Recent US Dollar Strength
The last six months have seen impressive gains for the US Dollar versus the Yen, Euro, Emerging Market currencies, and commodities. USD strength is likely to persist; however, we expect that it will proceed at a more moderate pace. From the end of June through the end of September, the US Dollar strengthened 6.64% and 7.95% against the Yen and Euro, respectively. Furthermore, the greenback strengthened 10.77% against a basket of commodities. These are strong moves exhibiting increasing momentum. If these trends are reinforced it will introduce a new dynamic to global financial markets. Potential developments include: import inflation in Japan and Europe, a stronger US consumer, lower US commodity and input costs, and lower US interest rates for longer. US large cap multinationals would face headwinds relative to domestically oriented US small caps, while foreign companies exposed to the US consumer could see gains in market share and profitability.
Interest Rate Differentials
The recent USD strength has been driven by relative monetary policy and global interest rate differentials. Liquidity seeks out yield, and flows to where it can earn the highest risk adjusted returns. The economic upturn in the US in the context of non-US economic disappointment has widened front-end rate spreads between the USD and every major currency except GBP and AUD. The interest rate differential between 10 Year UST Yields and 10 Year German Bund Yields is at the highest levels since 1999. The differential equaled 1.5534% as of the end of September, and is at a 99.67 percentile level versus the last 30 years (seen below in the spread summary and distribution chart).
This historically wide interest rate differential (higher rates in the US) is drawing international capital into US Dollars. These flows should increase demand for US financial assets ranging from Treasuries to Real Estate to Equities. The USD Index (a trade weighted basket of currencies) was up 3.85% in September. As seen below, the US Dollar strengthened vs. all expanded major currencies but the Chinese Renminbi during the month of September.
USD Trend to be reinforced by ECB and BOJ
In a capitalistic free market, this US Dollar strength and capital inflows into the United States would act to re-balance global markets. Interest rates would have bias to move lower in the US and higher internationally. US equities would tend to become overvalued while international equities could see price multiples contract. However, in the current context of systematic intervention and unprecedented central bank monetary policy these equilibriums are likely going to take longer to find.
The ECB has pledged, and appears poised, to expand their balance sheet by 1 Trillion Euros to combat very low inflation and weak economic growth. European economic weakness spurs and requires further reflation. The ECB is set to announce further details of its covered bond and ABS purchase programs on October 2nd and the second TLTRO operation takes place on Dec. 11th.
Likewise, Japan faces growth and inflation challenges and has responded in similar fashion. The Bank of Japan has been monetizing their sovereign debt with QQE (quantitative and qualitative easing) for the last 24 months. The Bank of Japan has purchased 70% of newly issued JGBs (Japanese Government Bonds) in total and over 100% on a net basis under its unprecedented monetary easing program.
What does this mean for global portfolios?
The relative monetary policy described above points to further strength for the US Dollar, and US Dollar strength can have a major impact on international equity returns for a US based investor. The two charts below show the performance of the United States, European Monetary Union, and Japanese equity markets. The first charts below shows the simple price appreciation of these markets in local currency terms. The second chart shows the performance of these equity markets in US Dollar terms. A US based investor would have experienced net returns in line with the performance seen in the second chart over the last six months. This is because a US based investor takes on the currency risk of international investments, whether using ETFs or individual ADR stocks.
In local currency terms, Japan was one of the best performing markets in September, and has nicely outperformed the US market over the last 6 months. The Japanese equity market from a Japanese investor’s perspective is doing quite well. Yen depreciation has resulted in positive Japanese earnings revisions. Japan strategists at JP Morgan estimate that each unit of yen depreciation vs. the dollar increases EPS by about one percentage point. With Yen weakening from 101 in mid-July to 109.50 at the end of September, the prospects of better than expected earnings in Japan are real.
Nonetheless, after allowing for the impact of a strengthening dollar, the performance of these international markets (for a US investor) is substantially lower. Furthermore, the volatility of these investments has increased as a result of uncertainty surrounding FX rates, relative monetary policy, and unbalanced economic growth.
