Friday, October 31, 2014

What Stronger Dollar Means for Your Investments?

On 10/29/2014, the dollar rallied after Fed announced the end of QE 3.[1] It seems that a bull market for the US dollar has come. As a matter of fact, John Mauldin has already predicted that for a number of years.[2] On a recent broadcast of Financial Sense News Hour, analyst Louise Yamada has also said that she believes the dollar may be beginning a new structural bull market.[3]

Assuming US dollar has entered a secular bull market, let's go over your investment options here—note that I am NOT a registered financial advisor.



What a Strong Dollar Means?


Assuming US Dollar will retain its world's reserve currency status, a strong US dollar means:
  • Lower inflation
    • See Diagram 1 ("DXY vs CPI")
    • The strengthening dollar, stagnant wages and declining oil prices all put downward pressure on prices.[7]
    • Given the disinflationary pressures around the world, the rising US dollar effectively "imports" disinflation into the US.[22]
  • Domestic labor cost becomes relatively more expensive than foreign countries'
    • This could potentially encourage manufacturers to shift away from the US (e.g., to Mexico or even Canada).
  • US exported goods or services become more expensive for foreign buyers
    • U.S. companies will sell fewer goods abroad and book smaller profits when sales are translated back into more expensive U.S. dollar.
    • This hurts U.S. companies on their earnings, particularly multinationals such as Coca-Cola, MCD, ORCL or IBM which will see less earnings coming from foreign markets.
    • Information technology, energy and materials are the three sectors with the largest foreign sales percentage.
    • Nearly half of S&P 500 revenues come from overseas.[18]
  • Lower commodity prices
    • The U.S. dollar trends inversely to commodities
    • It translates to lower costs for companies who consume raw materials in order to produce a product, which increase their profits.
    • The rising dollar and falling crude (commodity prices) point towards the US importing deflationary conditions from struggling economies around the world.
    • If you’re invested in dollar denominated commodities, such as gold, that tend to fall when the U.S. dollar is rising.[16]
  • Cheaper oil[11]
    • Citigroup estimates:[19]>/sup>
      • If oil prices stabilize near current levels, the typical U.S. household will receive the equivalent of a $600 annual tax cut. 
      • Oil that’s 20 percent cheaper than the 3-year average price amounts to a $1.1 trillion annual stimulus to the global economy.
    • Trucking companies, airlines, oil refiners, and chemical manufacturers may benefit from cheaper oil.
    • It will hurt both renewable energy industry and energy efficiency business. [25]
    • US consumers spend about 6% of their total consumption expenditures on energy,  So, cheap oil tends to help US GDP.
      • A strong dollar may not actually hurt US GDP that much because US export only accounts for 15% of its GDP.[21]
    • This essentially transfers wealth from Mid East of oil producing countries to consumers of oil importing countries.
    • But, it could at some point threaten the US shale-oil boom[2,17,20]

  • US stock market becomes more attractive 
    • Overall, until any negative effects (see section "Balance of Payment Cycle") begin to manifest, a stronger Dollar suggests money will continue to be attracted to the U.S. stock market, especially stocks whose sales are primarily domestic, and not international, and particularly for large-cap stocks.
    • The ratio the U.S. stock market to the international stock market ($WLSH:$DJW) is a leading indicator for the U.S. dollar (see Diagram 2 above). 
    • 1% move in the dollar can have a 2% impact (either positively or negatively) on the earnings of the S&P 500 companies.
      • The ETF for the US top 100 companies is OEF
      • It is the larger companies that get the biggest hit from the stronger dollar. 
    • Lower risk of appetite
      • Strengthening of US dollar (or falling UDN) may be foreshadowing a reduction of risk appetite.[10]
    • Rising long bond yields
      • High interest rates support the dollar while low interest rates do not
      • If the Dollar continues its correlation, the long bond yields could rise (see Diagram 3 below).
      • The Fed has just stopped their bond buying program altogether, and interest rates can only go in one direction—higher.


What to Invest in a Strong Dollar Environment?


As a general rule of thumb, the companies that will probably put up the best numbers and outlooks are those with a primarily domestic market (unaffected by foreign developments and the strength of the dollar), those that are typically commodity buyers (think retail), and those who have somewhat secular rather than cyclical growth prospects.

