The Dollar and the Investment Climate

The underlying theme in the foreign exchange market is the divergence between the US and UK on one hand and the euro area and Japan on the other.  That divergence, however, may not explain the developments in the other capital markets.

The US S&P 500 and the Dow Jones Stoxx 600 in Europe recorded its worst week in a couple of years.  US and UK 10-year yields declined by the most this year (~14 bp) and are levels last since in the middle of last year.  

Many commodity prices have fallen sharply, and the CRB Index has completed unwound the partly weather-induced gains in the Q1.  It has approached the area where it had bottomed last November and this past January.  Oil prices have also tumbled.  The price of WTI has fallen 10% in the past two weeks.  It is still as much as $10 a barrel above where it bottomed in 2011-2012.

Many want to attribute this to the rise of the US dollar.  This is deduced from economic theory. A rise in the dollar hurts exports, weighs on earnings of US companies, pressures commodity prices, most still priced in US dollars.  All things being equal...  

Yet unrecognized by the Financial Times in its "Dollar's relentless rise is beginning to cause headaches", last week, as this price action was being recorded, the dollar lost ground against all the major currencies and many emerging market currencies.    Indeed, that, not its "relentless rise" was the real development last week.   We do think the dollar is in a long-term uptrend against most of the currencies, the point is that its relationship to other markets is more complicated than often appreciated.. Not understanding this will make it more difficult to navigate in this investment climate.

These kind of stories could be pre-written or written by a robot.   The S&P 500 was rallying throughout the dollar's advance.  Leave aside the fact that many have been anticipating a pullback because of the over-extended nature of the rally and the historic pattern of weakening during and after the earnings season.  As soon as there is a pullback, there is a ready-made story.

The euro peaked in May and sterling in July.  The dollar bottomed against the yen early this year and broke out of its four-month two-yen range (~JPY101-JPY103) in late-August.    The S&P peaked on September 19.        It is true that currency appreciation is tantamount of some tightening of financial conditions.   The real issue is how much has the dollar appreciated and how much-tightening financial conditions has taken place.

First, on a broad trade-weighted measure, adjusted for inflation, the US dollar has appreciated 2% since the end of last year.  Second, econometric work suggests that a 10% appreciation reduces growth by about 0.4% over the course of a year.  If this is true, then one must conclude that the impact on the US economy of the dollar's rise is, thus far, negligible.

Reducing price developments in the markets to the dollar makes real analysis superfluous.  It allows one to avoid the complicated story of how there has been a breakdown in discipline within OPEC, and Saudi Arabia is not acting as the swing producer, but instead is boost output and cutting prices.  Iran matched these discounts to Asia last week.  Alternatively some see a US-Saudi alliance to pressure Russia, though the booming US fracking and shale sector feels its under attack too.  

The bumper US harvest, which goes a long way toward explaining the drop in foodstuff prices, is a function of the agri-business responded to the price signals--high prices previously--and boosting output.   For several years now it is China's demand for industrial commodities that seemed to drive prices.  Not only has the world's second largest economy slowed, but officials have also cracked down on the use of commodities to disguise capital flows or to back loans.  Australian iron ore miners and Chilean copper miners know that the rise in the dollar is not the cause of their woes.

The Fed's references to the dollar were misunderstood.   The FOMC minutes give more air time to the wide range of opinions at the central bank.  Because of this, we insist it is not the proper medium to understand the Fed's message.   Our insight of the importance of the Troika (Yellen, Fischer, and Dudley) illustrates this point.   Apparently, few paid much attention to Fischer's comments, but he was clear on October 9 the dollar's rise was "entirely appropriate."

It is true that significant dollar appreciation could become an important headwind, all other things being equal.  That is precisely our jobs as investors to recognize that all other things rarely equal and to understand what is different now.  Offsetting the tightening impulse that might be emanating for the foreign exchange market, is the decline in US interest rates.  The decline in US interest rates despite the Fed nearly done with its purchases, is arguably the most significant surprise for investors this year.

It is within this broader context; we share the following six observations about the week ahead.

1.  Weak euro area industrial production data is baked in the cake, not only by the PMIs, but more importantly Germany's 4% decline that has already been reported.  At the end of the week, new benchmark revisions to GDP for Europe will be announced.  The level of GDP is likely to be increased as more activities will be included.  The implication for the recent rate of growth is not clear.  

2.  Euro zone fiscal policy issues may overshadow monetary policy and economic issues in the days ahead.  It has already been tipped that the Irish budget (Tuesday) will likely include the closing of a controversial corporate tax loophole.  The OECD is pushing hard for countries to end such practices, which have drawn US tech and pharma, among others.  In addition, there is likely to be more speculation at the Eurogroup meeting about the French budget.  The Wall Street Journal reported last week that France's budget may be rejected by the European Commission, (which is struggling with the European Parliament over Juncker's nominations).  Note that with S&P downgrade of Finland before the weekend, now only two euro zone countries remain AAA credits: Germany and Luxembourg.  This risks a downgrade of EFSF and ESM facilities. 

3. Softer UK inflation and sub-1% earnings growth is likely to reinforce the shift in BOE rate expectations. The implied yield of the March 2015 short-sterling futures contract has fallen 50 bp since early June, from 120 bp to 70 bp last week.  Softer economic data,  including the housing market, softer inflation, a more defections from the Tories to UKIP encourage speculation that the first rate cut may take place after the May 2015 elections.  

4.  US data is expected to be mixed and is unlikely to change perceptions of the trajectory of Fed policy.  Retail sales are likely to be soft in the headline due to already known information like the slowdown in auto sales and soft gasoline prices.  However, the measure used for GDP calculations (excludes autos, gasoline and building materials) should post a healthy increase of around 0.4%.  As we have noted before, this is consumption is being fueled out of current income as credit card usage is largely flat.  Industrial production, on the other hand, is likely to bounce back after a soft August. Still, there is scope for disappointment, due to the inventory cycle and weakness in foreign markets. Softness in import prices points to a subdued PPI report while the dramatic weakness in equities and Ebola fears may weigh on consumer sentiment.  

5.  The fall in commodity prices, especially oil prices, may blunt some of the impacts of the weaker yen on Japanese inflation.  Producer prices increases are expected to have moderated in September.  Excluding the impact of the sales tax increase, there is risk that producer price increases slowed to less than 1% (year-over-year) for the first time since May 2013.   While the BOJ's Kuroda says more easing can be delivered if necessary, we suspect it will not be deemed necessary, and that fiscal policy (supplemental budget) will be used to support the economy.  

6.  China will report September trade balance surplus, reserves, and lending data.  The lending data is of passing interest as officials continue to encourage a move to the equity market from shadow banking products.  China's reserve growth has been the main evidence for the argument that the yuan is under-valued that officials are preventing it from appreciating.  After growing near $500 bln between June 2013 and June 2014, reserve growth is likely to have slowed considerably.  The Bloomberg consensus expects PBOC reserves grew by around $20 bln in Q3, sufficient to lift their holdings above $4 trillion, but a marked slowdown nonetheless.  This is unlikely to silence China's critics. They will likely shift their attention to the surging trade surplus. Exports are expected to have risen 12% from a year ago, compared with a 9.4% increase in August. Imports may have fallen 2% after a 2.4% decline in August.  This will produce a trade surplus a bit below the record $49.84 bln surplus reported in August.  The average monthly trade surplus in the 12-months through August was $25.46 bln.  In the 12-month period through August 2013, the average monthly trade surplus was $22.05 bln. In the 12-month period through August 2012, the average monthly surplus was $15.24 bln.