Tuesday, February 3rd, 2015

The Eternal Triangle

We have had a substantial overweight position in US Treasuries since August last year. This applies to every asset allocation model which is allowed to own them, irrespective of the host currency. But we still encounter clients outside the US who are either reluctant to buy Treasuries or to commit to a full overweight. When we opened the position, the reason most frequently given was the fear that the Fed would raise rates aggressively. Now it is the risk of a significant retracement by the dollar.

We are dollar-bulls, so we think the short-term risk of retracement is small for two main reasons: (1) the divergence of monetary policy in US and other regions –particularly the Eurozone; (2) the dollar is only just above the half-way mark of its 20-year range vs the Euro and the yen. We would never ignore the risk of a dollar correction, but we don’t fully understand the reason for these fears. Many of the traditional tools for forecasting FX rates like balance of payments, purchasing power parity, and interest rate differentials have lost their predictive power in an era of central bank activism. Furthermore none of the four main central banks (Fed, BoE, ECB or BoJ) have said anything to indicate that they are unhappy with recent trends in the FX markets.

Perhaps the reason for the nervousness is this very lack of reliable indicators, in which case we hope the following logic is helpful. We think that best indicator of an imminent retracement in the dollar will be the US equity market itself. For some time we have been puzzled by the unresponsiveness of US earnings estimates in the face of the rising dollar. Corporate hedging policies make it hard to estimate the precise impact for each quarter, but it is not difficult to estimate the full-year effect. If 40% of earnings come from outside the US and trade-weighted dollar rises 15%, roughly 6% needs to come off estimates for 2015. This is probably enough to reduce eps growth to zero, before the impact of buybacks, and when US investors get round to believing this they are almost certainly going to be disappointed.

There is an additional risk that lower overseas energy costs and labour costs could put at risk the re-shoring benefits enjoyed by the US economy in recent years. We will only know that investors are concerned when US equities undergo a correction. When that happens we think it is very likely that dollar will retrace some of its recent gains. If US equities correct we would expect (1) US Treasury yields to go lower (2) most international equities to fall by at least as much as the US market. So non-US investors would lose on the currency but gain on US Treasuries. They would lose on US equities and on the currency. They would suffer no currency loss on domestic equities, but their total loss is likely to be greater than the net loss on US Treasuries.

In summary we agree that sooner or later the dollar will retrace some of its recent strength, but we think the US equity market is likely to be the best real-time indicator of this happening. This means that non-US investors can safely own US Treasuries until such time as US equities correct, at which point they may have the opportunity to lock in some outperformance relative to their own domestic equity markets.

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