While the dollar strength is certainly not unexpected, as we have predicted it for over a year now, the velocity of the gain against virtually all other major and minor foreign currencies in the world has impacted the financial markets in various ways depending on the region.
It is paramount to understand regional interrelationships in order to make sound investment decisions. It’s time to review all the facts, step back, reflect, decide on asset allocation and invest accordingly. Volatility creates opportunity in all asset classes both long and short.
Before we delve into the effect of a strong dollar on various asset classes and industry and company selection, it is important to spend a few minutes understanding why currencies move up or down. While many economists point to purchasing parity as the primary reason, that is one of many. I like to believe that currencies move based on views of relative economic growth, relative interest rates, relative inflationary expectations, relative monetary and fiscal policies, relative financial stability and relative political stability and policies. I’m sure that there are many other factors that you could add to this list, but let’s keep it simple.
Let’s take a look at the economic landscape in each region to better understand currency and its effect on investing.
1. The United States is at the center of the global currency moves. Its currency has strengthened against all other major currencies, including the euro, the yen, the Canadian dollar and the yuan. The primary reasons for the shift toward the dollar began over a year ago and have a lot to do with energy independence changing the long-term dynamics of the U.S economy for the better. Global competitiveness would be enhanced. The gain in the dollar has accelerated recently due primarily to widened interest rate differentials with other areas of the world such as Europe and Japan and continued relative strength in the U.S. economy. Fears of an imminent Fed rate hike due to employment growth and perceived strength in the economy has only accelerated the rise in the dollar and widened interest rate differentials.
I mentioned last week that employment was only one of many data points that the Fed uses in deciding on policy and that I believed that many other data points would lead the Fed to wait until later in the year before raising rates. Let’s mention what else the Fed will be viewing this week at its monthly meeting: Consumer sentiment fell for the fourth straight month; retail sales declined for the last three months; import prices and inflationary expectations remain weak and well below the Fed target of 2 percent; wholesale inventories are up while sales are down; exports are weak; the dollar is super strong; and growth overseas is suspect. The scale tips toward maintaining the current Fed policy.
2. The Eurozone and the euro appear to be the center of everyone’s attention, too. The euro easily broke through 105 euros to the dollar last week without much resistance. The reasons for the accelerated decline are obvious: The ECB began its massive QE program last week; European interest rates continued to decline to record lows, boosting the interest rate differential; Eurozone industrial output fell in January; and consumer prices fell in most countries, due in large part to lower energy costs and fears of deflation persist. It is interesting to note that last week I mentioned that economic growth forecasts were recently raised for the next three years, boosted by the effects of QE, improving exports and higher consumer spending aided by lower energy costs. But remember that oil is priced in dollars, so the benefit for the consumer and companies in Europe is significantly less than in the states. Positive change is in the air, but patience is the order of the day.
3. China is clearly concerned about meeting even its reduced growth target of 7 percent for 2015. Premier Keqianq announced over the weekend that the government is ready to institute additional stimulus to stimulate growth and, most importantly, employment. Employment growth is the number one goal of the government as it tries to shift growth from exports to internal consumption. Economic data was relatively weak in January and February, so the government lowered interest rates, increased money supply and permitted the yuan to decline in value to boost exports. The government is also making changes to its financial system, relaxing state controls and introducing deposit insurance. I remain optimistic on China’s future as it builds a sounder foundation for sustainable growth, albeit around 6 percent. Not bad!
4. Japan has continued its aggressive QE program, as interest rates continued to decline to record lows, widening the interest rate differential with the dollar. The yen fell to over 121 to the dollar. No surprises here. It is clear that there has been a shift in long-term government policy, much like in China, to stimulate domestic demand away from reliance on exports. The Japanese stock market continues to rise, boosted by the Bank of Japan’s aggressive purchase of ETFs that track Japan’s stock indexes along with large purchases of ETFs by the Japan’s Government Pension Board. Note the BOJ is buying both bonds and stocks to stimulate the economy.
Investors don’t like excessive volatility. This past week the dollar advanced further; energy prices (dollar denominated) and industrial commodity prices fell further; the U.S stock market fell due to fears of a Fed rate increase; European markets rose, boosted by QE and lower interest rates; the Japanese markets rose for reasons mentioned above; and Asian markets advanced. An American investor in foreign markets must hedge currencies or lose most of the gains due to a strong dollar.
I still believe that spring will represent an inflection point for many of the concerns that exist for the global economy and the financial markets. Be patient! Specifically, I do expect that the European economy will rise off of the floor and exhibit accelerating growth; the U.S economy will pick up steam after a disappointing first quarter, which clearly will come in with less than 2 percent growth; and China, Japan and India will do better too, so the prospects for global growth will improve with ramifications for asset allocation and investing.
Currency moves over the long term are the great equalizer, balancing growth prospects by region as long as markets remain open without government trade barriers unless there is dumping. Yes, dumping exists, which means product is moving across regions below cost to gain volume at the expense of local producers. Just look at the domestic steel industry.
The effect of a strong dollar is that U.S. economic growth suffers from lower exports, offset by lower interest rates than would be anticipated due to foreign capital flows. Multinationals report lower profits in dollars, but the key for long-term investing is regional diversification. Commodity prices are held down and inflationary expectations stay muted.
The strong dollar is a net benefit at the moment for the world as it will moderate growth in the U.S. This could help hold off Fed rate increases and it will stimulate exports and growth overseas.
Investors need to be patient and not react to the daily volatility unless there is a reason for change. The key is to maintain ample liquidity at all times to be able to take advantage of out-sized market move and invest in companies going through positive change or sell companies short if they are headed in the opposite direction. I suggest that you take a look again at Alcoa and General Electric. Alcoa continues to move downstream, reducing its commodity exposure, while General Electric continues to reduce its exposure to its banking businesses while adding to its industrial areas.
Change is everywhere. Invest accordingly!
Bill Ehrman is founder and CIO of Paix et Prospérité Fund (www.prosperitefund.com). He was formerly co-CIO with Byron Wien at Century Capital Associates and was CIO and partner at George Soros’ Quantum Fund.
