Market Bulletin November 11, 2014

Transcription

1 Market Bulletin November 11, 2014 AUTHORS Stephanie Flanders Chief Market Strategist for the UK & Europe Alex Dryden Market Analyst Tai Hui Chief Market Strategist Asia Should investors fear a rising dollar? Some recent developments in global markets could be temporary, but there is a widespread consensus that a stronger US dollar is here to stay. Emerging market (EM) economies have traditionally had much to fear from a rising greenback, while for developed countries it has often been a boon, helping to prolong the upside of the economic cycle by putting downward pressure on interest rates and inflation in the US. However, these are not normal times for world markets or for US monetary policy. It is worth asking whether these past lessons of history are likely to hold true today, and worth considering the implications of a stronger dollar for investors. There s one key conclusion: in currency markets, as in life, it s not just what you do that matters, but the way that you do it. Investors need not fear a further rise in the dollar if it occurs in a fairly orderly manner, particularly if it keeps US monetary policy looser for longer. But a more dramatic strengthening could pose more risks to investors in global markets. Why is the dollar rising? Currencies are notoriously hard to predict, but from an economic standpoint, it should come as no surprise to see the dollar strengthen over the past two years. Several key factors are pushing the currency up: Relative growth. After a 4.6 surge in real GDP in the 2Q14, the US economy appears to have grown by a healthy 3 in 3Q14. This is particularly strong relative to economic data from the eurozone, Japan and China, which have all seen a significant loss of momentum during the course of 3Q14. Relative monetary policy and bond yields. As a result of this economic divergence, we expect the Federal Reserve (Fed) to increase interest rates in 2015, unlike either the European Central Bank (ECB) or the Bank of Japan. This suggests that both short- and long-term interest rates will be higher in the US than in other places for some time to come, resulting in greater inflows of investor capital and continuing support for a stronger dollar. Rising US energy independence, as a result of shale energy production. In 2013, the US imported just 6.6 million barrels of oil or 35 of its total energy consumption. In 2005, some 60 of oil consumed was imported from overseas. This trend has had a dramatic effect in shrinking America s current account deficit which is likely to continue for some time. In theory, a lower US current account deficit reduces the global supply of dollars and raises the price.

2 Market bulletin There is clearly significant support for a strengthening dollar in the coming months. However, it is important to keep the latest gains in perspective. As shown by Exhibit 1, the size and length of the latest moves are relatively small from a historical perspective. It is not uncommon for a cycle of appreciation (or depreciation) to last for several years and cause movements of in the value of the US dollar. So, we have a while to go before we can really talk about a new era of dollar strength. EXHIBIT 1: THE RISE AND FALL OF THE US DOLLAR US Dollar TWI : : : Plaza Accord : : Louvre Accord : : '73 '75 '77 '79 '81 '83 '85 '87 '89 '91 '93 '95 '97 '99 '01 '03 '05 '07 '09 '11 '13 Source: FactSet, J.P. Morgan Asset Management. Data as at 22 October This will be a benign development for investors in developed markets including the US if it is simply the result of the US growing faster than the rest of the world. But it is more worrisome if it is driven more by fears elsewhere. What we don t want is for the dollar to become a one-way bet for investors who think they can expect to earn not just higher returns on US financial assets, but the added benefit of a stronger currency to boot. In such an environment, EM economies are likely to see major capital outflows, and the US central bank might also struggle to push down long-term interest rates, even when policy rates go up. Neither development would be very healthy for global investors, or for the global economy. The dollar smile in Exhibit 2 helps to make this point. Essentially, it shows that the US dollar will tend to outperform in both high relative growth environments where investors favour US assets or low global growth environments, where risk aversion sees selling of foreign stocks and demand for Treasuries. We hope we are in the first environment, not the second. But in a world of persistent and widespread disinflationary pressures, the risks of the more negative scenario are clearly there. EXHIBIT 2:US GDP GROWTH VERSUS US DOLLAR INDEX: THE US DOLLAR SMILE US GDP growth versus USD index US dollar index USD GDP growth (y/y) Source: Bloomberg, J.P. Morgan Asset Management. Data as at 22 October Economic implications of a stronger dollar By itself, dollar strength is usually associated with a tightening in domestic economic conditions: the Organization of Economic Co-operation and Development s (OECD) rule of thumb is that 10 appreciation in the trade-weighted dollar cuts 0.5 percentage points from GDP growth and 0.3 percentage points from CPI inflation in the first year. But that doesn t account for the positive effect of lower oil prices, which have accompanied the recent appreciation in the dollar. As Exhibit 3 shows, there has been a strong correlation this year between movements in the dollar and movements in mediumterm US inflation expectations, which have come down sharply in response to not just the stronger dollar, but declining commodity prices. Lower energy prices act like a tax cut for US households and businesses, boosting their real incomes. They also make it easier for the Fed to keep interest rates lower for longer, all other things equal, and long rates are also likely to be pushed down by bond investors coming into the US looking for higher returns. Taking those factors into account, we believe that the strengthening in the currency will be a net positive for the US economy, even if it makes life a bit more complicated for the Fed. That suggests a broadly benign impact on US stocks as well, though some sectors are likely to fare better than others (see Investment implications on page 3). 2 Market Bulletin Should investors fear a rising dollar?

