As we head into the final third of the trading year, it is appropriate to look at the global economy and what it means for our market going forward. The world is a very bifurcated place right now. Europe is on the verge of stalling yet again as Italy is in outright deflation, 10 year yields for Spanish debt are under 3% and German monthly retail sales just came at their weakest level in over 2.5 years.
The recovery in Japan under "Abenomics" is still uncertain. The Japanese Central Bank engaged in their own version of quantitative easing on steroids which help boost the Nikkei more than 55% in 2013. Government spending has also been boosted. Unfortunately, now comes the hard part; labor and market reforms needed to boost competitiveness and consumer spending. It is still uncertain whether the government has the will to do what is necessary in this area and the Japanese economy shrunk in the last completed quarter due to a sales tax rise to 8% from 5% currently which is needed to address the country's huge deficit.
The economic picture is much brighter here in the United States. Domestic auto sales look poised to cross over the 17mm annual mark, something that has not happened since July 2006. Manufacturing and construction readings also came in stronger than expected on Tuesday. Finally, we are seeing real job growth after being mired for five years in the weakest post-war recovery on record.
The difference in the economies of the major developed markets is starting to show up in currency markets and also in the recent rise of our 10 year treasury yield. The dollar has gained nicely against both the Euro and Yen and the ten year has moved from ~2.3% to ~2.45% in quick order. The Euro has moved from over $1.36 to $1.31 recently and the Yen is at a seven month low against the dollar.
With the Federal Reserve about to end its quantitative easing stance after more than five years in October, domestic economic growth projected to be around 3% in the back half of 2014, and with the European Central Bank quite likely to engage in its own QE program by the end of the year; these recent trends should continue if not accelerate.
So what should investors do to position their portfolios for what looks like the trend to a higher dollar? Here are a couple of steps I think investors should take to bolster/protect their portfolios.
- Underweight American multi-nationals that get a good portion of their sales from Europe as their earnings will be impacted due to the lower Euro. McDonald's (NYSE:MCD) is a good example of a domestic company that gets a good portion (~30%) of its revenue from the eurozone that I would be avoiding here; both due to a falling Euro and other internal problems the company seems to be having lately.
- Reduce exposure to high yield sectors like Utilities and Real Estate Investment Trusts (REITs). These areas traditionally get impacted negatively anytime interest rates run up like they did in the back half of 2013 which caused these sectors to deeply underperform the overall market in the last six months of last year. As I detailed yesterday, I have cut my exposure to REITs substantially over the past couple of months with some exceptions.
- The stronger dollar will undermine the case for owning commodities and commodity based sectors. In trading yesterday, investors were provided a glimpse of this when oil fell almost $3 a barrel in trading Tuesday. Natural gas, gold and silver were also very weak. It is time to lighten one's exposure to the mining sector. I am also moving from overweight to equal weight on the energy sector which is still benefiting from huge domestic production growth and should be able to withstand some decline in energy prices; provided it is not too severe. However, lower energy prices will still be a headwind to the sector.
- Finally, it might be time to boost exposure to Europe in front of a likely move by the ECB to flood their market with additional liquidity. Both U.S. and Japanese equities soared when their central banks engaged in "easing," European bourses should see some of the same positive impacts. An investor can increase exposure by buying a currency hedged mutual fund or ETF based on Europe or by buying individual names. I like Netherlands based AEGON N.V. (NYSE:AEG) as I recently highlighted as a play that will benefit from quantitative easing by the ECB and by a falling Euro.
This an initial list of what I see as the likely impacts to a rising dollar and slightly higher interest rates on our markets. These are topics we will revisit often for the rest of 2014 as these trends bear watching for investors.
Disclosure: The author is long AEG.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.