
Well, for assets, we had 30 plus years of total superiority of the U.S. economy. end US assets, the US exception. Now, over the last four, five years now, investors have started to observe and account for a change in that performance. And there's been now about five years that US assets are more volatile than others, new regime, because of maybe potentially excessive leverage in the way this model has been pushed further than others. It's already been more volatile. More recently, performance also has been challenged. We've had 30 years of steady outperformance of U.S. equities, of steady performance of U.S. bonds as well as a safe haven. More recently, it's a lot less the case, and the curves have steepened a lot, so investors are a lot more cautious to lend to the U.S. over the medium or long term. And more recently, equity performance as well has been... maybe at par, if not below, other markets. Not by much, but that's a change. After 10, 15 years of regular outperformance of U.S. assets, it's no longer the case. So for investors, from a return and risk perspective, U.S. assets have changed, or at least are in question. Now, there was always another big reason. for investors to hold U.S. assets and to keep that link with the U.S. economy and the dollar, its first security. A lot of countries need the U.S. for their security, and that links them to the U.S. assets, to the U.S. economy and its assets, and the payment of oil for at least the Gulf-producing countries. You have in the Gulf. And these two reasons with the conflict now also now getting challenged. Because of these reasons and security oil, these countries had to recycle their dollars in the US or in US assets. It's going to come in question now. Security, countries in the Gulf realized that maybe the security was not as guaranteed as they thought or that they were promised. So they may end up first need to rebuild a number of infrastructure. They may not do that entirely in dollars as they did in the past. They may wish to diversify that away a bit from the US saying, it's not as perfect as I thought. Maybe I should think of not necessarily an entirely different solution, but some more diversified or more broader solution for... my infrastructures and potentially reinforce that defense with potentially other systems coming from elsewhere in the world so you you start from countries that were 100 dollars that may progressively decide to take a bit of that out of the dollar world and spend it with different countries that means potentially medium-term pressure on u.s assets and on the dollar you Now, the second element is oil. Oil is... Historically paid in dollars. That's the reserve currency of the world. That's the commodity currency. Now we've seen with the conflict that, you know, what, a week into the conflict, you had almost immediately China providing the ability to pay for oil in yuan, in renminbi. And they offered that regularly over the last two months to countries that were struggling to get access to oil. That's a major signal to the world. That tells particularly Asian economies, India, Korea, Japan, all benefited from this facility offered by China. So there's an option. There's an alternative to the dollar when you need to buy oil. And if the U.S. is constrained and the dollar is constrained to get your oil, then you may turn to China to get access to it. So that's a major change that also participates in this sort of rebalancing of the world, rebalancing of the world's reserve currency, telling the world you may need less dollars and you do have an alternative with the Chinese renminbi.
Speaker #0
So we've seen all, and I think everybody's following the news on the impact on the petrodollar and also on the security side. But if there are less demands globally for dollar,
Speaker #1
how come that the dollar has appreciated those last two months versus the other currencies? You're catching me there. Yeah, well, that's due to the phenomenon that is directly linked to the US exception. We call the dollar smile. Dollar is strong in two situations, in the two extremes. When the economy is running hot, so on the right of the smile, dollar is strong because that's typically where a leveraged economy like the U.S. economy outgrows everyone. In this situation, you've got better economic performance in the U.S., better performance of U.S. assets. So people, investors, all want to hold these assets. And the dollar is strong. And the dollar is also strong on the other side when things turn sour, hard lending, external shock. Why that? Because as the reserve currency, the world is essentially dollarized. The majority of the world's countries and investors are dollarized. And what do you do when there's a shock? you tend to take the money back home. First, immediately you need dollars to fund your oil. In the case of an oil shock, your margin calls, if markets tend to fall, you need immediately dollars for funding. And you need, right after that, dollars because you want more dollars because you want to secure your portfolio and take the money back in your own currency. So that's... The two big reasons why the dollar is strong also on the far left of the growth spectrum. Now, the dollar is weak in the middle. When growth is okay, there's not much volatility, and then investors, what do they do? They just diversify away from the dollar. They hold dollars. They want to seek risk premium here and there because it's not too volatile. So it makes sense to diversify your portfolio away of U.S. assets. That's the middle of the smile. Now, what's happening now is actually challenging that dollar smile, that shape of smile. It's being challenged on the right with the higher volatility and, say, less superior returns you had on US assets recently over the last three, five years. So you have less reasons to hold dollar on the right side of the smile. And the US economy also is now more struggling to outgrow others. Now the conflict is a hit to the left of the smile. Now to look at numbers, the dollar was not that strong in the recent period. Yeah, you're right to say it's been quite strong, it went up. But now you're talking about 40% oil shock. Historically, when you have such a shock, The dollar is a lot, lot stronger than that. Today, we're talking 2%, 3% dollar appreciation, and it's now coming back down again. 40% appreciation historically would have been more like 7%, 10% appreciation of the dollar. So you can already see. that the left of the smile did not function as much as it did in the past. And what's happening may challenge it further. If countries are saying, I should not be 100% dollars for my security, I should not rely 100% on the dollar for my oil payments, of course, that means diversification away, and that means the very reason why that left of the smile was so strong, so protective. fades and the smile basically flatters. That's what's happening now. And we would expect that to continue and the conflicts to only accelerate this phenomenon.
