Wednesday, October 4th, 2017

Actions Speak Louder than Words

The dollar has turned, but is this move sustainable? There are many ways of approaching the question, but most of them involve the use of forecasts and regular readers know that our research has always been a forecast free-zone. We prefer to look at what investors are doing and try to interpret their opinions from their actions. This article looks at what they did immediately before and after the week of September 8th, when the dollar index (DXY) bottomed. The RSI chart shows that the dollar was in oversold territory for seven out of eight weeks before and immediately after that date, so this was a major turning point.

Asset Allocation: Our US dollar multi-asset portfolio has had a very high exposure to equities for most of 2017. It’s mainly due to the very low volatility of risk assets, so equity exposure can’t get any higher in response to the stronger dollar. By contrast our euro-denominated portfolio is very sensitive to the weak dollar. Before the turn, the biggest overweights were investment-grade and Eurozone government bonds. Without a currency hedge, international equities were producing negative returns, and investors could not stay invested in equites without losing money overseas or running a massive overweight in the Eurozone. This would have left them very exposed to the risk of forecast downgrades. Now this risk is falling, they can once again invest in the Eurozone recovery, and rebuild their global equity exposure./p>

Country Allocation: We have a global model which looks at 40 developed and emerging countries. All returns are measured in dollars with obvious implications for the relative performance of the US and the dollar bloc. Since early September we have seen a clear move out of most Eurozone countries (Italy and Austria excepted) and into China and commodity-related stories. Within the Eurozone, Germany, the export champion, has gone from being ranked #9 (out of 11) to #6. For the previous six months we were reducing exposure and it was falling down the rankings. You don’t have to believe in an export surge, just a smaller risk of an export decline. Note also that the improvement in Germany has taken place against the backdrop of an election result which would have disappointed many investors./p>

Sector Allocation: In each region there are one or two equity sectors which investors use to express their views on currency. We can do this exercise in the US, but it’s often easier to see what happening to the dollar by looking outside the US. In the Eurozone, our models have increased exposure to Industrials and Consumer Discretionary (think German autos). They have also increased exposure to Energy by a lot more than they have in the US – i.e. there is an additional factor at work apart from the recovery in the price of crude. We see the same three sectors benefit in Japan. However, in China, Industrials are ranked #9 and have not budged. This is puzzling until we recall that renminbi is still pegged to the dollar as part of a basket and that a rising dollar could potentially make Chinese exports less competitive against those of countries in the rest of Asia which are not represented in the basket.

None of this analysis proves the dollar will continue to strengthen. However, investors across a broad spread of asset classes and strategies have responded in a manner which is consistent with this idea. All of these changes start within one week either side of the dollar index bottoming and, so far, none of them have retraced any of their recent moves. If this is just a co-incidence, it is not one we wish to stand in the way of.

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