3 EXHIBIT 3: THE US DOLLAR AND INFLATION EXPECTATIONS 3.1 US dollar broad TWI US 5y/5y inflation expectations The macroeconomic impact of a stronger dollar is more complicated for EM economies, which are at a very different stage in their economic cycle than the developed world. At first glance, a stronger dollar looks positive for these economies too, by giving them a competitive boost in US markets and slowing the path to tighter US monetary policy. But a stronger dollar could also aggravate inflation problems in some parts of the emerging world, and suck foreign capital out of emerging markets, back to the US leading to serious market volatility and difficult challenges for policy makers. 2.5 Dec-13 Jan-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Sep-14 Oct-14 Source: Bloomberg, J.P. Morgan Asset Management. Data as at 22 October For the eurozone, the net result of a stronger dollar and a weaker euro is likely to be strongly positive, since it should help to boost nominal GDP. The ECB reckons that a 10 change in the value of the currency generates a percentage point change in inflation. Therefore a weakening US dollar has been acting against the central bank in the period of euro strengthening. We might now hope to see that act in reverse, though the fall in the price of oil might lessen the effect, in the short run. As Exhibit 4 shows, falling food and energy prices have played a big role in the dramatic fall in eurozone inflation in the past 18 months. But longer term, lower energy costs will also act like a significant tax cut for European households and firms rather more than in the US, given Europe s greater dependence on imported energy. 88 In the late 1990s, this dynamic helped produce the Asian financial crisis. But most EM economies are in a much stronger position than they were then, when large external imbalances had been built up during the period of relatively cheap global liquidity, and many had committed themselves to unsustainable exchange rate pegs. These days, the amount of foreign currency debt is considerably lower, fundamentals are stronger in most cases and many have an exchange rate that is free to depreciate and act as a safety valve, as occurred during the taper tantrum of With the eurozone now set to run a current account surplus for the foreseeable future, the outflow of capital from emerging markets might also be mitigated this time around by inflows from Europe, as European investors look for more profitable places to park their excess savings. For all these reasons, we believe the net result of a stronger dollar for emerging markets is going to be difficult to predict and depend heavily on individual country circumstances. But it is safe to say that nearly all of these countries are likely to see some volatility in their domestic markets as these different forces play out. EXHIBIT 4: THE IMPACT OF FALLING FOOD & ENERGY PRICES ON THE DROP IN EUROZONE INFLATION Since January Food (lhs) Energy (lhs) Industrial goods (lhs) Services (lhs) CPI (rhs) -1.8 Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Jul Source: Eurostat, FactSet, J.P. Morgan Asset Management. Data as at 22 October J.P. Morgan Asset Management 3