Speaker #0
So that's for you and for H2O Asset Management, that's a sign of the end of the US exception, the fact that the dollar smile is not anymore. Working as it used to work in the past.
Speaker #1
Yes, the conflict in essence accelerates the end of the U.S. exception in taking the economy, U.S. economy back to, say, normal. We already had U.S. assets back to normal. It's now telling us the dollar as well has to get back to normal, become more normal. and no longer the unique reserve currency of the world that shows strength where others don't because of its unicity. It's now in competition with other currencies for that status. And the Chinese yuan now is in a position to already to compete with the dollar. Now it's in Asia, essentially. In the future, it will continue to grow. Its share will continue to grow and better balance the world's monetary system in competing with the dollar as a reserve currency. And possibly later on, why not as well, the euro? So you are now entering a world of no longer a single currency as a reserve, but multiple reserve currencies for investors. countries. So
Speaker #0
Euro will be a topic of one of our future podcasts. Thanks for tuning into this episode of Think Macro. Vincent, always a pleasure. Thank you.
Speaker #1
Thanks, Babac.
Speaker #0
If you have any questions, please do not hesitate to contact your H2AM sales rep or visit our website at www.h2o-am.com And finally, if you enjoyed this episode, don't forget to subscribe. Thank you all and see you soon. Thank you.

Description

Hosted on Ausha. See ausha.co/privacy-policy for more information.

Transcription

Speaker #0
Hello everyone and welcome back to Think Macro. Today I'm back with Vincent Chahier, CIO of H2O Asset Management. Hello Vincent. Hello Babac. Great to see you. We've got a lot to cover in this episode. What are the macro consequences of the conflict in the Middle East? What does it mean for growth, for the consumer, and for the US in particular? And on the long term, what's the impact to the US dollar? So Vincent, let's dive in. My first question,
Speaker #1
isn't it above all a shock for Asia and European countries rather than the USA? Yeah, indeed. Europe and Asia are oil importing countries. So they suffer more from the shock than the US that exports oil. And it's a serious shock. 40% increase in prices from roughly $60 to about $100 today for these countries is probably the largest shock we have seen in more than 50 years. So by its magnitude, it's already a big shock. And it could become an even bigger shock by its length. It's been two months so far, and we know that it's going to take months before we reopen the Strait of Hormuz and before the oil flows. back to normal levels and take the price down again. So the combination of the magnitude and the length makes it a serious economic shock. Now, Asia and Europe have means to weather the shock. You're talking about regions that have saving buffers. Consumers have large savings they can use to absorb the shock. there are Political means to absorb the shock as well. We've seen that countries like Korea, Germany recently implemented measures, fiscal measures to help the consumer and companies absorb the shock. You have leeway there. And even over the medium term, if the shock was to last longer, central banks have some leeway to cut rates down the road. You mean… Cut rates, because I think the first two elements,
Speaker #0
the cushion with the saving on one side and the help from the government on the fiscal side, I think everybody and the Senate can see that happening. But you mentioned cutting rates. Well, everything that we read on news is that the increase of the price of the oil barrel has a direct impact on inflation. And on the contrary, we see that central banks want to fight the inflation. So they rather want to increase the rate than cutting it.
