Currency Market Reflects Global Economic Stability

Summary

• After last year's global economic scare, 2019 looks to be a better year.
• U.S. dollar and other currencies reflect stability for world economy.
• Yuan strength also suggests a U.S.-China trade war truce lies ahead.

A periodic review of the world’s leading currencies can be instructive for equity investors as well as currency traders, for it tends to reveal what the market thinks about the intermediate-term (3-9 month) global economic outlook. The turmoil experienced by the emerging markets in 2018 was indeed adequately reflected in the strength of the U.S. dollar and the corresponding weakness in other major currencies.

With that in mind, we’ll take a look at the leading currencies in today’s report as we review the major trends. As I’ll argue here, the overall “big picture” message of the currency market is that last year’s fears of a global economic slowdown have diminished, and investors are now expecting brighter prospects for growth in 2019.

Last year’s major setback to the global economy was underscored by falling prices for stocks in China and the emerging market countries. This was perhaps nowhere more visible than in the iShares MSCI Emerging Markets ETF (EEM), which many observers use as a benchmark for emerging market equities. Shown here is the past year’s performance in EEM along with its 50-day moving average. As you can see here, EEM spent the bulk of 2018 trending below its 50-day MA. This weakness in the EM equity markets served as a partial catalyst to the volatility in the U.S. stock market later in the year.

Source: BigCharts

Even more than the equity market, however, the currencies of some of the largest emerging nations displayed significant weakness and revealed the political and monetary problems which threatened the growth of these developing economies. For instance, as one of the leading emerging nations, Brazil experienced a great deal of volatility in the first nine months of last year. Brazil’s GDP grew by just 1% in 2017 and was just slightly higher in 2018. Economists had previously anticipated a stronger recovery for Brazil in 2018, which in part fueled the decline in its equity market. Shown below is a chart displaying the last nine years of Brazil's GDP growth.

Source: World Bank

An even bigger reflection of a country’s economic strength, however, is the strength or weakness in its currency. For Brazil, the Real currency told the story of last year’s disappointing economic performance. Shown here is the WisdomTree Brazilian Real Strategy Fund (BZF), which can be used as a proxy for the currency. The steep plunge in the Real’s value between March and September is reflected in this chart.

Source: BigCharts

The Real currency has since bottomed and launched a recovery since September, however, and this also reflects the improved economic outlook for Brazil based partly on its new business-friendly government. What’s more, the improvement in the Real since last fall suggests that a measure of stability has returned to its commodity-dependent economy. As China and the other major emerging nations have seen their intermediate-term outlooks improve, the demand for commodities should increase in 2019. This in turn should boost Brazil’s economy further, which is evidently being anticipated by the Real.

Another sign that the global economy is on the mend can be seen in the following graph. In a recent blog, economist Scott Grannis discussed the relative strength of industrial metals prices versus the U.S. dollar. This graph shows that commodity prices have been remarkably strong despite the recent strength in the dollar.

Source: Calafia Beach Pundit

Commenting on this strong performance, Grannis wrote:

This suggests to me that the global economy is, and remains in, fairly good shape. It also is evidence that the Fed is not so tight as to artificially push up the value of the dollar. The dollar is relatively strong not because money is tight, but because the outlook for the U.S. economy is better than that for most other major economies, and that's a good thing.”

While we’re on the subject of the dollar, shown below is the U.S. dollar index (DXY). As you can see here, the dollar index remains well under its highs from two years ago despite its recent rally. This graph is a picture of stability, for it shows the dollar to be neither too strong nor too weak relative to its long-term average. As such, it suggests a U.S. economy that isn’t too hot, nor too cold, and therefore ideal for economic growth in the coming months.

Source: BigCharts

The stability reflected in the U.S. dollar also has bullish implications for the global economy, for a stable dollar means natural resource-dependent emerging countries won’t have to worry about lower commodity prices anytime soon. A significantly stronger dollar would put downward pressure on commodities, which is what has triggered past crises in the emerging markets.

China’s currency, moreover, reflects a similar level of stability. Shown here is the WisdomTree Chinese Yuan Strategy Fund (CYB), a yuan proxy which is also one of the single most important charts for evaluating China’s economic strength. Some observers, including Grannis, believe that the yuan’s latest rise is a sign that the market believes a resolution to the U.S.-China trade war is likely to be made.

Source: BigCharts

A final observation worth mentioning is that safe-haven currencies such as the Japanese yen and the Swiss franc aren’t reflecting extremely high levels of investor concern. If far-sighted participants truly believed the global economy was in any danger this year, surely, the yen and franc would now be in a sustained rally mode. Instead, the yen and the Swiss franc are showing no such urgency among currency traders. Shown here for illustrative purposes is the Invesco CurrencyShares Swiss Franc Trust (FXF). As you can see, FXF is near a two-year low and hasn’t had a meaningful rally since last summer when fears of a global economic slowdown reached fever pitch.

Source: BigCharts

In conclusion, the combined message of the major currencies is one of economic stability. This stability is in contrast to last year’s abnormal volatility, and now that the emerging market outlook has improved, we should see a time of restoration for the world’s equity markets. In light of this bullish outlook, investors should be overweight U.S. stocks with some exposure to the emerging markets via the iShares MSCI Emerging Markets ETF. Investors should also remain optimistic that a trade truce between the U.S. and China will be made this year. This more than perhaps any other factor would fuel a major rebound of the world economy and ensure an even more bullish outlook for equities.

Disclosure: I am/we are long SPHQ, IAU, XLE. 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.