While most everyone in the investment world has been focused like a laser beam on the amazing U.S. stock market, some subtle shifts are happening that could have major implications for investors. These shifts are not large yet, but they are significant if they are the beginning of a trend. For the last couple of years the investment landscape has been dominated by a stable to stronger U.S. Dollar, an expectation of stronger U.S. growth - largely unmet - and rising U.S. stocks. That may be in the process of changing.
With all the attention on new records for the S&P 500 you might not have noticed that the two year old downtrend in commodities appears to have come to an end. The CRB index, a broad measure of commodity prices, has been trending lower since early 2011 and while some of that is no doubt due to weaker growth and weaker growth expectations in China, a large part of the trend has been determined by the direction of the U.S. dollar. At its low in early 2011, the trade weighted dollar index traded at 72.7, within shouting distance of the low established in 2008. By mid 2013 the index had reached nearly 85 and a 17% gain. While the dollar was rising, commodities fell in lockstep with the CRB index down 26%.
The dollar index peaked in mid 2013 and has fallen a bit over 6% from its high. Commodities didn't get the message until the end of the year but are up nearly 13% just since the turn of the calendar year. If one looks at gold, the weakness is confirmed with the yellow metal rising over 12% since the beginning of the year. The dollar index most widely cited though understates recent dollar weakness. While the Euro and Pound have been rising steadily since the dollar index peak in mid 2013, emerging and commodity currencies continued their weakness. The Aussie dollar and Canadian dollar both continued to fall after the peak of the narrow dollar index as did the Brazilian Real. What has changed over the last few weeks is that those currencies have joined the majors in moving higher against the dollar.
The dollar hasn't been weak against all currencies, with the Japanese Yen the obvious exception. The Yen did rally at the beginning of the year coinciding with anxiety about emerging markets but has recently resumed its fall. Joining the devaluation party the last two weeks has been the Chinese Yuan, which until then had been on a relentless rise against the dollar. The stated reason for the change in direction from the Chinese government was two fold. First, it was intended to get the attention of speculators who have been making leveraged bets on a continued rise. Second, it was an intentional widening of the established trading band in anticipation of a freer floating Yuan in the future. Frankly, neither explanation makes much sense. China has a dollar shortage so cutting off capital inflows would seem a curious way to solve that problem. Massive foreign exchange intervention as a prelude to a freer float is just plain contradictory.
The Occam's Razor explanation is that the Chinese economy isn't performing that well and they see a devaluation of the Yen as a further threat to already falling growth. Chinese politics cannot be separated from economic growth and China's leaders are acting as all politicians do - in a way that protects their power. China's problems have been well documented by our own Jeff Snider - most recently here - and their real problem is a lack of growth outside China. If they can't count on export growth through U.S. economic growth then the alternative is to gain market share through currency devaluation. That may or may not work - it hasn't done much for Japan yet - but it is a very orthodox approach. Weak Chinese growth would also explain as much as anything else the recently announced plan to raise defense spending by 12%. Having built all the empty apartment buildings they can justify, the Chinese government is resorting to tried and true methods to goose growth.
I had thought that the recent moves in the dollar and commodities were a response to weak U.S. economic data. Weaker data means a possible stall in the Fed's desire to taper QE and coupled with the refusal of the ECB to engage in the QE folly, the Euro becomes relatively more attractive. But that doesn't explain the move in the Aussie and Canadian dollars or the Brazilian Real. Those moves are hard to explain except in the context of renewed Chinese economic strength, something that appears unlikely based on the recent Chinese PMI numbers. If the Yuan stops rising or weakens further against the dollar and in conjunction with a rise in defense spending to offset the drop in other types of capital investment, it seems more logical to anticipate a Chinese growth revival.
What does this mean for investors? If we look back to the last period of dollar weakness from 2002 to 2008, we might get some clues. First and most obvious, it probably means the end of U.S. stocks leading the global standings. From 2002 to 2008 the EAFE index rose by 218% while the S&P rose only about 40%. Second, it means that just as everyone has abandoned commodities as an asset class, they might be ready to shine again. From 2002 to 2008 the CRB index rose 260% and gold a stunning 328%.
I don't know if these trends are sustainable yet as there are significant differences between the '02-'08 period and today. Not least of which is that the U.S. was on a credit binge at the time and fed the growth of the rest of the world through the purchase of big houses, granite countertops, appliances and anything else you could finance with a home equity loan. We probably don't have the ability to expand our debts to the same degree we could in 2002 although I wouldn't put anything past our banking/Federal Reserve masters and the gullibility of U.S. consumers. After all, they've been convinced to go out and borrow billions in pursuit of college degrees of dubious worth and they've apparently forgotten about the dangers of chasing real estate prices higher just a few years after the bursting of our last bubble.
If this recent trend change is durable, investors may need to reconsider their recent love affair with U.S. stocks and learn about international diversification and the benefits of owning hard assets. In fact, those who have practiced true diversification even while it has been a drag on performance the last two years will benefit from doing nothing more than rebalancing their portfolios. The shift should be easier when one realizes that basically every stock market on the planet is cheaper than the U.S. right now. Even if this is just a short term head fake, long term investors should be thinking about practicing that oldest of investing aphorisms - sell high and buy low.