Tuesday, May 5th, 2015

Wobbly Dollar, Stable Japan

There has been much comment on the recent weakness of the dollar so this week we discuss (1) our view on what caused it and (2) its effects on asset allocation and sector strategy. We are suspicious of explanations which focus on the weakness of US GDP in Q1 because there was enough data to support this hypothesis in February and March when the dollar was actually rising against most currencies. In common with most commentators we expect a strong rebound in Q2 and would be surprised if the Q1 data have radically altered the FOMC’s views on the timing of the next rate-rise.

We also note that the dollar has been stable against most of its major trading partners apart from the euro and the Canadian dollar. Most of the currencies which have risen against the dollar, like the Canadian dollar and the Russian rouble, have benefitted from the recent strength in energy prices while the euro has risen in tandem with German and core Eurozone bond yields. Please note that the yen has hardly moved. Although we don’t believe in forecasts, we are allowed to be suspicious of a consensus which argues for a new trend on the basis of small breech of a few 50-day moving averages. If this is right most of the effects we observe will be reversed in coming weeks and recent price action has given rise to a series of buying or selling opportunities.

Our country charts suggests that the risk-reward ratio for core-Eurozone equities deteriorated sharply during the month of April. We see evidence of profit-taking in Germany, the Netherlands, Belgium and Finland. There has also been a knock-on effect in Switzerland and Sweden. This is obvious in local currency terms, but in dollar terms the equity weakness has more than offset the strength of the currency. If this relationship holds in reverse, investors are being offered an opportunity to buy Eurozone equities and hedge the currency at a rate which would be been regarded as very attractive four weeks ago – especially if Greece moves ever closer to default.

Within US equities, dollar weakness helps to relieve the downward pressure on estimates for the big overseas earners – the most important of which is Technology, which has risen from #4 to #2 in our ranking over the last four weeks. It also removes support from Small Caps which were outperforming until recently because they did not share this drag on their earnings. In Europe we see signs of pressure on export-orientated sectors such as Consumer Discretionary and Industrials (which are also impacted by rising oil prices). Dollar strength later in the year should be enough to restore all these trends to the status quo ante (i.e. weaker US Tech, stronger US Small Caps and Euro Industrials etc).

There is however one region which is scarcely affected by recent volatility in the currency markets. As mentioned earlier the yen has hardly moved from its central rate of 120 to the dollar and the equity market is likewise unaffected. Last week’s sell-off of 2% should be seen in the context of a 1% gain for the month of April. When reviewing the performance data for all major equity regions we notice that Japan now has the lowest volatility in dollar and euro terms, as well as in local currency terms. This makes Japanese equities more attractive in risk-adjusted terms to almost every major institutional investor in the world. This is likely to remain true whatever happens to the dollar in the future.

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