All About the Benjamins
Global imbalances are growing ever more intense, and that’s visible most clearly in the incredible strength of the US dollar. It’s becoming quite extraordinary.
To see the strength of its upward trend, look at how the dollar index (comparing the US currency to a few of its biggest developed-market peers, led by the euro and Japanese yen) is performing compared to its own 200-day moving average, a widely accepted measure of the long-term trend. Only once before in this century has the dollar been so far ahead, and that was in 2015 as foreign exchange markets adjusted to the epic fall in the oil price that had started the previous year:
Everywhere the dollar’s power is apparent. Against the currencies of two major Asian exporters, Japan and South Korea, the dollar has now almost topped its extreme from 1998, set in the aftermath of the Asian financial crisis. Korea’s won is still far stronger than during its disastrous devaluation in 1997 — but has still sold off to its lowest level since the Global Financial Crisis of 2008:
Will this provoke a response from central banks? The yen is nearing the point where the Bank of Japan might decide to act. The following chart is from Mansoor Mohi-uddin, chief economist at the Bank of Singapore Ltd.:
The yen is now very close to its level the last time the BOJ intervened to strengthen it (there were several interventions to weaken it, especially in the wake of the GFC). The market is testing the central bank’s resolve to avoid such a move, and also its determination to continue with yield curve control (intervening to keep 10-year bond yields low) at a time when everyone else is tightening. This could vitiate any attempts to strengthen the yen. Mohi-uddin offers this lesson from the last time the yen was this weak:
In 1998, the JPY plunged as local banks struggled to recover from the bursting of Japan’s 1980s bubble and the worsening Asian Financial Crisis kept the BOJ dovish. The USD was also supported by the hawkish Fed keeping its fed funds interest rate high at 5.50% to counter inflation. In response, the Bank of Japan, on behalf of the Ministry of Finance, intervened to defend the JPY by selling USDs. But the action was unsuccessful. The USD rose to 147-148 and only peaked when Russia defaulted on its bonds. The shock forced hedge funds to cover their losses in Russia by unwinding their profitable JPY shorts, causing the USD to tumble and to end the year around 115 against Japan’s currency. In 2022, the JPY is set to plunge again towards its 1998 lows of 147-148 unless a shock makes the Fed or the BOJ shift stance.
Even direct intervention didn’t work — the key was the global economic framework. As the BOJ knows that intervention won’t achieve much if it stays dovish while the Fed is hawkish, the odds are that it tries to ride out the storm. The risk named by Mohi-uddin and other strategists is that there will be nothing to stop speculators pushing the yen even further down — and strengthening the dollar still further in the process.
Then of course there is the euro, which has recently dropped below parity to the dollar for the first time in two decades. With the European Central Bank meeting due shortly after you receive this newsletter, note that the difference in real yields between the US and eurozone appears to drive the dollar’s gains. The correlation between the growing disparity in the US’ favor, and the strength of the dollar, is glaring:
But in the case of Europe, it’s possibly misleading to attribute this to the interplay between different central banks. Instead, the driving force, as ever, is the war between Russia and Ukraine and the differential effect this has on European and US energy prices. This energy shock has played out very differently from all predecessors by afflicting Europe far worse than the US. Usually, the dollar has a direct inverse relationship with the oil price, which is natural as all oil transactions are denominated in dollars. The oil crash after OPEC discipline broke down in 2014 was directly matched by a strengthening dollar. This time around, the dollar has strengthened even as the energy prices have risen. The reversal of the relationship over the last 12 months is nothing short of astonishing:
Alan Ruskin, veteran foreign exchange strategist at Deutsche Bank AG, points out that the dollar’s run is less about central banks, and more about the energy price shock on European fundamentals. Indeed, the impact on the eurozone’s current account has been so severe that he suggests that the euro is doing well still to be hovering around parity, rather than weakening further:
A global energy shock has transmitted itself in unique ways to the EUR vs US economy. These differences are also reflected in the S&P’s outperformance vs the DAX by ~10% over the same period. In addition, the energy shocks have added very significantly to EUR balance of payments risks as EUR area’s Current Account shifts from large surplus to deficit, while reducing relative real return dramatically. By that notion, the EUR still tracking in sight of parity is a EUR resilient result.
The ECB is of course aware of these solemn developments for the European economy and their likely consequences for growth. It’s also aware that inflation has taken hold in a way never seen since the introduction of the euro in 1999:
Unlike the Fed, the ECB is mandated solely to fight inflation, and not worry about growth. That means, according to Morgane Delledonne, head of investment strategy for Europe at Global X ETFs, that the meeting is bound to be hawkish:
Now the question is whether we have a 50-basis-point rate hike with the hawkish press conference or a 75-basis-point rate hike with the data-dependent more neutral tone. I think that the debate is there. Over the last month, yes, the ECB will have taken into account that we had an upside surprise from inflation and a downside surprise on gas supply from Russia with energy prices continuing to rise. These conditions point to a hawkish meeting. But the positive news I think is that it appears that Russia may have exhausted its economic leverage through gas cuts now. The latest GDP estimate update for Q2 was quite reassuring. When you look at the economic data, you have some resilience across Europe, if you take Germany aside. So I think the meeting will not create much of volatility even if it’s a hawkish meeting. And I think the main outcome would be a strengthened euro.
