In Part 1 I mused about historical volatility, returns in the three QE environments, and corporate earnings and buybacks (see here). While that post was more backward-looking, this will look at the current macroeconomic considerations with a look to the future.
The Forex Market (fx) is the largest and most liquid market in the world, averaging $5.3 trillion in daily trading value as of the most recent survey by the Bank for International Settlements (April, 2013). If you combine both the equity and bond market figures, you are likely over half of that, but not by much.
The forex market also is much more focused on macro-economics, as these considerations are the prime movers of currency trends. I do not think I'm going to far out on a limb to say that change of high-impact in currency movements are much more quickly digested in the forex market than the equity market. There are exceptions, but traders in fx thus are much less inclined to hold a long position in a currency than, say, an investor in Tesla.
The size of the fx market, focus on macro pressures, and less emotional trading makes the forex market a much better barometer for general sentiment and future projections than its equity cousin. This in mind, let us take a quick look at a couple currency pairs and try and glean a bit of actionable investment advice from them.
The Eurodollar is the most actively-traded currency pair by far, comprising almost 30% of fx trading volume. Known by its nickname "Fiber", Eurodollar and its movement has the most impact on U.S. corporate earnings. The idea of "strong dollar" is most prevalent here, as the weaker euro means earnings by U.S. companies in the Eurozone are worth less dollars when repatriated.
Mid 2014 through 2015 was the time of a great weakening in the euro, the first pressure on U.S. corporate earnings. By the end of that timeframe, the euro was down 20%, giving a 20% haircut to every repatriated dollar from international sales.
I won't go into every reason for this, but I will highlight the two most important factors: Concerns in the stability of Eurozone periphery sovereign debit and monetary policy divergence. The Grexit crisis was a huge drag on the euro when concerns were at their peak in March/April of 2015, with the eurodollar trading in the 1.04s, down over 13% from the beginning of the year.
The biggest concern was not the impact of a Greek default per se, but the lasting consequences of instability in the Eurozone itself. If Greece defaulted, it would cause massive financial strain; if it exited the Eurozone, it would cast doubt on the longevity of the Eurozone itself, which had its origin monetarily only 16 years prior.
As it happened, the European Central Bank (ECB), the International Monetary Fund and other institutions approved a bailout package for Greece, effectively kicking the debt can down the road. It is of strong likelihood that this issue will arise again in a short time, and perhaps this time it will not just be Greece, but also Portugal, Spain, and Italy that need bailouts to survive.
Monetary policy divergence speaks to the difference between the Fed and the ECB regarding the fiduciary environments they project (this is ongoing). Put simply, the Fed was and is trying to tighten monetary policy, while the Eurozone is loosening it.
The Fed is trying to hike interest rates in order to curb future inflation after three rounds of quantitative easing. On the flip-side, the Eurozone has entered into its own QE program, buying asset-backed securities, public sector debt, and covered bonds. To make a complicated matter simple, the Fed's tightening policy should act as a tailwind to the U.S. dollar, whereas the ECB's easing policy should conversely be a headwind to the euro. This would thus cause a strong downward trend to the Eurodollar.
Although Mario Draghi, President of the ECB, is making it clear that that fiscal body will do whatever it takes to continue its fiduciary loosening, the Fed is running into some hurdles for continuing its tightening. Global concerns over oil and China as well as domestic volatility in the U.S. stock market are causing many economists to lessen their projections for rate hikes in 2016. March's Fed meeting and conference may bring more clarity to the picture. In the meantime, many big banks such as Citigroup and Goldman Sachs still see the Euro progressively weakening in 2016.
The second currency of note is Dollar/yen, referred to as "Ninja". The "Ninja" nickname is kind of like one of those nicknames you tried to give yourself in high school that just never took off.
Dollar/Yen is commonly cited as a "carry trade" currency, as investors can sell yen (which yields very low interest) and invest dollars into treasury bonds at a higher rate of return. This is a risk-off approach, for as long as yields are going up, the spread can be leveraged and short-term bonds will yield a high rate of return through this carry trade.
When the environment turns to risk-on, U.S. Bond yields decrease (and of course, bond prices increase). This, then, causes a selling pressure in carry traders, as those that sold JPY to buy bonds now have capital appreciation in those bonds. In addition, establishing new carry trade positions will not be as alluring due to contracting spread. When U.S. bond yields go down, we thus see USD/JPY depreciating as the carry traders head back to yen.
A prolonged rise in Yen, then, would mark a global risk-off setting. This is what we see here, as USD/JPY has dropped from its June 2015 high in the 125s, to its current 112s. In February alone we have seen it drop from the 121s, marking a clear indication of risk sentiment in the currency markets. Many forecasters call for a drop to 110 in the coming months.
