“I must say a word about fear. It is life’s only true opponent. Only fear can defeat life. It is a clever, treacherous adversary, how well I know. It has no decency, respects no law or convention, shows no mercy. It goes for your weakest spot, which it finds with unnerving ease. It begins in your mind, always … so you must fight hard to express it. You must fight hard to shine the light of words upon it. Because if you don’t, if your fear becomes a wordless darkness that you avoid, perhaps even manage to forget, you open yourself to further attacks of fear because you never truly fought the opponent who defeated you.”
– Excerpt from Life of Pi by Yann Martel
Doctor: You do not fear death. You think this makes you strong. It makes you weak.
Bruce: Why?
Doctor: How can you move faster than possible, fight longer than possible, without the most powerful impulse of the spirit? The fear of death.
Bruce: I do fear death. I fear dying in here while my city burns. And there’s no one there to save it.
Doctor: Then make the climb.
Bruce: How?
Doctor: As the child did – without the rope. Then fear will find you again.
― The Dark Knight Rises (2012)
The Minsky Moment – a term coined by Paul McCulley of PIMCO that refers to the central concept underlying American economist Hyman Minsky’s theory on the inherent instability of financial markets – has been ubiquitously quoted by just about every major research publication and financial periodical in the aftermath of the Global Financial Crisis. Based on yesterday’s market action, we may have just witnessed another Minsky Moment. And it was not pleasant. Many of you will have experienced fear – we certainly did – and felt your neurologically programmed fight or flight reflex kick-in. While fight or flight responses have their benefits, such responses tend not to be helpful at times of stock market crashes. We overrode our urges to react, turned off our screens, silenced our Twitter feed and spent the rest of the day reading – everything and anything except the financial news.
As we immersed ourselves, once again, into the frantic and frenzied world of financial markets this morning some of the reactions from the media, sell-side, FinTwit and the like have been predictable, the usual suspects – risk parity funds, the Fed, Goldman Sachs, the US government and algorithmic traders – have all been blamed in one form or another. The question, for market participants, however, is not whose fault it is but what, if anything, should we be doing with our portfolios at this juncture.
In the process of portfolio construction we, as analysts, make, in effect, choices amongst several different competing hypotheses. Analysis of competing hypotheses involves:
- identifying the evidence and assumptions with diagnostic value in assessing the likelihood of each hypothesis; and
- outlining future milestones that may indicate whether events are following the expected path or not.
In our opinion, one’s view on the medium-term direction of the US dollar is central to the type of portfolio that one constructs today. So the hypothesis and its alternative in this case are:
- Hypothesis: We are in a structural lower US dollar environment
- Alternative hypothesis: The US dollar has bottomed and is headed higher
Over the last few months we have written about or initiated trade ideas related to a number of themes, most notably Europe’s domestic recovery, the potential for a strong rally in agriculture commodities, rising inflation in the US and higher oil prices. Central to all of these investment themes is the view that we are in a structurally lower US dollar environment. This view is predicated on a number of factors, including but not limited to:
- The US faces a public pension funding gap estimated to be USD 3.85 trillion. This funding gap may never be filled but it certainly will not be filled if we have a strong US dollar and declining equity markets. History has shown time and again that elected officials and unelected rulers, alike, have long understood the benefits of tampering with the value of their currency. Given the choices available we expect President Trump to be an advocate of a weak dollar policy. A weaker dollar improves the profitability of US large caps, which in turn should be supportive of equity markets.
- The weakening of the US dollar over the course of 2017 suggests that both US growth and higher short-term interest rates had been priced in; the market, however, did not fully appreciate the economic recovery underway in the rest of the world. The surprise was amplified by the prospects of earlier than anticipated tightening of monetary policy by the ECB.
- The US budget deficit is forecast to exceed USD 1 trillion in 2019 and the Congressional Budget Office expects US budget deficits to continue to grow.
The US dollar is very much in a bear market at the moment. As with any bear market we should expect bear market rallies, which can be sharp and painful – especially when positioning is stretched in one direction. For our weak dollar hypothesis to be nullified we would need to see at least one of the following:
- continued strength in the US dollar from now till the end of summer i.e. a period of at least six months;
- a reversal in US fiscal policy; or
- a sharp acceleration in monetary policy tightening by the Fed.
At this stage and given the sharp decline in the US dollar, cyclical rallies are par for the course. The recently enacted tax reform is likely to increase the flow of capital into the US and at the same time boost capital spending and the profitability of US companies. Moreover, if the Republicans are able to consolidate power in the mid-term elections, this too should temporarily strengthen the US dollar – somewhat counter intuitively we think a consolidation of power would strengthen the case of a weaker US dollar as President Trump would have more leeway in increasing fiscal deficits.
Investment Perspective
The question then is what type of portfolio should one have under a structurally weak US dollar environment. In broad strokes, our thinking is as follows:
- US bonds have more value than other developed market bonds. Any bond allocation should be tilted towards the US with a bias towards shorter duration instruments.
- International equities have more value than US equities. Use periods of intermittent US dollar strength to build positions in mid-cap equities in Europe and add to our exposure to Japan.
- Within US equity markets, give preference to large caps over small- and mid-caps. A weaker dollar has an outsized impact on the profitability of large caps relative to domestically focused small and mid-cap businesses.
- Commodity and commodity producers should benefit from a weaker dollar and, as previously discussed, higher capital spending arising both from the US and from China’s Belt and Road Initiative.
- Oil, after speculative positioning re-adjusts to less frothy levels, should benefit from a lower US dollar and robust global demand.
- Emerging markets to outperform developed markets.
In the final analysis, we consider the recent surge in market volatility as a signal for the shift in momentum as opposed to the start of a bear market. The analogue of the fifteen year US dollar cycle best captures our thinking:
Dollar Index Analogue – 15 Year Cycle (Normalised)
Source: Bloomberg
Similarly, consider the fifteen year cycle analogue of the ratio of the MSCI Emerging Market Index to the S&P 500 Index.
MSCI EM Index to S&P 500 Analogue – 15 Year Cycle (Normalised)
Source: Bloomberg
This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.