Some analysts have recommended the following sectors or stocks:
  • Equity REITs with low P/FFO ratios - Hospitality Properties Trust (NYSE:HPT) and Lexington Realty Trust (NYSE:LXP), 
  • Business Development Companies - Ares Capital (NASDAQ:ARCC), telephone companies - AT&T (NYSE:T) and Verizon (NYSE:VZ),
  • Agency mortgage REITs - Annaly Capital (NYSE:NLY)
  • MKC, TGT, SON, KMB, NNN, WGL, AFL, ITW, HCP, PBCT, ORI, T
  • PAYX, DFS
Be warned that the stock market can be short-term bullish and long-term bearish (see also the next section).  Moving forward, the market faces a cruel double-edged sword:
    • If there is strong growth, it will prompt the Fed to begin raising rates, causing investors to demand higher returns and businesses to cut back.
    • If there is weak growth, it will threaten corporate earnings and spark worries about another recession. 
Either way, stocks may fall.  On 11/01/2014, Chris Puplava has provided the following advice:[10]
We’ve seen some pretty wild swings in the market lately but what is more important than the swings is the shifting flow of money from lower quality to higher assets. This is a hallmark for aging bull markets and was exactly the same condition we saw leading up to the 2000 and 2007 tops. Tops are a process and there is no set time table for how long this late-stage phase of the bull market will continue given global central bank intervention (just look at the BOJ announcement today). What is more important than trying to spot a top is to begin focusing more on risk management as risks are always greatest near the end of a cycle, and to shift more towards higher quality assets.

Balance of Payment Cycle


Before you jump both feet all in for your strong-Dollar investments, consider this crisis looming on the horizon. Predicted by Kyle Bass in the autumn of 2009, he has said that the easy-money policy will end badly:[6]
He said that – in addtion to a likely string of sovereign defaults in Europe and an outright currency collapse in Japan – the global debt drama would end with an epic US dollar rally, a dramatic reversal in capital flows, and an absolute bloodbath for emerging markets.

In [6], Worth Wray has described a phenomenon known as “balance of payments cycle” (i.e. an inflow-induced boom followed by an outflow-induced currency crisis), which tends to occur in three distinct phases:


  • Capital Inflows
    • This generates growth boom.
  • Capital-Dependent Growth
    • Growth increasingly relies on capital inflows.
  • Capital Outflows
    • This causes growth to collapse
Due to global easy-money policies. easy money ran blindly in search of more attractive returns. Most of them find their ways into emerging markets. This broad-based, debt-fueled overinvestment may appear to kick economic growth into overdrive for a while; but eventually disappointing returns and consequent selling lead to capital flight and currency collapse.

As Bass said,  the global debt drama would end with an epic US dollar rally and that is happening in front of our eyes now.  This may be signaling the beginning of the third and final phase of "balance of payment cycle."  In this phase, Bass has predicted that we will see a dramatic reversal in capital flows, and an absolute bloodbath in emerging markets.

In a CNBC interview on 10/22/2014, Kyle Bass explained that a policy divergence is set to accelerate in the next couple of weeks, as the Fed will likely taper its QE3 purchases to zero. Two days later, Kyle notes, the odds are high that the Bank of Japan will make a Halloween Day announcement that it is expanding its own asset purchases. Such moves only increase the pressure on Mario Draghi and the ECB to pursue “overt QE” of their own.

At the time I am writing (10/31/2014), spooky thing just occurred, Bass' prediction has just come true—Bank of Japan has announced its new stimulus today.  After the announcement, we immediately saw the Dollar rallied another +0.82% (note that such move is big in currency market).

As predicted in a recent Casey Research Report, its analysts think another crash is coming and it will make the 2008 correction look like a walk in the park. We don't know how soon that scenario will play out because no one has a crystal ball.  One thing for sure is volatility will return in a big way. So, invest your money cautiously.

Disclosure


This article is for information purpose only. We do not have positions in any stock or ETF mentioned in this article.

Notes

  1. Some of the conclusions covered here may appear to be contradictory.  For example, "Lower inflation" vs "Rising long bond yields" or "Bull market" vs. "Bear market."  It all depends on your investment horizon: short term vs. long term.

