INSIGHTS

On March 17, 2015

The Direction of the Dollar and Deflation

Ray Dalio, founder of investment firm Bridgewater Associates stated in an interview recently, “to make money in the markets, you have to think independently and be humble. You have to be an independent thinker because you can’t make money agreeing with the consensus view, which is already embedded in the price.” Perhaps the most pronounced embedding of the herd’s belief is the strength in the U.S. dollar and the deflationary pressures that have disregarded the drop in oil. One could argue the quantitative easing’s impact on European interest rates, but that would require a more dedicated discussion.

The strong dollar is having an immense impact on earnings and expectations as U.S. goods become more expensive. The dollar rose 4% in 12 days ending Thursday March 12, and according to Citigroup, the trailing 175 days has seen the strongest rally since measuring began in the 1970s and the ending of the Gold Standard in December 1971. The dollar has rallied in anticipation of the Federal Reserve raising rates as well as a risk off trade relative to the suppressing of the euro by the implementing of quantitative easing by the European Central Bank (ECB).

To explain this risk off trade, consider the spread between the benchmark 10-year Eurozone bond, the German Bund and the U.S. Treasury 10-year spread since implementation of the euro in 1998, has stood at 44 bps (basis points). Currently it’s at 181 basis points, meaning there is a strong relative value in the U.S. 10-year, which yields 2.08% in a currency appreciating, versus the 10-year Bund which is denominated in the depreciating euro. Eventually, however, this spread will compress, and when it does it looks to be coming from the direction that is currently not the majority’s belief: a rise in the rates in Europe. As a little pre-cursor why, consider the ECB just raised the GDP growth rate for the European Union from 1.00% to 1.50%. This falls on the increasing growth rate of retail sales, rising consumer confidence and the outperformance of earnings from the companies focused on exporting. As another embedding of the herd, consider that JP Morgan recently estimated the U.S. dollar is currently pricing in a 100-basis point hike from the Federal Reserve.

This also corresponds with the fanaticism with deflation from the headlines bombarding the common investor to the deep discussions that are occurring within central banks across the globe. Here are some highlights that should give the investor some pause for thought on whether the deflation and its impact from oil is a true “900-pound gorilla” or another round of Ebola headline hype.

• As we have detailed, the job openings to unemployed ratio has accelerated much quicker and has historically pointed to rising wage pressures.
• According to Deutsche Bank, no country in the G20 group is actually at deflation as measured by core prices on a year-over-year basis. Japan has been a regular on this list since the 1990s with Saudi Arabia second in most appearances and China doing a “photobomb” in 2010. This was measured since 1971.
• The People’s Bank of China (PBoC) has initiated several stimulus packages recently and has begun focusing on growth in lieu of reduction of leverage. The announcement by the Minister of Finance to issue one trillion renminbi to help absorb the local government (read shadow banking) debt maturing this year as well as the interest rate cuts should not be overlooked, in our view. Even with a new lower target of 7% GDP annual growth rate, China looks to be embarking on a new trajectory economically which should help to offset the negative Producer Price Index, which has been negative on a year-over-year basis 42% of the time since 1995.
• A unique measure of inflation as done by collaboration between MIT and State Street Research is the PriceStats Inflation series which looks at five million online prices for common goods and measures the price change. We feel the recent spike is not one that should be discounted nor taken as an anomaly considering what has occurred in the past.

• Lastly, consider the long term, the last 55 years of measuring the PCE (Personal Consumption Expenditure) core and PCE price index in the United States and notice how many times it has gone negative: not once on the core inflation and only briefly for seven months in 2009. Exactly nine months from the time oil corrected from its high in 2008 of 140+ to its cycle low of near $40…sound somewhat familiar? We are at that same exact timeframe now from the correction of oil last summer. “What to Expect When You’re Expecting” isn’t meant just for new moms!

What we ultimately see this as is nothing more than a “buy on the rumor and sell on the news,” only on much bigger scale than the price fluctuation of an individual company. Being patient with the contrarian viewpoints and vigilantly evaluating the fundamentals of the original thesis, often leads to great success. These currently crowded trades lead us to continue to favor small and mid-cap growth domestically and international equity allocations such as large export-driven European companies and the BRICK (Brazil, Russia, India, China and South Korea) emerging market theme. As we approach parity with the euro and the U.S. dollar, we would begin to look for European-denominated corporate debt to take advantage of a longer term euro reversion higher.

CRN: 2015-0316-4665R

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