Speaker #1
Yeah, yeah, of course, they are in the role there. They need to keep control of inflation and particularly the ECB or the Bank of England that really target inflation first. But in this stagflationary shock we are facing now, the flation... component is now and is actually small compared to the stagnation component that comes right after. We are not in 2022. We're not in a world of strong demand that can take a higher oil price, energy shock into an inflation spiral as happened in 2022, when out of COVID, we all wanted to travel, go to the restaurant and spend. Demand was not very strong at the start of this year in any of these countries, actually anywhere in the world. So the risk of morphing this inflation shock, this supply shock into some sort of inflation spiral is pretty small. Now, yet central banks do communicate on inflation first because that's part of the game. In doing so, they prevent that from happening. the anchor inflation expectations. They're telling companies, guys, don't do like in 2022, don't pass on prices because I will hike. And right after, because I just hiked, you're going to face recession. So please don't do it. Stay calm, absorb the shock by yourself and avoid getting into that inflation spiral. So that's essentially a communication exercise. And when you look at numbers, so far it works because of the lack. of demand at the start of the conflict. And this communication, you don't see in any country, whether Europe, Asia, or the US, any de-anchoring of inflation expectations. Companies do not price so far, oil prices into their end. good price and there's no such spiral as we observed in 19 in 2022 so wait that's the difference between a supply and a and a demand uh shock uh but everything you said uh on europe is it also valid for the usa it's it's quite different in the us uh we already mentioned it in our previous discussions uh the us economy is is in a more fragile position okay the shock is smaller. at the economy level. But because of the fragilities of the economy, the shock could morph into something more serious. First thing, okay, it's smaller at the level of the economy, but the consumer himself faces as big a shock as in any other region. At the pump, it may even be bigger in the US because the tax component, the tax part of the price is smaller. than in other countries. So when the market price rises 40%, the impact of the pump is actually bigger. In the US, you're talking today 20-25% already, and rising. So for the consumer, which is the weak part of the US economy, the impact is already very significant. And the US economy needs the consumer. It needs consumption to run. It's based on that. It's fueled by consumption. So anything that takes that consumption down is a serious matter for the U.S. economy. And so they don't have this leeway on the fiscal side and also on the saving side in the U.S.? Yeah, absolutely. I mean, these are the fragilities of the U.S. economy. You don't have such safety nets you have in other regions. No excess savings, very little. fiscal room because of the large deficits the economy is running, little monetary leeway as well. Remember, the Fed over the last year or so has focused on growth more than inflation. So they're already low compared to their sort of neutral rate. So that, of course, reduces the leeway they may have in case of pressure on growth. And now more locally, We have to bear in mind that before the conflict, you already had some pressure on consumption in the US because of tariffs last year. And you already had some pressure to the upside on inflation. Inflation was actually going up into the conflicts before it happened. So you already had sort of a squeeze to the consumer's purchasing power. Now, the shock only magnifies that. Thank you. You are at risk there. No safety nets and pressure on the consumer that has no real savings to absorb the shock may morph into something more serious. And there's this notion in the US of stall speed. You know, the US economy is a leveraged economy. And that's its strength. That's what makes it outgrow other economies when things do well. And they do that through markets, you know, markets. accelerate the engine. It's a jet, the US economy, when we are more like running an Airbus. So we're slower in Europe. Now, the good news is that we can fly at a slower speed. Now, the US jet is faster, but if it slows down too much, then it falls below stall speed and immediately falls into recession. That's the difficulty. of this leveraged economy now the problem is at the turn of the year you were already close to that stall speed with this consumer purchasing power squeeze you had or slow down you had into the year the new shock yes not as big as elsewhere may be sufficient to take us below that stall speed and morph into some negative loop that that that loop that usually takes the us economy further up could loop the other way and take it down, accelerating it down. If confidence falls, takes consumption down, then you just not have less consumption for the economy. You also have less performance of assets. And both the economy and markets start turning the wrong way. And that's what takes you into recession. So we need to be very careful. on the US economy because of that proximity of the growth we had into the conflicts and the stall speed it needs to keep on growing. But you were talking about the economy and the markets.
