Market strategy viewpoint – October 29, 2009

Marc A. Zabicki, CFA – Sr. Market Strategist

The dollar debate

Key conditions

Trading during the financial crisis created an important space for the U.S. dollar as the safe-haven currency of choice during the downturn. With some financial market risk-taking now back in vogue, the safe-haven trade is now being unwound, putting downward pressure on the dollar.

Low U.S. interest rates have helped the dollar take the place of the Japanese yen in the prevailing carry trade phenomenon. Borrowing in U.S. dollars and buying higher-yielding assets has caused additional downside pressure on the greenback.

The U.S. dollar's trajectory has assumed an increasingly important role in the direction of the U.S. equity market in recent months. There is a clear pattern of negative correlation between the U.S. Dollar Index and the S&P 500 Index. Traders may be signaling that they see a weaker U.S. dollar as important for a U.S. economic recovery and an early step in the cure of global financial imbalances.

While a weaker U.S. dollar may be viewed as somewhat necessary to boost U.S. exports and help prop up U.S. corporate earnings, U.S. government officials need to support the dollar to a degree that it does not lose its place as the world's reserve currency.

To-date, the U.S. government's lack of conviction in reducing the deficit has been a key fundamental issue that could put further downward pressure on the dollar. Easy monetary policy from the U.S. Federal Reserve also serves to hold down the dollar's value and prolong the carry trade.

The dollar debate

It seems as though these days everyone wants to talk about the dollar, and the market is indeed paying more attention key currency movements. Recent rhetoric from foreign officials and commentary from market participants on the functional value of the dollar as the world's currency has heightened the argument about the importance of the dollar's direction. Dollar weakness of late, coupled with some material strength in other major currencies, has been much talked-about. We will try to put some perspective on the dollar's recent trading path, cover some of the fundamentals that may be moving the dollar, and note the impact the dollar is having on equity trading. Our general view is that the dollar is likely to trade weaker in the coming months, based on some fundamental weaknesses, and comparatively easy monetary policy. However, the downside is likely to remain orderly as it is in the best interest of global central banks to continue to cushion the fall. Thus, we consider any investment strategy built around the dollar's direction as necessarily peripheral rather than core. In our view, the key driver of the equity market will continue to be the state of the economy and monetary policy direction, rather than the dollar. Finally, in terms of the dollar, we will note some places to be for those investors that are anticipating some dollar weakness both near-term and long-term.

The dollar's recent path — clearing the air

Much has been written and stated about the worry over the U.S. dollar's recent downward trajectory, and the dollar has become story number one in the financial media. Concerns vary from the dollar's position as the world's reserve currency to its impact on capital investment in the U.S. While the downward push in the dollar has been notable, it is important to put the recent trading path of the dollar in its proper context. Some quote the 15% fall in the dollar since the March high or the 6% fall year-to-date as signs that the dollar is losing its place as the world's key currency. What is missing from this analysis is the 6% rise in the dollar in 2008 and the 14% trough-to-peak rise in the dollar between December 2008 and March 2009. In the proper context, the dollar is in the process of giving back what it had gained as the world's "safe-haven" currency during the financial and economic downturn (see Dollar Index graph below). While talk that the dollar is losing its reserve currency status is likely a bit premature, in our view, we are anticipating the currency to move lower as global credit tensions ease and risk-taking causes investors to unwind their safe-haven trades. Technically, the Dollar Index could see several points of selling pressure over the near term, but we see 72 as a level of important support. However, sustainable trades through 72, coupled with little, positive fiscal direction from the U.S. government may usher in the risk of more protracted weakness.

Fundamental foundation for a weaker dollar

We believe there is indeed some fundamental argument to be made for a weaker dollar as the U.S. government's budget gap has widened and there has been little indication of a definitive plan to reduce the fiscal imbalance. Comparatively, the U.S.' hold on its budget is now growing more tenuous and debt balances as a percent of GDP have surpassed those of some key Eurozone economies (see table below). Fundamentally, this rate of change in the U.S. fiscal deficit should (and has) justifiably put downward pressure on the dollar, in our view. As the market perceives the U.S. economy theoretically approaching some Eurozone economies from a regulatory, entitlement, taxation, and deficit standpoint, the dollar has clearly felt the affects. The greenback is down 18.0% against the euro, 7.2% versus the yen, and 18.6% versus the pound since the U.S. equity market trough. While some of the trading may be due to the U.S. fiscal direction, much of the direction likely has been influenced by the unwind of the U.S dollar safe-haven trade. Further, we find some modest disconnect with the relative performance of the dollar versus other global currencies given the presence of foreign deficit problems as well. The downward shift in the greenback may be somewhat of a statement about the uncertainty of future U.S. fiscal policy, but much of the activity of late has likely been induced by trading momentum.