What This Means to Oil and Gold
What do you get when you have a strengthening U.S. dollar and weakening manufacturing forecast? Plunging commodities and emerging market outflows. The fact that crude prices have taken a nosedive is unsurprising, as is further weakening of gold in 2015 (more on that later).
Is oil going to bounce? You betcha; it will form a bottom at some point. But it is the magnitude that should be focused on, not the timing of when it will happen. $100/barrel oil may well be gone for decades if not forever, as rising inventory levels in an easy-credit backdrop of falling demand in emerging markets (China in particular) mean that a string of bankruptcies is unlikely to right the supply-demand inefficiency. Bloomberg reports that new "supply exceeds demand by as much as 1.7 million barrels per day" and that "only 0.1 percent of global output has been curtailed because it's unprofitable." That wasn't reported a year ago with oil in the $50s/barrel; it was a week ago with oil around $30/barrel.
Mass media has been frantically attempting to predict a bottom in oil and asking "is it time to buy [E&P company]?" while the price of crude keeps heading relentlessly downward. Macroeconomics outweigh greed, and not losing a dollar is more powerful a persuasion than gaining one. While the EIA (U.S. Energy Information Association) predicts $50/barrel for average price in 2017, the real question we should be asking ourselves is "are major E&P oil companies actually pricing in the lower-for-longer earnings environment?" If you read my article showing why Exxon could hit $48 per share in a little over a year, you might second guess what you took for granted.
The whole developed world shows deflation, and yet the Fed is raising rates to combat coming inflation. Of course, this might just be policy borne of desperation, as the U.S. balance sheet could sure use some inflation to whittle away at that $19 trillion...
In this situation, gold is coming more to the forefront of investing strategies. I am not going to prattle on about gold, but suffice it to say it is very curiously treated if one views it with an eye to the long-term past as well as the future. On the one hand, you will hear "gold bugs" cite its value as an inflation hedge and flight-to-safety commodity, and on the other hear that it is worthless and simply a metal with no inherent value; I believe the latter view is a product of blindness to history.
Gold is an asset that has held its value for thousands of years, and as such is very appropriately deemed a lasting commodity. Its price is largely determined by supply/demand and by the fiat currency of one's nation. We saw gold most recently spike during the Great Recession and shed value in the subsequent years of QE and stock market inflation. Those that reject gold's value seem to be almost universally those that are young and have enjoyed the capital appreciation of the last 7 years, at which time gold's value has steadily lessened. Although terribly young myself, perhaps my risk-adverse leanings have outweighed the impetuousness of my youth, for I believe in the inherent value of gold.
If we do take gold to be the historical commodity of safety that it is, wouldn't this be a good time to initiate a position in the (actual) asset? It could very well be. If one invested in gold every time the stock market was historically overvalued (by whatever mark you wish to adhere to), it could very well be a significant asset.
Inflation-Adjusted gold spot
In the short-term, however, Citigroup calls for a $1070 average for 2016, as analysts there seem to think that the global growth fears are overdone. In addition to this retraction from the flight-to-safety, the U.S. dollar and price of gold are negatively correlated, for if gold is itself a stable asset, its price rises and falls based on the currency of one's country. If the USD thus returns to its strengthening path with Eurozone/United States policy divergence, this downward price target would likely be realized.
Why the Global Meltdown Doesn't Matter
It's taken quite a bit of explanation to get to this ending, so hopefully you have borne with my musings. It is a setting where the USD is strengthening, commodities are weak, global growth and inflation are negligible, and fiscal policy is tightening that we find ourselves awash in volatility. Confronted with these serious considerations, should you be in the stock market at all?
The short answer is yes, if you have a long-enough timeline. Long-term gains in the equity markets far outweigh those in the bond markets. The caveat to this yes is that not all stocks are created equal.
Growth stocks with outrageous projections to the future (Tesla) are among those hit hardest by the sell-off in equity markets, along with those with substantial debt/equity ratios. The dream can only carry you so far until investors lose patience and need to see earnings (instead of 87 cent/share losses). Of course, you can still announce a partnership of with a company in which you are a 22% shareholder, and that might stop the bleeding...
Apologies for the digression, but the point of the matter is now is the time to reconsider your portfolio. If you got caught up in the "noise" surrounding a stock and not its realistic potential compared to current valuation, you might want to consider getting out. Consider establishing positions in companies with strong balance sheets and little debt. Look at earnings histories and projections anchored on facts and conservative estimations. Have a mind to current valuations and macro-economic tailwinds. In short, find value, not stories.
Like many right now, I view the tumult in the equity market as a long-term positive, a healthy correction after extraordinarily accommodative monetary policy. Don't lose sight of the importance of that correction, or how it changes the playing-field. Understand, consider, invest for the future.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.