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Dollar Rise Warrants Caution

Posted by RAA on Dec 7, 2015 2:30:01 PM


Market_Matters_large_PNG.pngThe dollar’s strength over the last 16 months has increased the risk associated with the already narrow equity rally. The world’s most important central bank (the Federal Reserve) wants to start raising interest rates at a time when the rest of the world is having trouble growing.

We feel this could be a mistake by encouraging dollar strength and more oil weakness against a fragile global backdrop. Nonetheless, this stance by the Fed reinforces our equity tilt towards large caps, domestic over international and the more defensive sectors. Lastly, a strengthening dollar increases risks in the emerging market world by undermining commodities, including oil.

Normalization

Senior Fed officials continue to signal their desire to hike interest rates or start the normalization process after the next FOMC meeting on December 15-16, unless something changes. The main barrier to Fed action lies with the currency market. If the dollar were to break out to significantly new highs, this could put the Fed back on hold. Even without a breakout, the continued appreciation of the dollar versus other currencies increases the “riskiness” of the equity rally and limits the upside in Treasury yields.

The Fed knows that by starting the normalization process that it is going to attract more foreign investors to buy dollars, thus driving up its price versus other currencies even more. As stated above, the main impact of the dollar strengthening will be to suppress commodity prices and put oil prices at risk. This, in turn, increases the risks in emerging markets, so we have temporarily exited them, and also increases the risk in U.S. high-yield corporate bonds, which is why we have significantly reduced our positions because of their exposure to energy and materials.

What is interesting about the high-yield space is that if you take out energy related bonds, the yield spreads over Treasuries are still well within their range since 2010. It is just when you add energy high-yields that the yield spreads over Treasuries become significantly wider.

Even if the U.S. economy were rock-solid, which it is not, a stronger dollar and weaker commodity prices still increase fragility abroad. So, from an equity point of view we remain constructive longer term but we are cautious in the near term, which is why we are underweight equities for the time being.

As we look at Treasury yields, specifically the 10 year Treasury, our assumption is that we are range bound in the 2.0-2.5% range. One key to this underlying view is that the rest of the world (ROW) cannot grow without more stimulus, which in turn should help keep a lid on how high the dollar can trade. As a result, until there is more growth abroad, any dollar sell-offs should be moderate but difficult to time. Without more ROW stimulus, the 10 year Treasury will probably trade in the lower area of this range.

The other key assumption to our 2.0-2.5% yield range is that U.S. growth does not accelerate. This seems likely not to happen given that both consumers and businesses have been wary about borrowing to try and expand growth. If the U.S. can show some signs of longer-term growth on the horizon, that would make the Fed more confident about normalizing interest rates. In summary, the three most important issues in the short term that are a challenge to the direction of both the equity market and the Treasury yields are:

  • Oil
  • Dollar strength
  • ROW and stimulus

 

Oil

  • In the absence of greater consumer willingness to spend, deflationary influences from lower oil prices will dominate. The University of Michigan recently came out with their long-term inflation expectation and it has come down from over 3% in 2010 to around 2.5% today.
  • U.S. capital spending (capex) will have difficulty rebounding with energy capex falling sharply for the foreseeable future.
  • A renewed decline in energy prices increases the risk of a stress event in corporate bonds and emerging markets.
  • The oil drop comes at a fragile time for the ROW as it continues to rely on a U.S. consumer that appears unwilling to ramp up spending.

Dollar Strength

As we have talked about in previous newsletters, a stronger dollar makes the products that we export abroad more expensive and less competitive compared to similar products made by companies outside of the USA. This creates a significant challenge for our multi-national companies domiciled here to grow their top line (revenues). It makes growing their earnings equally difficult.

ROW and Stimulus

The ROW is in a fragile economic state and without central bank stimulus it is going to be difficult and challenging for their economies to start growing again at a rate that will help pull themselves out of a very slow growth environment. They need to ramp up their growth if for no other reason than to be able to meet current debt obligations.

We are speaking, in general, about many European countries and a lot of the emerging market economies. America cannot be the main engine of growth for the rest of the world as we are now too inter-connected. Everyone must “pull their own weight” to get the global economy back on track again. While we believe that this will eventually happen, it may take years for that to be realized.

 

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Disclaimer: This blog is intended for informational purposes only and should not be construed as individual investment advice. Actual recommendations are provided by RAA following consultation and are custom-tailored to each investor’s unique needs and circumstances. The information contained herein is from sources believed to be accurate and reliable. However, RAA accepts no legal responsibility for any errors or omissions. Investments in stocks, bonds, and mutual funds may increase or decrease in value. Past performance is no guarantee of future results. Any of the charts and graphs included in this blog are not recommendations for the purchase and sale of any security.

Topics: Investment Updates