Speaker #0
And if we just look at the market for a minute, which is not necessarily the point of this podcast because we like to have views on macro, but what we've seen from the beginning of the year, is that the US market is beating records even now. Last week, we had new records on the S&P 500. So how do you reconcile this view of potential recession in the US while on the other side in the market,
Speaker #1
mainly driven by this AI boom? we have those new records. Yeah, but recession is always a risk. It can never be a given. And the US has this remarkable ability to generate confidence and avoid falling below that stall speed. AI is such an answer to that question. Last year, you had pressure from tariffs. You had also pressure on the US economy. And then comes the AI investment theme that brings both investment to the economy and confidence. A new theme with productivity gains down the road, pushing markets up, that adds to the confidence and to wealth. I mean, all that participates in that positive loop the U.S. economy likes to use to outgrow and keep it going above. above stall speed. Now, it's one thread, and it relies a lot on confidence. When you are facing a shock like this, the one we're facing now with high oil prices, potentially for an extended period of time, it can really dump in confidence. It can tell investors, hey, guys, I'm already giving free capital, investing in AI in these big companies, hundreds of billions of dollars, in the hope of... good profits in three, five, maybe more years. Shall I continue to do that? If now I'm facing a serious shock where my purchasing power is at stake and I'm a bit squeezed now, usually in this kind of environment, you may say, well, five, seven years is a bit too far away. Let me just refocus on the present. And you may have a situation where investors and consumers a little bit less keen to provide free capital to these companies, and you start running a market pressure that potentially takes stock market prices down a bit, adds a risk premium to the theme, and then you start looping the wrong way because you have then pressure on stock markets that affects confidence, confidence affects consumption, consumption affects profits, and the market goes down again, and you start looping the wrong way. So we need to be very cautious with this theme. It's not physical, fundamental economy where you've got money in the pockets, you spend. No, you spend on the basis of hopes in a theme. Makes sense, but it's a faraway theme that is always, always relies, always holds on confidence.
Speaker #0
And one topic we discussed also with... with many clients is in their portfolios, some are starting to lose confidence in a portion of their portfolio on private assets. Do you think that can be also a trigger that they will be more careful on their overall portfolio and the investments they will make?
Speaker #1
To some extent, yes. Because again, there you are in the mindset. of US consumers and participants. But it's not systemic. So it's not similar to what happened in 2008 with the CDOs and subprimes. It's not systemic. It's more like a lot of US investors have exposure to private assets, but in a way that is quite small proportions, say, with many different actors. You have a system where liquidity... is well managed with restrictions, but well organized. So it's hard to see something systemic there that takes... prices down and sort of accelerates to the downside. But investors are taking a loss there, at least a mark-to-market loss, 20%, 25% liquidity discount because there are some redemptions. That's never psychologically never good. So the risk here is not systemic, but is a accumulation of confidence shocks. You're starting from a... not so strong position. There are questions asked on AI. There are questions asked on private assets. And then comes an oil shock on top of all this. Together, you may have enough to turn confidence down and take the economy below stall speed. And then you start living the wrong way and end up with a recession, yes.
Speaker #0
When your jet stops or its speed is not fast enough. And it falls. And it falls. If we extend our horizon, if we look further ahead on the U.S. economy down the road five years or ten years, what will be your predictions?
Speaker #1
Well, for assets, we had 30 plus years of total superiority of the U.S. economy. end US assets, the US exception. Now, over the last four, five years now, investors have started to observe and account for a change in that performance. And there's been now about five years that US assets are more volatile than others, new regime, because of maybe potentially excessive leverage in the way this model has been pushed further than others. It's already been more volatile. More recently, performance also has been challenged. We've had 30 years of steady outperformance of U.S. equities, of steady performance of U.S. bonds as well as a safe haven. More recently, it's a lot less the case, and the curves have steepened a lot, so investors are a lot more cautious to lend to the U.S. over the medium or long term. And more recently, equity performance as well has been... maybe at par, if not below, other markets. Not by much, but that's a change. After 10, 15 years of regular outperformance of U.S. assets, it's no longer the case. So for investors, from a return and risk perspective, U.S. assets have changed, or at least are in question. Now, there was always another big reason. for investors to hold U.S. assets and to keep that link with the U.S. economy and the dollar, its first security. A lot of countries need the U.S. for their security, and that links them to the U.S. assets, to the U.S. economy and its assets, and the payment of oil for at least the Gulf-producing countries. You have in the Gulf. And these two reasons with the conflict now also now getting challenged. Because of these reasons and security oil, these countries had to recycle their dollars in the US or in US assets. It's going to come in question now. Security, countries in the Gulf realized that maybe the security was not as guaranteed as they thought or that they were promised. So they may end up first need to rebuild a number of infrastructure. They may not do that entirely in dollars as they did in the past. They may wish to diversify that away a bit from the US saying, it's not as perfect as I thought. Maybe I should think of not necessarily an entirely different solution, but some more diversified or more broader solution for... my infrastructures and potentially reinforce that defense with potentially other systems coming from elsewhere in the world so you you start from countries that were 100 dollars that may progressively decide to take a bit of that out of the dollar world and spend it with different countries that means potentially medium-term pressure on u.s assets and on the dollar you Now, the second element is oil. Oil is... Historically paid in dollars. That's the reserve currency of the world. That's the commodity currency. Now we've seen with the conflict that, you know, what, a week into the conflict, you had almost immediately China providing the ability to pay for oil in yuan, in renminbi. And they offered that regularly over the last two months to countries that were struggling to get access to oil. That's a major signal to the world. That tells particularly Asian economies, India, Korea, Japan, all benefited from this facility offered by China. So there's an option. There's an alternative to the dollar when you need to buy oil. And if the U.S. is constrained and the dollar is constrained to get your oil, then you may turn to China to get access to it. So that's a major change that also participates in this sort of rebalancing of the world, rebalancing of the world's reserve currency, telling the world you may need less dollars and you do have an alternative with the Chinese renminbi.
