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One reason markets tend to get a little nervous in September is that its
time for investors to ponder about their asset allocation for the remainder of
the year and beyond. With the markets at or near record highs and the US
dollar on a roll, what could possibly go wrong? Lets look at whats next
for the dollar, gold, and currencies.
A couple of highlights:
- Equity markets are at or near record highs;
- Measures of complacency are near record levels (for
example, the VIX index, a measure of implied stock market volatility, is
near historical lows).
- 10 Year U.S. Treasuries are yielding around 2.4%, near
record lows.
The theory is that with the U.S. pulling ahead, the greenback must
win. A couple of caveats to this theory:
- The U.S. recovery might not be as healthy as it appears:
the housing market remains vulnerable; many retailers have challenges;
inventory stuffing might be happening at some tech firms; and how can
the U.S. recover when Europe and parts of emerging markets are slowing
down?
- U.S. real interest rates are increasingly more negative
than Eurozone real interest rates. With the Fed all but promising to be
late in raising rates, odds are that the differential will increase. In
this context, the notion of an exit appears absurd.
- There is no historical correlation between a rising
interest rate environment and a stronger dollar. Thats because U.S.
Treasuries might lose in value as rates rise, providing a disincentive
for foreigners to hold the greenback.
- In our analysis, the Feds actions have made risky
assets appear, well, less risky, causing everything from stock prices to
junk bonds to be more expensive. This is referred to as a compression of
risk premia. We go as far as arguing that our recovery is based on asset
price inflation. As such, should the Fed truly pursue an exit, risk
premia might expand once again, putting not only asset prices, but the
entire recovery at risk. As a result, we have warned investors about a
potential crash.
Yet, its clear that the euro has been underperforming of late. Why? In
our assessment, the euros weakness is not due to interest rate
differentials, not because of monetary policy. Instead, the tit-for-tat
sanctions between Russia and the European Union are causing a serious blow to
both confidence and economic activity. As an investor, you might say you
dont care why a particular security or currency is down, but it does matter
in terms of assessing the outlook more broadly. Market participants scream
for more easy money from the European Central Bank (ECB), but printing money
wont ease tensions with Russia. In recent years in particular, a lot of
emphasis has been on the ECB, as the ECB is the one body in Europe that can
decisively act. But while we will mince every word of ECB head Draghi, we
might be watching the wrong spectacle.
There have always been loud euro bears. The euro bulls, yours truly
included, have held the upper hand while pointing out how ineffective
monetary policy is in weakening the euro. But when other factors i.e., the
Ukrainian crisis set the tone, the euro bulls are stepping aside, allowing
the bears to pile in. And boy have they piled in, with short positions the
largest since the peak of the Eurozone debt crisis. That in and of itself
can, of course, create the dynamics for a bounce back in the euro. But for
the euro to resume its ascent, the Ukrainian crisis must be resolved. And
thats a challenge, as Russias President Putin might have an interest in
perpetual instability in the region. The situation isnt helped by the fact
that Europe historically outsources its foreign policy to the U.S., with a
U.S. President that takes what looks to be a more European approach to
foreign policy. The only good news is that markets tend to get used to
any environment. In the short-term, though, the euro appears to be bouncing
around based on a mix of rumors and action coming out of Russia and Ukraine.
Like everything else in Europe, the process is a messy one. Incidentally,
Putin understands Europe much better than Europe understands Russia. For him,
sanctions may be a low price to pay to re-assert Russias influence over
Eastern Ukraine.
And why is gold down if geopolitical tensions are high and rising interest
rates arent real (pardon the pun in a negative real interest rate
environment)?. Well, as of this writing, even with recent drops in the price
of gold, the shiny metal is up over 5.5% in dollar terms year-to-date. We can
pick other horizons over which it is down (such as over the past 12 months)
and yet others over which it is up. We dont like to buy gold because of
geopolitical tensions, as such tensions more often than not tend to be
short-lived. We like gold long-term because we dont think we can afford
positive real interest rates. A Newport Beach based portfolio manager places
interest rates in the new normal environment at about 2%. We sympathize
with that view, but would like to add that this may well mean that we will
live in a persistent state of financial repression, meaning real interest
rates may be negative as far as the eye can see. For those more inclined to
look at the short to medium term, lets keep in mind that many of
speculators in gold have been shaken out of the market and would like to
argue that the remaining holders of gold are reasonably strong hands
these days, i.e., those buying gold actually like gold. Thats in stark
contrast to buyers of many other assets, including the S&P, where buyers
merely buy the stock market to keep up. On the Nasdaq in particular we have
started to see some excesses that are rather reminiscent of the dot-com
bubble.
So which currency should you invest in? Some might say the Swiss franc, as
the Swiss are conveniently not joining sanctions against Russia; Swiss cheese
exports are surging as Russians love foreign cheese, but cant get French or
other European cheeses anymore (no offense meant, but they dont miss
American cheese). Indeed, the Swiss franc has outperformed the Euro of late.
But lets not forget that the Swiss National Bank has put in a ceiling on
the Swiss franc versus the Euro; betting against that might be an uphill
battle.
Instead, we have long suggested investors look a little bit off the main
stage, notably Australia. Many wrote off Australia as a tumbling mining
sector and a threat of a Chinese hard landing, amongst others, caused
headwinds to the Australian dollar. But as happens all too often, thats
exactly where there is value to be found. In the major currency space, the
Australian dollar is the best performing currency year-to-date. And while the
Chinese Yuan is down year-to-date, its only behind the Brazilian Real in
the emerging market space over the past three months.
On Tuesday, September 16, 2014, please join me for a fireside chat.
We will make most of the hour available for you to ask questions. Please register
to participate. We no longer record our webinars (the regulatory overhead is
too much hassle), so join live to get answers to the questions you always
wanted to ask.
If you havent done so, also make sure you sign up for Merk
Insights. If you believe this analysis might be of value to your friends,
please share it on your favorite social media site.
Axel Merk
Axel Merk is President and Chief Investment Officer, Merk Investments,
Manager of the Merk Funds.
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