Looking ahead fundamentally, the U.S. government posted a $1.4 trillion deficit in the year ended September 30, and the White House has forecasted deficits of over $1 trillion through 2011. In our view, the government will need to present credible deficit reduction measures in order to reduce the talk of pressure over its "AAA" credit rating and ease the pressure on the dollar. Both major rating agencies (Moody's and Standard & Poors') have stable outlooks on the U.S. credit rating, implying a downgrade is not expected for up to two years. However, the worry is that pressure on the credit rating or the erosion of the dollar's status on the world stage could put upward pressure on interest rates, further dampening the recovery, and further impairing any government effort to close the budget gap. In our view, the government will need to show progress in deficit reduction or clarify a deficit reduction plan in order to ease concern over the U.S. credit standing and provide a firmer foundation for the dollar. Until then, we believe the dollar has both technical and fundamental reasons to go lower.

Dollar keying equity moves?

The variation of the U.S. dollar's value has been notable in helping direct the U.S. equity markets of late, as some investors likely view the greenback's carry trade status as a statement on the appetite for global market risk taking. Similar to how the Japanese yen was treated before the credit crisis, investors, with interest rates at essentially zero in the U.S., have been increasingly borrowing dollars to invest in higher-yielding assets. Further, some investors may be betting a downward trajectory in the dollar and thus a potential orderly devaluing in the greenback is the necessary anecdote for global financial imbalances and necessary for stable global growth. In the U.S., a weaker dollar makes exports more desirable and makes foreign imports more expensive for U.S. consumers. The weakening dollar gives domestic businesses a competitive edge at home, making their products cheaper than rival imports. Thus, some market participants claim that the U.S. government is willingly devaluing the dollar to aid U.S.-based companies, to stimulate the domestic economy, and to reduce current account deficits. In the near-term, U.S. stocks are getting a benefit in-part because rising exports are partially offsetting some of the weakness in U.S. consumer spending and may provide a modestly positive impact on U.S. GDP

The carry-trade impact and the view that a lower dollar may be aiding a domestic recovery is likely playing a role in the in the growing negative correlation between the U.S. Dollar Index and the S&P 500 Index in our view (see table below). Investors should note that correlation statistics range from perfectly correlated (+1) to perfectly negatively correlated (-1). The data in the table show that the upside trend in stocks is being increasingly impacted by a weaker dollar of late, while weakness in stocks often coincides with dollar strength. Perhaps this is where the importance of the carry trade is reflected, as dollar weakness likely prolongs the trade and clears the way for additional risk taking, which is good for the U.S. equity market. Given the correlation statistics presented, short-term investors may be wise to note the dollar's trajectory when setting portfolio strategy.

Eyes on Ben

A key issue that could cause a turn in the dollar's fortunes is a shift in monetary policy. Lately, several U.S. Federal Reserve officials and Fed Chairman Ben Bernanke himself have been clear in their indications that monetary policy should remain accommodative in the months ahead. However, a hint of a shift in policy and/or an increase in interest rates could provide immediate trading support for the dollar, causing the carry trade to be partially unwound, and induce a negative reaction in equity markets. We have commented of late on the importance of U.S. monetary policy in creating a glide path for higher equity prices during this business cycle recovery. Given the carry trade phenomenon, the hint of higher interest rates could have a substantial impact on equity prices. Consequently, we believe keeping an eye on monetary policy direction is even more important in this business cycle than it has been in the past. Right now consensus has the Fed maintaining its benchmark interest rate at current levels through the first half of 2010, but investors should watch closely for signs of a change in the Fed's view.