Strong US Dollar = Low Rates for “Considerable Time”
Growth should continue to be weak globally, and deleveraging is still needed. The private sector appears to made substantial progress, but governments are still faced with eventual spending cuts and tax hikes. This suggests that incomes and wage gains will remain under pressure; making runaway inflation unlikely in Europe and Japan, but also in the United States. The continued USD strength proposed above suggests that prices, commodities, and input costs are likely to remain contained. All of this points to lower interest rates for longer. While it seems a majority of market strategists expect higher rates, US rate forwards through 2017 remain solidly below consensus and Fed forecasts for short USD rates.
The Fed has defended against decreasing inflation expectations in the past. Entering markets or providing guidance that has reinitiated USD weakness. The question is whether or not current US growth is strong enough to create inflation in the face of a strengthening US Dollar (i.e. demand pull inflation). In other words, is demand for commodities, like oil and base metals, strong enough to drive prices higher (inflation) despite strength in the USD? Or does the Fed need to step back in and once again backstop the economy, provide liquidity, and protect against U.S. deflationary pressures coming from Europe and Japan?As of the end of September, the US Dollar has strengthened to 4 year highs, inflation expectations, as defined by the Fed’s Five-year Forward Breakeven Inflation Rate, have moved to 3 year lows. In other words, inflationary pressures are as low as they have been since 2011 (Blue line in the chart below).
Global Accommodative Monetary Policy is Bullish for Risk Assets
Central banks are keeping the reflation story alive in developed countries, providing support to economies and abundant liquidity to markets. Our analysis suggests that the Fed will remain accommodative, but less so than either the ECB or BOJ. This relative under-accommodation points towards further US Dollar strength, persistent global liquidity, and anchored benchmark interest rates. Furthermore, longer term inflation risk would be to the upside because the Fed and Janet Yellen will likely wait to see the “white of the eyes” of inflation before blinking and raising rates. This indicates negative real interest rates for a “considerable time” and implies that risk assets will outperform risk-free assets, equities are relatively more attractive than fixed income, and the crowded chase for yield with continue. In this environment, we recommend currency hedged international exposures. ETFs that hedge out the impact of currency returns, like DXJ and DBJP for Japan, HEZU and DBEU for the Europe, and HEWG and DBGR for Germany, have seen meaningful AUM growth and become popular investment vehicles for a good reason.
Diversify with Equities, not Currencies
International equity allocations continue to play an important role in global portfolios, but we advise taking more calculated currency risk in today’s market environment. As seen below, the current Price to EBITDA discount (-3.35x) between the US and the European Monetary Union is larger than 94% of the observations seen since 1995. Japan’s Price to EBITDA discount (-2.98x) is similarly attractive, currently larger than 86% of the observations seen since 1995. Of course, cheap can always get cheaper and U.S. equities should certainly remain a core allocation, but for longer-term investors the upside to developed international exposure is significant, especially after protecting against currency weakness. The ECB’s coming reflation boost should unlock value in Eurozone equities, and we expect that Japanese risk assets will benefit from further monetary easing from the BOJ.
Lastly, to hedge/protect this broader US Dollar strength thesis, we recommend energy and the OIL ETF. This commodity should respond nicely to any re-initiation of quantitative easing, U.S. inflation, or economic surge. Furthermore, the OIL ETF taps into an attractive roll yield provided by the steep backwardation currently seen in crude oil futures.
This article was compiled by James Calhoun, a Portfolio Manager at Accuvest Global Advisors. This article is strictly informational and should be used for research use only. It should not be construed as advertising material. The opinions expressed are not intended to provide investing or other advice or guidance with respect to the matters addressed in this brochure. All relevant facts, including individual circumstances, need to be considered by the reader to arrive at investment conclusions to comply with matters addressed in this brochure. Charts and information are sourced from Bloomberg, unless otherwise noted. Remember that investing involves risks, as the value of your investment will fluctuate over time and you may gain or lose money. You should seek advice from your financial adviser before making investment decisions. Investment risks are borne solely by the investor and not by AGA. AGA is an independent investment advisor registered with the SEC. All disclosures, marketing brochures, and supplemental firm sheets are available upon request.