🔎Turning tides
Don't underestimate the ongoing restructuring of the international trade system. It reverses one of the most powerful forces for asset flows and asset returns in the last 15 years.
As a regular FA reader, the below probably doesn’t include much new for you. I believe it’s worth to reiterate these points anyway because they are very important to understand the current macro environment.
TLDR Summary
The US is in the strongest position imaginable in international trade. For the last 15 years, the rest of the world has been effectively paying them for the privilege to serve them with goods and services. The US has been like a giant vacuum cleaner for consumption and investment. It made the US stock market outperform the rest of the world by about 350% since 2010.
Markets work well when they are governed by self-correcting mechanisms. Getting paid to consume is a self-reinforcing process. Self-reinforcing processes spiral out of control and create bubbles which pop upon deleveraging.
The leverage in the US economy is primarily visible in the rich valuation of its assets which is driven by enormous interest from foreign investors. The rest of the world is overallocated to US assets. This will unravel when the right catalyst hits financial markets at the right time.
America’s trade policy pivot could be such a catalyst. US stocks started underperforming the moment Trump declared war on the international trade system. That is not coincidence and it could signal a major tidal shift in global capital flows.
Getting paid to consume…
A currency is supplied by the government and its agents: central bank money creation, credit creation (fractional reserve banking) and deficit spending (government bond issuance).
A currency is demanded by those who need it for transactions (to buy goods, services or assets denominated in the currency) or by those who want to hold it as a store of value. In balance of payments terms, demand for a currency can either be driven by the trade balance or it can be driven by the capital balance.
Let’s illustrate that with an example. Imagine there are two countries, X and Y. X has a trade surplus with Y.
Currency X will appreciate against Y if Y’s demand for X’s products is higher than X’s demand for Y’s assets. Citizens of Y will then demand currency X to pay citizens of X who are in turn not equally interested in holding or using currency Y.
This is the typical case. The German Mark and the Japanese Yen appreciated against the US Dollar for this reason for many years. China had to acquire huge FX reserves to avoid a similar appreciation.
Upward pressure for the currency of the exporting nation is healthy and it helps to self-correct trade imbalances. X’s products get more expensive, Y will experience inflation and Y’s trade deficit declines. Or at least it doesn’t spiral out of control.
However, if X’s demand for Y’s assets exceeds Y’s demand for X’s products, Y’s currency will appreciate even with trade deficits. It’s a weird case where Y’s citizens effectively get paid for absorbing economic production and X’s citizens get punished for their production. It’s a deflationary environment for Y because X wants its assets and its currency. Y’s citizens get richer without working for it. This is extremely rare and at its current scale it’s certainly unprecedented.
…is a self-reinforcing process…
This process is not self-correcting, but self-reinforcing. Currency X depreciates because citizens of X want to invest in Y more than they can through their trade proceeds. This depreciation makes exports from X to Y even more attractive. With time, all investment and consumption moves into Y. X starves of capital. X becomes nothing more than a factory for Y. Operated by wage slaves.
This is exactly what has been going on for the last 15 years. X has been the rest of the world. Y has been the US. The US Dollar has been appreciating with persistent and rising trade deficits.
As a result, the US Dollar is overvalued. One Euro currently buys $1.16. To get to purchasing power parity (where it had been in the past), it would have to buy $1.41.
This overvaluation is a form of leverage. It makes Americans overconsume similar like the housing leverage made them overconsume twenty years ago. More on the role of leverage later. Let’s first appreciate the difference between self-correcting and self-reinforcing market processes more.
…that spirals out of control and creates bubbles…
Markets are typically beautiful in that they are typically self-correcting because market participants engage in arbitrage or arbitrage-like transactions. There are tons of mechanisms that are similar to the trade surplus driven currency appreciation explained above.
If the price of a product or asset gets too high, consumers and investors will look for substitutes. They might replace butter with margarine for example. Or they might trade a growth stock for a value stock which offers a more attractive time value of money.
As one of those beautiful examples, you might remember from my Peabody article that US coal and natural gas are trading exactly at their energetic cost parity. Both work very well as substitutes for one another. Gas wells compete with coal mines just like they compete with other gas wells.
However, some market forces are subject to processes that are not self-correcting, but self-reinforcing.
Think about a currency carry trade for example. Investors borrow in a low rate currency and invest the proceeds in a high rate currency. They earn a positive return as long as the high rate currency doesn’t depreciate by more than the rate spread. Now, the more investors are pouring into this carry trade, the stronger the high rate currency will be. The capital inflow boosts the economy and pushes rates even higher. The more crowded the trade, the better it performs.
