October 2014 – The Dollar Arrives
For those who place faith in the seasonality of markets, September did not disappoint with its tendency towards heightened financial market volatility. While the month began on a firm note for risk assets, September concluded with weakness in which the underperformance of high yield credit and emerging market equities spilled into the first week of October, only to be arrested by a strong U.S. non-farm payroll number. The main question investors are asking themselves is whether the fundamentals have changed. We believe that today’s markets are being driven by divergences among central bank policy which are creating greater dispersion among asset class performances.
The currency markets tell the story. In September, the tradeweighted U.S. Dollar (USD) Index gained 3.85% and finished 3Q14 up 7.69%. The Index is currently trading at levels last seen in 2010 and is being driven by a variety of factors. Among them is the monetary policy component in which markets are beginning to discount the prospect of a Federal Reserve rate hike which could come as early as 1H15. The exact timing of the hike remains data dependent and attention will continue to focus on slack in the labor market and sluggish wage growth.
But barring an unexpected shock, the Federal Reserve is embarking on a path towards rate normalization which is providing a tailwind to the USD.
This stands in sharp contrast to the European Central Bank (ECB) and the Bank of Japan (BoJ) which are moving fullsteam ahead with their highly accommodative monetary policies. The ECB will begin its purchases of Asset Backed Securities (ABS) and covered bonds this October and could expand its balance sheet by as much as 1 trillion euros over the next two years. If disinflation persists in the Eurozone, the ECB could move towards the outright purchase of sovereign bonds—quantitative easing—though this would surely be met with political resistance from the German Bundesbank.
Since the ECB announced its new asset purchase program, the euro has fallen by nearly 5% against the USD and weakened 7.75% in 3Q14. Disinflationary pressures meanwhile have kept bond-yields near record lows with the 10-year German Bund at 0.925%. A weaker euro and sub-1% yields have increased demand for USD-denominated assets. What's more, the spread between the German and U.S. 10-year benchmark is trading around all-time highs. Investors waiting for U.S. treasuries to move higher ought to look at European yields which have provided an anchor to U.S. bond markets.
Similar dislocations can be seen in Japan, whose central bank continues with its expansionary monetary policy. In September, the Japanese currency depreciated 5.35% against the USD to around 110 JPY/USD, levels last seen in 2008. Yields are also paltry with investors receiving 0.518% for a 10-year Japanese bond.
It is not only Developed Markets which have seen large moves in their currencies. The Brazilian Real is down 9% over the last month while the Turkish Lira depreciated 6% in September. While not nearly as drastic as the depreciations which occurred during last year’s taper-tantrum, the moves appear to be driven by some of the same catalysts: namely the time, pace and extent of rate normalization in the U.S.
The moves seen in September—which were exacerbated by the rationale du jour, (Ebola, protests in HK, continued unrest in Ukraine, ISIS,) led to large outflows from U.S. high yield funds during the month. Yields on the Bank of America US High Yield Index rose to 6.7% in September and are back around 6.35% currently. We believe that not much has changed with regards to the fundamentals in this asset class as default rates remain low amid healthy issuance.
However, the spread tightening which has been seen throughout the year has led to some position squaring as we are probably moving towards the final stages of the credit rally. On this basis, we are comfortable paring back some of our high yield exposure when the market recovers into the rest of the year.
On the equity side, we believe that U.S. equity markets will lead the way forward and are comfortable with our overweight position despite the lofty valuations of certain sectors. We continue to prefer large-cap names which will benefit from the expected increase in capex. In Europe, weakening aggregate demand in the Eurozone is likely to weigh on earnings and we prefer to gain exposure through large-cap companies with exposure to the U.S. and which will benefit from a falling euro. We continue to believe that Japanese equities will advance given government policy, valuations and momentum going into the final quarter of the year. In the EM space, we think China and certain parts of Asia are attractively priced and are comfortable maintaining our exposure there.
It is noteworthy that despite all of the geopolitical risks out there, Brent crude oil fell 9% during the month to around $92, a two-year low. While the supply story is well known—the U.S. is expected to overtake Saudi Arabia as the world’s largest producer of oil and related liquids—there is a demand narrative as well which is indicative of an uneven global growth story.
Markets are growing increasingly vulnerable to expectations of Central Bank behavior—namely the ECB and Federal Reserve. This environment is creating divergences but also opportunities. In that context, risk-management combined with rigorous sector and geographical selection will remain key factors for investment performance. As usual, don’t hesitate to contact us to discuss our investment views or financial markets more generally.