One week / one topic: Confidence cracks

What happened?

As perilous as it sounds to say so, major asset classes are implying very different market views.

While equities remain optimistically attuned to every twist-and-turn announcement about trade negotiations and government bonds are seemingly discounting the implications of continued (or forced, in case of a recession) fiscal largesse, the FX market is the most puzzling at the moment.

And yet, it might also be the source of the highest-quality signal…

Currencies move in mysterious ways even by markets standards – they are ultimately made-up things conjured out of thin air – but, most of the time, interest rate differentials remain a useful gauge as investors tend to prefer owning currencies that pay higher interest.

As of late, this relationship has however completely broken down for the US dollar.

President Trump’s announcements represent a strong – dare we say, historic – discontinuity with the Pax Americana / Washington consensus doctrine of yore.

Investors were caught off-guard and massively overweight US assets, and now the talk of the town is about the need to shift capital outside of the US.

While this might well be behind its recent sharp move lower, the Dollar remains quite expensive through any sort of long-term valuation lens.

Looking at Gold and Bitcoin for what they are not (i.e. fiat currencies), it is also clear that confidence in the value of the US Dollar has been going down for a while.

In the 54 years since the Nixon shock, the Dollar has lost ~99% of its purchasing power vs gold – or about 9% per annum. (2% inflation target, anyone?)

Meanwhile, the only thing that opposed political sides seem to agree on is ‘more borrowing’, plus now you have a President openly threatening to fire the Fed Chairman… no wonder confidence is shot.

But what are the implications for portfolios, right here and right now?

Our observations

• Fundamentals: If belief in ‘US exceptionalism’ has indeed crumbled, the still-elevated valuation picture suggests that there is room for significantly more downside… but that’s a big “if”.

• Price action: To contextualize recent moves, historically we’ve seen falls of 25-30% in the Dollar when starting from similar valuations levels in the mid-1980s and early 2000s.

• Investor beliefs: Once you say certain things, it is virtually impossible to put the genie back in the bottle… short-term gyrations might well be upwards, but to some extent the damage is done.

So what?

While trying to resist the temptation to pontificate about currency debasement, the downfall of empires and the lot, there seem to be at least a couple of valuable observations to be made.

First, the scale of inflows into US assets over the last 10+ years was massive.

It seems reasonable to imagine that – if investors no longer want to invest so much capital in the US anymore – it will take quite some time to reverse.

If that’s the case, it could well be a tradeable phenomenon for more nimble players.

Second, Emerging Markets (EM) currencies now also look more attractive.

While you’ve always had interest rate differentials on your side (as investors demand higher compensation to own assets denominated in these currencies), the Dollar is now less appealing on the other side of the equation.

As we retain conviction in EM bonds as an attractive source of potential returns – and since most EM yield curves are now upward-sloping – we are then actively considering to pursue higher available yields by investing in longer-maturity bonds.

Mood music: Pink Floyd – Wish You Were Here