Or think about momentum investing. When investors stop caring about the earnings of assets and only buy based on price action, they switch off the self-correction function of markets. No price of Bitcoin or Tesla stock is too high to buy.
…which pop upon deleveraging.
The problem with such self-reinforcing processes is that they almost always attract leverage. This leverage can be explicit. The leverage in an FX carry trade is straight forward because it is simply the amount borrowed in the low rate currency. Other explicit forms of leverage include for example margin debt or levered ETFs which are very popular these days.
Other forms of leverage are more implicit. Open interest in call options for example. Buying a call option is like buying the underlying with leverage. The market maker selling you the option becomes your stock custodian and the option’s theta is the interest you pay them.
Some forms of leverage are even more implicit in nature than that. For example, if you have a certain group of investors that are flipping certain assets such as crypto or meme stocks amongst each other at ever higher prices, you don’t need them to use explicit leverage to create a bubble. I sell you 50% of my shitcoin for $1. You sell me 25% back for $2. Our net worths have both doubled without creating any real economic value.
The leverage is in our mutual trust that we will keep buying from each other at the higher price. It’s in the ratio between asset values and economic activity. We can both never consume the entire market value of our combined shitcoin holding. Similar to how all of the depositors of a highly leveraged banking system cannot get all their money back because the liquidity shock would nuke the assets in the banking system.
Leverage can even be as simple as an overallocation to an asset or asset class in the portfolios of those who either overestimate its returns or underestimate its risk. The deleveraging then happens once they realize that the risk/return profiles of alternative assets are more attractive than they thought.
Leverage is not necessarily a bad thing. Our entire system is based on leverage. Many economic processes would not be possible if we didn’t have the ability to borrow. It’s the portion of leverage that is excessive that is causing the problem. Leverage employed by those who underestimate the volatility of the underlying and are than unable or unwilling to bear it.
The GFC was a giant margin call for overextended real estate speculators.
The volmageddon events of February 2018 and March 2020 were margin calls for short volatility traders.
2022 was a deleveraging event for pandemic era call buyers.
The leverage in the US economy is primarily in its rich asset valuations…
The leverage in the US economy of 2025 is primarily visible in its very rich asset valuations, most prominently in the value of the US Dollar as indicated earlier and in the value of the stock market. The forward P/E ratio of the S&P 500 is 35% above its 30-year average. The CAPE ratio is 40% above.
The Buffett Indicator is at an all time high, far above historical benchmarks.
In FX-adjusted terms, the S&P 500 could easily drop 50% and nobody could call it dirt cheap. It would still carry a modest valuation premium to reflect the strength of the US economy. I am not predicting such a rerating to the downside. I am merely contextualizing the valuation of US assets.
…which are driven by enormous interest from foreign investors.
An important driver for this rich asset valuation is that foreigners have poured capital into the US. Over the last 25 years, the US has run a cumulative trade deficit of $15tn. That’s the cumulative net investment from foreigners into the US.
This net investment currently has a market value of more than $25tn.
The US economy has been a unique haven for capital due to its phenomenal ability to generate returns. This is due to the innovation power of the US technology and fossil fuel industries, due to the economies of scale in its financial markets and consumer markets, due to its attractiveness for skilled labor and due to tax arbitrage. Tax arbitrage because the US has no federal VAT, which makes it an attractive market for foreign production. I discussed this in more detail here. It would overburden this article to explain it here.
This uniqueness has driven the huge outperformance of US stocks vs. international stocks for the last 15 years. The US stock market outperformed the rest of the world by about 350% since 2010.
With the exception of brief hiccups in 2014/15 (China bubble) and 2021 (pandemic bubble), this outperformance has happened pretty much in a straight line.
The rich valuation of its assets is one of the greatest strength of the US. It lowers the cost of capital and incentivizes investment and innovation. The capital from abroad is crucial to support this valuation premium. It’s a real risk that foreigners could one day direct their funds somewhere else.
Case in point, US stocks started underperforming the moment Trump declared war on the international trade system earlier this year. You can see that in the most recent drop in the chart above, but it’s perhaps more visible in the chart below.
Tariffs make it less attractive to sell products and services to the US which in turns makes it less attractive to invest into the US. Americans could change course back to the old model any time once they realize their mistake. But will they? Isn’t there a broad support for the new trade system based on tariffs and other protectionist measures?
Sincerely,
Rene
Fortunately or Unfortunately there is no other country like the US. Just incredible talent it attracts, capital and platform to innovate and create. Maybe China is the alternative but international investors prefer the US for transperancy.