4 Market bulletin Investment implications US markets A strengthening US dollar is likely to have an adverse impact on US equities in the short term. It is estimated that in 2013 S&P 500 companies were holding over US$1.9 trillion in overseas investments, the value of which is likely to erode rapidly as the US dollar strengthens. However, from a revenue point of view the S&P 500 as a whole is well positioned to cope with the impact of a rising US dollar, as companies source only 40 of their revenues from overseas. But when considering the issue on a sector-by-sector basis, investors may see some weakness. The US technology sector sources approximately 60 of their revenues from overseas leaving companies exposed to the negative impact of a stronger dollar. In contrast domestically orientated sectors such as financials are positioned to benefit from the positive side effects of a stronger dollar. European markets The prospect of a weaker euro should be a major tailwind for European earnings, particularly when coupled with falling oil prices. There are questions marks over the impact that a weaker euro may have on boosting growth within the region however, recent estimates such that a 10 drop in the euro s tradeweighted index will boost earnings, on average, by more than 8. European equities have a broad global exposure with 45 of earnings coming from outside of Europe 20 of that from the US. A weaker euro would give a much needed boost to European equities, which have experienced falling earnings, on a year-onyear basis, for the best part of three years. EXHIBIT 5: STOXX 600 EARNINGS AND PERFORMANCE Index level, analyst estimates of the next 12 months of earnings STOXX 600 profits STOXX 600 index level 14 '07 '09 '10 '11 '12 '13 ' Emerging markets EM equity prices have historically had a very strong negative correlation with the trade weighted dollar. This is because a strong dollar has tended to go along with weaker commodity prices and capital outflows from emerging markets. There is also a currency translation effect, which lowers the dollar value of EM earnings. But now, especially, it is important for investors to note that not all of emerging markets will react in the same way to a strengthening US dollar. It is also possible that EM assets as a whole will have a slightly easier ride during this strengthening cycle, because energy and basic materials now represent a smaller proportion of the index than in some previous periods of dollar strength. EXHIBIT 6: COMMODITY SECTOR WEIGHT IN THE MSCI EMERGING S INDEX Commodity sector weight in MSCI EM Average: 26 Sep 2014: '94 '97 '99 '01 '03 '05 '07 '09 '11 '13 Source: MSCI, FactSet, J.P. Morgan Asset Management. Commodities includes energy and materials. Data as at 22 October On a 10-year time horizon, our analysis suggests that emerging economies in EMEA have a correlation with the US dollar, compared to the MSCI Emerging Markets Index, which has a correlation. Based on our analysis, Latin American emerging markets are likely to fare less well, having a correlation. But even there, we are likely to see exceptions (see the case of Mexico, on page 5). Source: STOXX, FactSet, J.P. Morgan Asset Management. Data as at 30 September Market Bulletin Should investors fear a rising dollar?

5 Market Bulletin EXHIBIT 7: THE CORRELATION OF EM ECONOMIES WITH THE US DOLLAR 5-year correlations 10-year correlations US TWI MSCI EM Latam EM Asia EM EMEA EM US TWI MSCI EM Latam EM Asia EM EMEA EM Source: MSCI, FactSet, J.P. Morgan Asset Management. 10-year correlations are from October 2004 to October year correlations are from October 2009 to October Overall, a significant strengthening of the dollar could provide a bumpy ride for emerging markets in the months and years ahead. But differentiation is the name of the game. As shown in Exhibit 8, some emerging markets with economies linked to global supply economies and especially the US consumer are likely to fare better during this period. And some, such as Mexico could fare very well indeed. EXHIBIT 8: EM ECONOMIES EXPOSURE TO US VIA TRADE Emerging market economies exposure to US via trade Gross merchandise trade to US, of GDP, Thailand Taiwan Saudi Arabia Malaysia Mexico 4 China Chile 2 S. Africa Philippines India Indonesia Brazil Hungary 0 Turkey Russia Value-added exports to US, of GDP, 2009 Conclusions Overall, a rising dollar would be a net positive for European assets, supporting export earnings for companies exporting to the US and helping the ECB prevent deflation. A strong dollar does pose greater risks to EM investors. The negative correlation between EM equity prices and the US dollar trade-weighted index is very strong indeed. But most EM economies are better placed to withstand a change in global conditions than they were during the last period of sustained dollar strength, in the late 1990s. There would also be a silver lining to the strong dollar, for countries dependent on foreign borrowing, if it helps the Fed keep interest rates lower for longer. A more nuanced approach suggests that countries in emerging Europe could be better insulated than most from any negative consequences, along with countries that are not heavily dependent on commodities for their income. EM economies that are closely linked to the US economy could well benefit notably Mexico. An important note of caution is that the rise in the dollar to date has been relatively modest compared to past periods of dollar strength. But if investors start to feel that the US is the only game in town, the dollar could rise every bit as far as it has in the past. That could have unpredictable and highly destabilising consequences for global markets and revive fears of asset bubbles in the US. This is not the most likely scenario, but it cannot be ruled out if growth in the rest of the world continues to disappoint. Source: OECD, FactSet, World Bank, IMF, Lombard Street Research, J.P. Morgan Asset Management. Data as at 4 November 2014.

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