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Reappraising the risk in equity
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In appraising the outlook for equity markets, it is instructive to consider the path of the US dollar. The world’s reserve currency is a barometer of global financial health. When the dollar is stable or appreciating, it acts as a store of value, protecting savings and encouraging investment. When the dollar weakens, the opposite is true. It destroys savings, undermines investment and fuels an environment of financial instability in which investors search for alternatives. The ten-year bear market in the dollar since 2002 now appears complete and the outlook for a firmer dollar will have implications for financial assets. |
The gravitational pull within equity markets seems to be heading west again; the rest of this decade may have more in keeping with the 1990s than the last. The latter half of the 1990s was a period of dollar strength. When Clinton was elected in 1992 he was fortunate enough to reap the fiscal benefits of tax hikes and a peace dividend that arose out of the fall of the Berlin Wall – two tailwinds which helped to restore a 4% federal deficit back to surplus during his time in office. This fiscal repair, together with robust monetary policy and positive real interest rates, meant the dollar strengthened and commodities weakened. Equities outperformed virtually all other assets and developed markets outperformed emerging markets.
The next decade provided a dramatic contrast. Under Bush, the US entered into costly military interventions which greatly increased federal spending. This, combined with a series of tax cuts, meant the fiscal position rapidly deteriorated from 2002. The dollar weakened, commodity prices surged – oil quintupled in price – and this acted as a tax on economy activity, especially in the developed world. Critically, the cyclical recovery in the US fiscal position between 2004 and 2007 was not verified by dollar strength. It was the canary in the coalmine signalling all was not well with the financial system.
Now, under Obama, we are entering a new period with conditions more reminiscent of the 1990s. After a surge in 2008, federal outlays in nominal terms have been flat since 2009 and sequestration will provide a further boost to fiscal discipline. Meanwhile, the peace dividend has returned as America has cut back its military spending having withdrawn from Iraq and initiated a withdrawal from Afghanistan. Since 2009, tax receipts have risen by over $600 million and we have seen the deficit shrink from $1.5 trillion to below $1 trillion. By next year the deficit could be back to 3-4% of GDP. Significantly, the stronger trend in the dollar in recent months is verifying these improvements and the stronger outlook for the US economy.
Progress is being made on the other US deficit – the trade deficit – as well. Historically, there has been a marked tendency for the US trade balance to deteriorate during periods of global economic growth due to the higher level of imports that increased demand brings about. Similarly, in 2009, the sharp improvement in the trade balance was largely precipitated by a sharp fall in demand and a consequent decline in imports. Recently, however, this long-lived relationship has broken down. We have seen a recovering economic growth environment accompanied by an improvement in the current account. The reason is shale energy.
Shale energy production has brought about a significant fall in US energy imports – from 12 billion barrels to 8 billions barrels of oil equivalent per day. Increased production has led to sharp falls in the price of US gas. In 2006, there was little difference between the US price and the average gas price of around $12 per million BTU. Now, the price in Japan is around $16, in Europe around $12 and in the US only $4. With the prospect of gas exports, there is little reason to believe the improvement in the trade balance will not continue and that is before we have even accounted for the secondary impact of cheaper local energy on the US industrial base.
So, structural improvements in the twin deficits are both pointing to a positive outlook for the US dollar. In fact, there is only one policy instrument holding the dollar back – QE. Central bank balance sheets have grown dramatically since 2008 with the Federal Reserve (and the Bank of England) being most aggressive. This is keeping a lid on the appreciation of the dollar.
However, while QE has quickly become an orthodox policy, it will not last forever. As the US economy strengthens, underpinned by a recovering housing market, unemployment (currently 7.5%) will continue to fall back to the Federal Reserve’s target level of 6.5%, the point at which we will see QE being wound down. We can expect this level of improvement in the unemployment rate will probably take around twelve months.
The Bank of Japan recently announced an aggressive new monetary policy which aims to double the size of its monetary base. Given the structural challenges in the eurozone, the ECB could also remain in easing mode for some time. This shift back towards tighter monetary policy and positive real interest rates in the US at a time when other major central banks will still be in easing mode is likely to be strongly positive for the dollar, implying a stabilisation if not outright appreciation.
So what are the implications for financial assets? If we look at commodities, there is a well-established correlation with the US dollar. Given the stronger trend in the dollar over the last few months, it has been no surprise to see weakness in commodities. It is important to note there may be other factors contributing to commodity weakness, principally developments on the supply side that have improved the supply outlook for hydrocarbons and minerals. But if this was the sole reason, then we would not have experienced the weakness in gold that we have seen at the same time. The fact that gold has been weak at the same time as other commodities suggests to me that we are seeing the end of the super-bull market in commodities and a restored sense of the dollar as a store of value among investors.
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Turning to equity markets, the strength of the dollar has also shown reasonable correlation with the rating attached to global equities – a relationship that is more than coincidental in my view. When the dollar strengthened in the 1990s, this was accompanied by a re-rating in equities as PE ratios expanded. Likewise, when the dollar weakened over the subsequent decade, this was accompanied by a sustained de-rating in equities. In my view, shifts in fiscal policy can help to explain shifts in the rating attached to equities; as deficits worsen and governments consume more domestic savings, there is inevitably less capital to invest in and support equities. The inference is that a more positive trend in the dollar could provide the foundation for a re-rating in equities. It is clear that the recent rally we have seen in stocks has been predicated on just such an improvement in equity values, with limited impetus coming from the earnings side of the ledger at present. Lastly, there may also be implications for the performance of developed markets versus emerging markets. Again, there has been a reasonably strong relationship with the dollar. In the late 1990s, emerging markets lagged developed markets as the dollar strengthened. And it was when the dollar weakened from 2002 onwards that emerging markets really began to outperform. However, if the dollar were to continue to rise, I don’t think the emerging markets would suffer as much as they did in the late 1990s. Back then, emerging markets were much more dependent on dollar-denominated ‘Brady’ bonds as a primary source of funding. Their liabilities were primarily in dollars so when the dollar strengthened they had no place to hide. Now, the financial infrastructure in emerging market is vastly superior in terms of funding and local currency bond issuance now dwarfs US-denominated emerging debt. As a result, the ability of emerging markets to withstand dollar appreciation is much greater than before. To sum up, based on the structural improvements we are seeing in the twin deficits, the ten-year bear market in the dollar looks complete. This is coinciding with an end to the commodity super-cycle, which will boost global activity, especially in the developed world. A strengthening dollar will be good for financial assets, providing a platform for a re-rating in equity markets. Within equities, we should recognise that the reasons for the structural underperformance of the developed world over the last decade may also be coming to an end. Long-term thesis
Source: FIL Limited.
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- fidelity international
- fidelity worldwide investment
- risk
- equity
- equity investing
- dominic rossi
