The end of US equity outperformance
In April 2008, the USD weakness in real terms that started in February 2002 ended months before a historical credit crunch and tailspin that required astronomical policy effort to mitigate. Since then, the USD has strengthened by 22% in real terms. And in August 2019, it reached a high enough level for the US Treasury Secretary Steve Mnuchin to declare that the US government does not intend to intervene in the USD for now — although he also said that the Trump administration had weighed up intervention. In other words, the US is planning to intervene if the Fed does not manage to weaken the USD through monetary policy.
This quarterly outlook examines how this situation will impact equity markets.
Emerging markets will thrive on weaker USD
The Fed uses the trade-weighted broad USD index to measure how strong the USD is relative to its trade partners’ currencies.
Over the period from July 1995 to August 2019, equity returns in the US, the world ex-US and emerging markets have had a negative correlation to the USD. In other words, whenever the USD weakens equity markets should strengthen. As the world’s reserve currency, largest trading currency and the currency used in commodity markets, the USD is an important component in financial conditions. Since the 2008 crash, emerging market countries have seen a large increase in issuance of USD bonds which has added another growth constraint from the USD.
If we break the period into regimes of stronger or weaker real USD, then a clear pattern appears. Whenever the USD strengthens, the US equity market outperforms the world ex-US and emerging markets and vice versa. As explained in our Quarterly Outlook, some form of USD intervention is the next logical policy step. Monetary policy has lost its effectiveness and fiscal stimulus is coming to slowly to offset the weakness in the global economy (the OECD’s leading indicators have been declining for 18 straight months). A great irony of any USD intervention is that it will partly help China, which is not exactly the strategy of the Trump administration but as with everything in life there are always trade-offs.
When the strong USD regime ends, investors should overweight European and especially emerging market equities. There is also good support for this strategic position from a valuation perspective as the valuation spread — measured on the dividend yield — has soared to historically attractive levels for the world ex-US and emerging markets.
US equities have had a historical run
As we have been writing over many quarters, US equities are expensive in both relative and absolute terms. They remain expensive due to multiple factors ranging from higher share of buybacks, safe-haven status, higher profit growth driven by technology monopolies and finally a healed financial sector. Valuation metrics are difficult to use as timing tools because the market can often remain insane for long periods and maybe we are going through such a period. But rich valuation premiums to other equity markets are typically not a good starting point for relative superior returns in the future.
In February 2019, equity markets celebrated the 10-year anniversary of the equity market bottom during the financial crisis. The celebration occurred with a historic equity outperformance over aggregate US government bonds of 339% or 16% annualised. This is one of the best 10-year periods for US equities relative to government bonds since 1973, only marginally topped by the dot-com peak. It is quite likely that the next 10 years will not offer attractive equity returns in terms of outperformance and especially not when factoring in the downside risk relative to upside risk.
Stronghold EUR is not in panic mode yet
Our team’s tactical asset allocation strategy, Stronghold, went online during the summer on our trading platforms through Saxo Bank’s managed portfolio service SaxoSelect. The model behind Stronghold is based on a pure mathematical framework aimed at reducing drawdowns while trying to maximise returns. The model has a strict risk budget and therefore cuts risk quickly if the market structure become highly correlated across asset classes.
The EUR version of the model is up 10.6% as of mid-September and increased exposure in equities slowly over the first half of the year. But in the last three months, its equity exposure has been reduced to around 40% with the main exposure in minimum volatility stocks. The portfolio is balanced as of September also reflecting our general stance to clients. Remain invested in equities but in high quality and minimum volatility stocks. Investors attempting to escape low yields with pure equity exposure are running portfolios that are at risk to policy mistakes and a potential global recession — which has a probability of around 25-40% within the next 6-12 months.
Outrageous Predictions 2023: The War Economy
- The constantly growing global need for energy drives the world's richest to huddle up and launch a R&D project in a size the world hasn't seen since the Manhattan Project gave the US the first atomic bomb.
French President Macron resignsThe political stalemate in France and the rise of Marie Le Pen following the 2022 elections corners President Macron, forcing him to give up on politics and resign from his position. At least for now.
Gold rockets to USD 3,000 as central banks fail on inflation mandateAs markets and central banks realise that the idea that inflation is transitory is wrong, and that prices will remain higher for longer, gold is sent through the roof, hitting a price tag of USD 3,000
EU Army forces EU down path to full unionWith continued challenges in the region and a US military that isn't aggressively enacting its former role as global policeman, the European Union agrees to create its own armed forces, bringing the whole region closer.
A country agrees to ban all meat production by 2030In an effort to become one of the global leaders on the path to net-zero emissions, one country decides to not only put a heavy tax on meat, but to ban domestic production entirely.
UK holds UnBrexit referendumFollowing a recession and domestic pressure, the United Kingdom is thrown into political turmoil that will end with a vote to wind back Brexit.
Widespread price controls are introduced to cap official inflationHistory tells us that with the war economy comes rationing and price controls. And this time is no different, as policymakers introduce strict price controls that lead to a range of unintended consequences.
OPEC+ & Chindia walk out of the IMF, agree to trade with new reserve assetSanctions against Russia have caused widespread turmoil due to US Dollar moves in countries across the globe that don't consider the US an ally. To relieve themselves from this, they leave the IMF and create a new reserve asset.
USDJPY fixed to the USD at 200 as Japan overhauls financial systemFollowing the challenges that faced the Japanese Yen in 2022, the Bank of Japan attempts to keep the currency from sliding. Unsuccessful on the long-term, Japan will launch a reset of its entire financial system.
Tax haven ban kills private equityWith the war economy comes an increased focus on national interests and sovereign nations' ability to assert themselves. In that regard, the OECD countries turn their attention on tax havens and pull the big guns out, banning them altogether.