The dollar is once again gaining favour among investors. Since the end of June, the trade weighted dollar index has followed a parabolic arc higher, with several catalysts responsible for the Greenback’s dramatic move. The usual geopolitical suspects include renewed Russian irredentism in eastern Ukraine and the threat posed by the Islamic State of Iraq and the Levant. On the economic front, action taken by the European Central Bank to reduce interest rates and weaken the euro has also created an incentive for money to move, as the central bank tries to deliver a modicum of inflation to the currency bloc. Finally, the threatened dissolution of the 307-year union between Scotland and England is the latest entrant on an international investors list of worries.
The strength of US economic activity appears to have surprised investors this summer. Examining the price action of the dollar during this period makes one wonder if the currency’s rise in July foreshadowed the surprises seen in August. As we noted at the time, comments from the Fed Chairman did little to clarify central bank policy during the annual Jackson Hole Symposium. Interest rate differentials and, by extension, the growth rates they imply will likely be the most enduring driver of and sustaining influence on the dollar’s rise.
Continued dollar strength will eventually exert downward pressure on the profits of US multinational corporations, as the value of foreign earnings are translated back into the “home currency” at less favourable exchange rates. If the past is any guide, investors tend to look through currency translations and focus on the operating performance of the businesses generating the earnings. The dollar’s steadily increasing strength, means investors should prepare themselves for the inevitable impact on third quarter profits and the headlines it will create. This is evidenced by analyst expectations for third quarter S&P 500 earnings, which have been falling since the beginning of the quarter.
A new Caledonia?
Scotland will hold a referendum on September 18th to decide on the future of its 307-year union with England. The outcome of the vote, until recently, appeared to be a foregone conclusion, with those wanting to remain part of Great Britain handily outnumbering those who favoured succession. Two recent polls upended expectations as one poll conducted by polling firm, TNS, revealed 39% of those surveyed would vote “no” and 38% would vote “yes” for independence. The remaining 23% were undecided. A poll YouGov conducted with The Sunday Times suggested the nationalists had nosed in front, though support for independence wilted a little in the same survey earlier this morning. With the camps closely divided, the undecided voters will be the final arbiters of the referendum.
What the future of an independent Scotland looks like is as equally unclear as the referendum outcome. The country represents over 30% of the land mass of the United Kingdom, but only 8% of the population and 9% of GDP. Proponents of independence plan to keep the pound as its currency, and, by extension, the Bank of England as its central bank, while seeking to join the European Union on similar terms to those of the UK. This might be fanciful thinking, as the leadership in Brussels and Westminster do not appear amenable to offering membership to, or sharing a currency with, a separatist movement. How oil revenues from the North Sea fields would be split between Holyrood and Westminster is equally unclear; it’s questionable that Scotland will enjoy oil revenue that is proportionate with the amount extracted from fields within its new borders.
One of the many lessons the euro crisis has offered is that a country without its own currency and central bank is a country that is not truly independent. Were Scotland able to continue to use the pound, or able to adopt the euro as part of a bid for membership, it would cede some independence. In the case of the former it would remain under the monetary and fiscal policies of its erstwhile partner, and, in the latter, be governed by the inclinations of Berlin. Were the country to float its own currency, it would likely have to pay an uncertainty premium to attract the capital needed to conduct its affairs, as it would not be able to borrow at the interest rates enjoyed by larger, more integrated neighbours.
Within a wider context, fears are emerging that if the Scottish independence movement wins, it will create a domino effect spilling over to the non-binding Catalonian referendum on independence in November, and possibly to the UK vote on membership of the European Union. Those looking to history to instruct the future should examine Canada’s experience with a separatist movement in the province of Quebec. The Parti Quebecois (PQ) managed to organise a referendum on sovereignty in 1995, the culmination of roughly 35 years of agitation for independence on the part of separatists. The effort failed in a nail biter: 49.4% to 50.6%. (This was actually the second referendum; the first was in 1980 and did not call for outright separation but to “negotiate sovereignty association with the rest of Canada”. That referendum failed with 60% of the electorate rejecting the proposal.) Since the 1995 defeat, separatist sentiment has receded, but not disappeared, in Quebec.
The bottom line in all this is that divorce is a messy affair that plunges its subjects into the unknown. None of the parties are likely to walk away from the experience happy, and markets have been taking note of this. If the Quebec experience is any indication, clarity will not emerge until the votes are tallied.