Speaker #0
So we've seen all, and I think everybody's following the news on the impact on the petrodollar and also on the security side. But if there are less demands globally for dollar,
Speaker #1
how come that the dollar has appreciated those last two months versus the other currencies? You're catching me there. Yeah, well, that's due to the phenomenon that is directly linked to the US exception. We call the dollar smile. Dollar is strong in two situations, in the two extremes. When the economy is running hot, so on the right of the smile, dollar is strong because that's typically where a leveraged economy like the U.S. economy outgrows everyone. In this situation, you've got better economic performance in the U.S., better performance of U.S. assets. So people, investors, all want to hold these assets. And the dollar is strong. And the dollar is also strong on the other side when things turn sour, hard lending, external shock. Why that? Because as the reserve currency, the world is essentially dollarized. The majority of the world's countries and investors are dollarized. And what do you do when there's a shock? you tend to take the money back home. First, immediately you need dollars to fund your oil. In the case of an oil shock, your margin calls, if markets tend to fall, you need immediately dollars for funding. And you need, right after that, dollars because you want more dollars because you want to secure your portfolio and take the money back in your own currency. So that's... The two big reasons why the dollar is strong also on the far left of the growth spectrum. Now, the dollar is weak in the middle. When growth is okay, there's not much volatility, and then investors, what do they do? They just diversify away from the dollar. They hold dollars. They want to seek risk premium here and there because it's not too volatile. So it makes sense to diversify your portfolio away of U.S. assets. That's the middle of the smile. Now, what's happening now is actually challenging that dollar smile, that shape of smile. It's being challenged on the right with the higher volatility and, say, less superior returns you had on US assets recently over the last three, five years. So you have less reasons to hold dollar on the right side of the smile. And the US economy also is now more struggling to outgrow others. Now the conflict is a hit to the left of the smile. Now to look at numbers, the dollar was not that strong in the recent period. Yeah, you're right to say it's been quite strong, it went up. But now you're talking about 40% oil shock. Historically, when you have such a shock, The dollar is a lot, lot stronger than that. Today, we're talking 2%, 3% dollar appreciation, and it's now coming back down again. 40% appreciation historically would have been more like 7%, 10% appreciation of the dollar. So you can already see. that the left of the smile did not function as much as it did in the past. And what's happening may challenge it further. If countries are saying, I should not be 100% dollars for my security, I should not rely 100% on the dollar for my oil payments, of course, that means diversification away, and that means the very reason why that left of the smile was so strong, so protective. fades and the smile basically flatters. That's what's happening now. And we would expect that to continue and the conflicts to only accelerate this phenomenon.
Speaker #0
So that's for you and for H2O Asset Management, that's a sign of the end of the US exception, the fact that the dollar smile is not anymore. Working as it used to work in the past.
Speaker #1
Yes, the conflict in essence accelerates the end of the U.S. exception in taking the economy, U.S. economy back to, say, normal. We already had U.S. assets back to normal. It's now telling us the dollar as well has to get back to normal, become more normal. and no longer the unique reserve currency of the world that shows strength where others don't because of its unicity. It's now in competition with other currencies for that status. And the Chinese yuan now is in a position to already to compete with the dollar. Now it's in Asia, essentially. In the future, it will continue to grow. Its share will continue to grow and better balance the world's monetary system in competing with the dollar as a reserve currency. And possibly later on, why not as well, the euro? So you are now entering a world of no longer a single currency as a reserve, but multiple reserve currencies for investors. countries. So
Speaker #0
Euro will be a topic of one of our future podcasts. Thanks for tuning into this episode of Think Macro. Vincent, always a pleasure. Thank you.
Speaker #1
Thanks, Babac.
Speaker #0
If you have any questions, please do not hesitate to contact your H2AM sales rep or visit our website at www.h2o-am.com And finally, if you enjoyed this episode, don't forget to subscribe. Thank you all and see you soon. Thank you.

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