Tuesday, September 30th, 2014

Goodbye Greece, Hello Japan

This is not the usual article about dollar strength. We are not going to forecast any exchange rates for any period or predict how long this regime will last. By way of orientation we give you three numbers: trade weighted dollar is now 105.2 according to the St Louis Fed. It bottomed at 94.0 in July 2011, and its most recent peak was 129.9 in February 2002. Factors behind the recent rally include (1) expectations of tighter monetary policy from the Fed, (2) faster growth in the US relative most major economies (3) the improving balance of payments thanks to the surge in onshore energy production.

From now on all our comments are about how our asset allocation and sector rotation models are responding to this challenge.

1. For US$ investors, domestic equities and fixed income become more attractive relative to overseas. This implies a gradual shift away from risk assets in favour of Treasuries and investment grade credit. At the moment we do not see any evidence that Fed is losing control of the long end of the curve (let alone the middle of it). Falling energy prices help to keep inflation under control.

2. US equities also benefit, but the focus shifts away from cyclical to secular growth. Our style models already have Growth as an overweight relative to Value, and our sector models favour technology, healthcare and materials – all of which have strong secular growth stories. Remember that the previous period of dollar strength was also associated with a preference for US technology and healthcare.

3. Outside the US, the focus is on Japan not Europe. Going forward the euro may well be weaker than the yen, but the yen is 18 months ahead in terms of devaluation from the previous peak. It is down 37% from the high whereas the euro is only down 10% and the high was in Q2 2014. In terms of export competitiveness it is the cumulative change which matters, not the current rate of change.

4. Another consequence of dollar strength is falling commodity prices, though in many cases the balance of supply and demand has also shifted. So we prefer exporters to the dollar bloc rather than pure commodity producers. Hence Korea and Taiwan over Australia, Mexico over Brazil, India over Russia.

5. For Euro-based investors, overseas equities become more attractive than euro-denominated fixed-income assets. Unhedged large-cap US equity is a simple and safe way to play this. The flip-side is that there is no need to chase risky yield pick-up trades in the periphery of the Eurozone. We have already downgraded Greek bonds to underweight, and would expect to do the same to Portugal and Italy (at least to Neutral) in due course.

6. We also warn that Eurozone exporters may not benefit as much as their supporters currently expect. First, most other currencies are also depreciating against the dollar. Is Germany more competitive than Japan? Is Italy better than Korea? Second, the US itself is more competitive because onshore energy production means that its cost base is lower than it would otherwise have been.

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