Stay Patient Against the Consensus Trade of 2015
Investors in search of long-term opportunities should consider looking outside the U.S.
SUMMARY
- After a short but strong run, we think that the U.S. dollar’s appreciation cannot continue forever at its recent pace.
- The U.S. dollar’s strength has us looking outside the U.S. for longer-term opportunities – ones that may require patience from investors.
- We think opportunity exists in currencies of countries that are economically competitive or that have the political will to enact important reforms.
The most crowded trade we see today is the rising U.S. dollar – it appears that most investors believe it is a one-way bet in 2015. As contrarian investors, consensus trades like this pique our interest. While a strong U.S. dollar may be a key investment theme for many macro investors, we think this appreciation is creating longer-term opportunities outside the U.S., both in the developed world as well as select emerging markets.
Despite its near-term strength, we do not believe the U.S. dollar will continue to rise at its recent pace. Instead, we believe that there could be some reversion to the mean and, as a result, we are cautiously optimistic about non-U.S. currency risk. In this Insight, we look at the causes of the U.S. dollar’s recent strength and where opportunities in currencies and countries are developing.
Why has the US dollar rally been so strong?
The U.S. dollar (as measured by the U.S. Dollar Index, or DXY) rallied 13.1% in the second half of 2014 and another 7.8% in the first quarter of 2015. In the past year, the DXY rapidly increased from one standard deviation below the 25-year average to nearly one standard deviation above the same average (Exhibit A). To put that move higher in context, it is of the same magnitude as we saw during the financial crisis in late 2008, only without the crisis.
The divergence in policies between the Federal Reserve (Fed) and other central banks explains the recent rapid appreciation in the DXY. Indeed, many other economies are growing slower relative to the U.S. To help boost growth, the European Central Bank (ECB) has adopted a similar quantitative easing (QE) program to the one the Fed employed over the past several years. As a result, yields in many European countries have continued to decline.
What are the effects of the strong U.S. dollar?
As the U.S. dollar has rapidly appreciated over the past year, we have seen corrections in both emerging markets and in commodity-producing countries. From our perspective, corrections of this nature historically tend to overshoot to the downside, creating selective opportunities. This is analogous to what we’ve seen in the commodity market recently; we believe the collapse in oil prices overran to the downside, creating attractive investment opportunities.
What might cause the US dollar to revert back to mean?
QE worked in the U.S. to weaken the U.S. dollar and eventually improve the economy; this fueled the dollar’s recent appreciation. We think there will be a similar result in Europe. The euro has weakened against the U.S. dollar, and we are starting to see preliminary signs of growth picking up in Europe. Additionally, we think expectations of a Fed rate hike are well-embedded in market expectations, even if the exact timing is still uncertain. Taken together, the recently improved European growth outlook and our belief that tighter Fed policy is mostly priced in suggests that the bulk of the dollar’s move higher is complete.
While the developed-market growth outlook has improved recently, emerging-market (EM) growth has been lackluster. As a result, many EM central banks have eased monetary policy and EM currencies have weakened considerably against the U.S. dollar. With the Fed likely to raise rates later this year and inflation likely to firm in most countries in the second half of the year, we think that most EM central bank easing cycles are close to ending. That combined with the fact that growth in EM countries is still outpacing growth in developed markets (Exhibit B) suggests that much of the correction that has taken place in EM currencies may largely be over.
How should investors consider positioning their portfolios?
Rather than assume broad exposure to emerging-market countries, we think it is more important to consider differentiation and finding select opportunities in emerging markets.
While competitive advantages are important, we think investors also need to consider the appetites countries have in enacting reforms. The financial crisis in 2008 taught us that politics trump all when growth is absent. Politics have become an important factor in the investment decision-making process, and it can help us to distinguish between governments and economies.
A few examples may help illustrate the importance of judging both competitive advantages of countries as well as their resolve to enact reforms. The Mexican peso saw a sharp depreciation last year due to concerns over slowing global growth. However, as a big trade partner with the U.S., we believe the decline in the peso presents an opportunity. In the past few years, Mexico has enacted tough reforms to help its sluggish economy. These included changes that liberalized the country’s energy sector and shook up the telecom and broadcasting industries.
India is another prime example where recent reforms are creating a potential investment opportunity. In addition to advantages the country has in services, India has enacted or is working to enact several reforms that aim to:
- Ease doing business, increase foreign investment and boost the country’s long-run growth potential.
- Increase central bank independence and credibility by establishing a formal inflation target and monetary policy committee.
- Implement a single unified goods and service tax (GST) rate across the country to replace varied tax rates and regulations currently in place.
Brazil hasn’t made as much reform progress as Mexico or India, but we expect a recent shift to more prudent and orthodox fiscal and monetary policy to bear positive results soon. In particular, recent public finance reform via revenue and spending adjustment is forecast to return the public sector’s primary balance to surplus after its first deficit since 1997 last year.
Of course, we do not have a positive view for all EM countries. In other cases, we have concerns about economic competitiveness or politics; notable among these names are Ukraine, Russia, South Africa and Turkey. This is where the experience and expertise of an investment manager can be helpful in discerning where opportunities may be overseas.
Consider commodity-rich developed markets, too
In addition to EM countries, we think there is value in select developed-market countries. As we detailed earlier, when growth does ramp up in Europe, we think the euro could appreciate against the U.S. dollar. We also think developed countries with strong growth momentum and ties to soft commodities are worth consideration. For example, we think New Zealand fits the mold of a commodity-rich country where the currency’s correction may be done.
Over the past year, the New Zealand dollar has fallen more than 18% peak to trough. However, we view several positive underpinnings for growth in the country. New Zealand has a competitive advantage when it comes to agriculture and soft commodities. Fundamentally, we think New Zealand’s terms of trade are attractive; the country imports its oil and exports the soft commodities, such as butter, cheese and meat. We also note that construction in the country has helped support growth in the economy.
Stay patient against the consensus trade
We believe in an investment strategy where the strength is buying when the masses are selling. With a multisector bond strategy that seeks to act opportunistically, we prefer to question what the consensus is missing rather than chase returns. We believe this is where the best returns and values are to be found in the markets.
We think investors should consider examining areas the market may be undervaluing, including emerging-market currencies. The key will be to maintain a long-term perspective. When making moves that are against a crowded trade, we think it pays to be a patient investor. Our normal time horizon is two to five years, not two to five weeks or months.
Multisector strategies are designed to take advantage of opportunities that arise in periods of increased short-term market dislocations, such as what we’re witnessing with the move in the U.S. dollar. An experienced manager with the proper expertise, long-term perspective and patience may be able to capitalize on these opportunities.
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