Time to Overweight U.S. Financial Markets?

Includes: DIA, ERO, QQQ, SPY, UDN, UUP
by: Matteo Radaelli

In the first three weeks of December, US financial assets have significantly outperformed other international financial assets, driven by the US Dollar appreciation against all major currencies. Indeed, the Dollar Index has risen by almost 3% so far in December, and by 4.7% against the Euro, boosting returns on US equity and bond indexes. The table below shows the December performance by major equity and bond indexes, using the European ETFs as a benchmark, as they replicate the underlying index performance.

The exchange-traded funds give ample evidence that the Nasdaq100 and the S&P500 are the top performers for December and that the US bond indexes have outperformed both the European and emerging market bond indexes this month.

As we pointed out last week, we expect the Euro to continue its downtrend against the US Dollar into the coming months as there is a clear possibility that the Fed and not the ECB will be the first Central Bank to hike rates in 2010. The news items that emerged during the week support this idea. In the US, industrial production for November and the leading indicator for December came as positive surprises. Both the data suggested that US economic activity is gathering strength and that the economy will likely continue on its path to recovery in the first half of 2010. In Europe, the Greek crisis seems far from resolved, with the rating agency Standard and Poor’s following Fitch in cutting its rating on Greek government debt to BBB+ from A- on the grounds that the measures the Greek authorities have recently announced to reduce the high fiscal deficit are not enough to rebalance public accounts.
Moreover, Germany’s industrial production and factory orders data for October released last week served as a grim reminder that the economic upturn may be slower than many economists have been expecting. The improvement in the December IFO business climate index is unlikely to assuage investor concern short term. Only a sharp upswing in economic activity at the tail end of the year may revive investor optimism about the European economic prospects. Overall, we believe that the Euro will weaken further against the US Dollar with a medium/long term target of 1.17, in line with the EUR/USD exchange rate fair value based on the PPP calculated by the OECD. (Click to enlarge)
However, the majority of the Central Banks will likely wait the first rate hike by the Fed before tightening, with some minor central banks (i.e. Australia, Israel, Norway, India) the only exception.
This may well be the case of the Swiss National Bank and the Riksbank, which are not seen tightening ahead of the Fed and the ECB as inflationary pressures are under control and with a view to fending off currency appreciation. Even the BoE does not forecast a rate hike any time soon, as economic growth is expected to remain anaemic for several quarters.
Under this scenario, US financial assets will likely continue to outperform other international financial assets going forward, unless negative economic surprises emerge. For this reason, beginning next week we recommend buying the Nasdaq100, which we prefer relative to the S&P500 due to its higher relative strength.
Disclosure: No positions