The dollar rundown — key investments in a weak-dollar environment

While there may be some near-term benefit for those investors building investment strategy around a weaker dollar, we are questioning the long-term benefits of the approach. We believe now that the safe-haven premium in the dollar has largely been unwound; the downside in the dollar may prove relatively minimal in the months ahead. Still, we are suggesting some investments that should benefit from: a) a cyclical rebound in global economies, and b) a modestly weaker dollar. Foremost, U.S.-based multinational companies that generate significant sales overseas should recognize multiple benefits from the current environment. These companies often borrow in "cheap" dollars and invest in faster growth overseas. International equities, especially equities in commodity heavy regions such as Australia, Canada, and Latin America could get a double-barreled benefit from demand growth and the negative correlation of a falling dollar and rising commodity prices. Lastly, commodities themselves are a definitive hedge against a falling dollar, plus commodity prices may be set to rise as global economic growth progresses.

Our broad U.S. equity market perspective

We believe the equity sell-off we have witnessed of late should be relatively short-lived and the volatility is not a surprise given the likely variable economic recovery. The third quarter earnings season, where 81% of S&P 500 companies have surpassed there earnings expectations so far, has been successful in showing some rebound in the health of corporations. Outlooks delivered by companies in their quarterly reports have been cautious, but business conditions are improving. We continue to expect the environment to be difficult and investors should anticipate bouts of volatility similar to what we are witnessing at the time this publication goes to print.

Our equity sector allocation recommendations remain balanced between defensive and cyclical groups to help investors digest some of the market's volatility. We suggest investors Overweight the Financials and Industrials spaces, and we have balanced that with what we believe is necessary defensive exposure during this recovery, an Overweight rating in the Health Care sector. While the market's trajectory has been mostly positive, we still consider defensive exposure as necessary to help buffer some economic inconsistencies that may arise. Meanwhile, Equalweight recommendations in Technology, Materials, and Energy have also been relatively well-placed to take advantage of the equity advance. Consumer Discretionary issues (Underweight) have indeed come under considerable pressure during the latest market sell-off. This is not unexpected given the high and potentially ill-founded expectations that had been priced into the group. We believe a consumer spending rebound will be relatively lackluster, while sector price moves, to us, have seemed to indicate more bullish expectations.

From a fundamental perspective, this market does not strike us as overly-expensive despite an approximate 57% run since the March lows. The S&P 500 Index trailing price-to earning multiple is 17.3x, which is at a level that displays value versus past points of business cycle recovery and does reflect the lack of inflation pressure and easy monetary policy. Further, we believe the S&P 500 Index's trailing multiple may be a bit overstated, given the substantial losses that occurred in Financials in late 2008 and early 2009. In regards to forward earnings multiples, the S&P 500 is set up at 15.1x earnings, which again is a reasonable number in our view.

Again, the Federal Reserve has created an environment for additional risk-taking wherein the central bank has provided a disincentive to hold cash (at a .06% 90-day T-bill rate) and other risk-less assets (at a 3.45% 10-year Treasury yield). Comparatively, these yields look decidedly unattractive compared to the forward S&P 500 earnings yield of 7.4%. Consequently, at a 400 basis point spread versus the 10-year and a 730 basis point spread versus the T-bill, we make the determination that investors could recognize investment reward for the assumed risk of the equity market.

The table below illustrates how we are recommending investors position their portfolios tactically in this environment. We believe our asset class allocations focus on the indication that investors should be taking additional risk in this environment, but that risk should be balanced by quality security selections. Notice that we believe much of the risk/reward positives in the bond market still exist in the investment grade corporate and municipal spaces, while Treasuries offer little upside in our view. Stock selections should again focus on quality, highlighted by our Large-cap overweight. The reason for this being that while we are at an attractive point in the business cycle and equities should be a healthy portion of a diversified portfolio, growth should remain choppy and risk in equity selections should be mitigated. Small-cap U.S. stocks and International stocks should be a key part of portfolios, but risk management here is important. A key approach that investors may wish to incorporate is to establish a long-term allocation plan and engage in tactical asset allocation shifts around those long-term allocations as economic and financial market conditions warrant. The table below, which is published on an ongoing basis in the Market Strategy Viewpoint may assist in this process.