References

  1. The Dollar Is Rallying After Fed Announces The End Of QE
  2. A Scary Story for Emerging Markets
  3. Louise Yamada: Cyclical Correction Likely in Stocks - New Bull Market Beginning for the Dollar
  4. Every Central Bank for Itself
  5. The Flat Debt Society
  6. The US Dollar Plays The Villain In The Emerging Markets Horror Story
  7. U.S. Growth Pace Moderate; Inflation Low, Employment Data Mixed
  8. Kyle Bass: Fed tapers to zero next week (10/22/2014)
  9. Dow, S&P surge into record territory after Japan stimulus
  10. Shift in Quality Spectrum Argues We’ve Entered Later Innings of Bull Market
  11. It Looks Like $80 Oil Is Here to Stay
  12. Japan risks Asian currency war with fresh QE blitz
    • Japan is exporting its deflationary pressures to the rest of Asia.
    • Currency war was always how this was going to end, and it risks sending a wave of deflation across the world from Asia,” Albert Edwards said.
  13. Bear Markets Don't Just Happen — They're Caused By These Two Conditions
    • Tight money, recessions, or both
    • "These conditions do not apply, nor will they until 2016 at the earliest," said David Rosenberg
  14. "Dangerous Scenario": Strong Dollar To Take Down Weak China
    • Because the link between the Chinese and American currencies, a rising dollar pushes the renminbi higher and the Chinese economy lower. 
    • As Citigroup’s Guilermo Mondino and David Lubin note, the combination of increasing short-term U.S. rates and a “more volatile” yuan could create “a dangerous scenario” of “a rather large capital outflow from China.”
  15. No Wonder The Dollar Is Up
  16. Study: Long-Term Rise In The Dollar Does Not Bode Well For Gold
  17. The US Shale Oil Bubble Is Ready to Burst
    • The basic economics of shale oil production are being ravaged by the 23% oil price drop since John Kerry and Saudi King Abdullah had their secret meeting near the Red Sea in early September to agree on the Saudi oil price war against Russia.
    • The shale oil and gas bonanza of the past five years in the USA has been built on a foundation of zero Federal Reserve interest rates and huge speculative investment by hungry Wall Street firms and funds.
  18. The Dollar Is A Lawnmower, The World Is Grass, And Emerging Markets And U.S. Multinationals Are Next
  19. Why a Strong Dollar Is the Ultimate Stimulus
  20. Charles Gave of GaveKal (Things That Make You Go Hmmm... 11/11/2014)
    • After all, after the 1985 crash in oil prices, the Texas banks went bust and the Texan economy did not do too well for quite awhile. Let us avoid the Texas of tomorrow, if possible.
  21. U.S. and China Exports as a Percentage of GDP, 1980-2030
  22. The Fed Concerned About 'Importing' Disinflation
  23. El-Erian: 'When You Have Very Sharp Moves in Currency, Something Breaks'
  24. Tightening by superpower Fed trumps mini-stimulus in Europe and Asia
    • More than 40 currencies have dollar pegs or "dirty floats", including China, joined to America's hip whether they like it or not.
    • Some $11 trillion of cross-border loans and bonds issued outside the US are denominated in dollars. 
  25. The Hidden Costs Of Cheap Oil
  26. Recession, Recovery, and Gold
    • Gold is not, in fact, a hedge against inflation. It’s something people buy when real returns on alternative assets are low.
  27. The Strong U.S. Dollar: Are We Ready For It?
    • A strong dollar requires companies to focus on productivity.  
      • Greater productivity requires training and education, it requires investment in better and better technology, and it requires changes to jobs and firms and startups that have not been present to the degree needed.
  28. How Much Higher Can The U.S. Dollar Go
  29. The Dollar Dog Ate Corporate America’s Homework: 6 Casualties of the Strong US Dollar (Mauldin Economics)
    • Dollar Casualties:
      • KMB, PG, JNJ, MON, DD, MMM
  30. Triffin's Paradox Revisited: Crunch-Time For The U.S. Dollar And The Global Economy
    • The core of Triffin's Paradox is that the issuer of a reserve currency must serve two entirely different sets of users: the domestic economy, and the international economy.

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