A Few Thoughts about Currencies and Equities

The S&P 500 closed strongly ahead of the weekend to extend the advancing streak to the seventh week and nine of the past ten.  Some efforts to decompose the return since the bottom in 2009 finds that roughly two-thirds can be explained by earnings growth and about a third to expansion valuation (price-to-earnings).  

Through last week, with about half of the S&P 500 having reported, earnings are up about 8.4% on a 6.3% increase in sales.  The Dow Jones Stoxx 600 that reported have seen an 8% increase in profits.  In Asia, 185 companies in the MSCI Asia Pacific Index that reported a 14% growth in earnings.  

Value investors bemoan the fact that after an eight-year bull market, the value opportunities are understandably scarce.  However, the outperformance of growth over value may not be fully appreciated.  We look at the Russell 1000 Growth Index and the Russell 1000 Value Index.  The spread between the two is now at its most since the tech bubble in the late 1990s and early 2000s.  However, to put in perspective, consider that the spread between the two indices is about a third of what where it peaked in 2000.  

The correlation (percentage change, 60-day rolling basis) between most currencies and the S&P 500 has broken down.  The two currencies for which a statistically significant relationship still appears to exist is the yen (0.55) and the Swiss franc (0.43).  The yen's correlation is among the most for the year (June 0.61).  Indeed, it is at the upper end of a two-year range.   Still, we note that the correlation between the dollar-yen exchange rate and the 10-year US Treasury yield (0.83) is just shy of the record seen earlier this month touch higher.  

The correlation between the dollar-franc and the S&P 500 is the currently the highest of the year and is moving in on last year's high near 0.46.  The correlation between the Swiss franc and the 10-year US yield is about 0.67 and represents a four-year high.  

Among the G7 bourses, Italy is the best performer this year with an 18.3% local return.  Germany's DAX edged ahead of the US today.  The DAX's minor gain today, lift to 15.3% year-to-date.  The Nikkei and S&P 500 are neck-to-neck with a 15.15% rise.  Canada's market is the worst performer in the G7 with less than a 5% gain year to date.   The outperformance of all the European markets and Japan is strictly a function of local currency exposure.  Completely unhedged, the Italian market is up 30% for dollar investors and the DAX is up more than 27%. 

 If the euro continues to weaken, it would not be surprising to see either European exposures pared by dollar-based investors or currency hedge ratios to be increased.  Recall that interest rate differentials are a key cost of a currency hedge in the forward market, and with US rates well above euro interest rates, the dollar-based investor is paid to hedge euro (and yen) exposure.   Note that the three-month cross-currency swaps put the dollar premium of 42-47 bp greater than the LIBOR spread. 

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