The key here is that the ECB is viewed as a captive of the unfurling drama over energy prices. The eurozone wants to cut energy consumption by 15%, which already more or less guarantees less growth. The central bank can do nothing about that. If energy prices keep rising, they will have much the same impact as a big fiscal shock, such as a tax hike. That would undermine the euro — even if the ECB does its bit to narrow the gap between yields in Europe and the US. In recent days, oil has been falling, thanks largely to pessimism about demand. News of another Covid lockdown in the Chinese megacity of Chengdu reinforces the risks to growth.
That oil price fall is directly helpful to the US, where gasoline prices are politically very important and are now almost back to their level before the Ukraine invasion. For Germany and the rest of the eurozone, cheaper oil helps much less because of the critical problem of natural gas supply. The ECB needs to do its job and fight inflation, but between the power of the dollar and the momentous struggle over gas pipelines, it appears to have been rendered oddly unimportant for now.
Now More Than Ever, It’s All About Tech
It’s been a tumultuous period for US equities the past few weeks, with many resorting to technical analysis to navigate the market. After a rally that some labeled a new bull market, optimism seemed to fizzle out when the S&P 500 failed to break through its 200-day moving average on Aug. 16.
Since then, the benchmark index has slumped around 16% for the year. It doesn’t help that September, a notoriously volatile month, might see the index retest its June low ahead of multiple macroeconomic events, from the Federal Reserve September meeting to the monthly Consumer Price Index data.
The culprit behind the broader rout? Tech stocks no doubt. The uptrend in US equities broke down due in part to the capitulation of mega-cap tech shares, according to Jim Paulsen, chief investment officer at the Leuthold Group. The sector has had an unparalleled impact on the overall performance of US equities, if nearly 100 years of history are any guide. We wrote about the trend Paulsen observed on Aug. 10. He analyzed data since 1926 and found that the S&P 500 only outperforms when the tech sector does so as well. And just as he might have predicted, the market selloff since then has been accompanied by sharp underperformance by tech stocks. Broader markets have moved in lockstep with the sector since the beginning of this year.
Why tech stocks are going through a beating isn’t difficult to explain. These companies are prone to fears of rising interest rates, especially since many of them are valued based on their projected profits far into the future. And as the Fed launches its most aggressive tightening monetary policy in decades and as yields rise, the future profits of tech firms will be worth far less.
Even Wednesday’s launch of a new line of iPhones by Apple Inc. did little to boost the sector. Shares of Apple, which comprises 13% of the tech-heavy Nasdaq 100, barely budged on a strong day for the broader market, gaining 0.9% to remain some 12% down for the year. But a tepid initial response to an Apple launch hasn’t been unusual in the post-Steve Jobs era. Bloomberg’s Subrat Patnaik reported that the stock has fallen seven times on the day the company has launched a model in the past decade. However, that was usually followed by a rebound over the months after the event; such a respite did not come after either of the last two iPhone announcements:
Why does tech still matter so much? According to Delledonne:
The fact now tech seems to take so much in the market is just a reflection of the underlying economy. We are going through digitization at a rapid pace and this energy crisis just increased the pace of digitizing … even with increased interest rates, companies should continue to weather higher rates more. I would say what we are seeing in the tech market is more driven by sentiment than actually real fundamentals.
That said, plenty of Wall Streeters are worried about the fundamentals, particularly corporate earnings. Among them is Morgan Stanley strategist Michael Wilson, who cut his expectations for earnings-per-share growth for the year. A slowing economy, he says, will likely be a bigger concern for stocks rather than red-hot inflation and a hawkish Fed. Earnings will be more important still. In fact, he expects earnings to fall 3% next year even if a recession is avoided.
A nuanced view for sure. But here’s Paulsen again offering a sliver of hope for US investors:
Although technology stocks have led the rout lower, the recent pullback has ‘strong undertones’… On a relative basis, many sectors that normally do best in bull markets — cyclical stocks, high-beta, low-quality, and small/mid-cap stocks — have shown remarkable resilience in the latest downswing and fared far better compared to earlier air-pockets this year… We are hopeful a ‘pullback with strong leadership undertones’ suggests the current market stumble may soon regain its footing and perhaps provide investors with an overdue year-end upside surprise?
And Paulsen is indeed right that small companies are performing relatively much better in this downward wave than in previous selloffs. The Russell 1000 index of large-cap stocks has barely beaten the Russell 2000 small-cap index for this year — although that is in part because of the poor performance of the mega-cap tech stocks:
Even if tech stocks are failing to lead, on Paulsen’s argument, the market’s internal behavior is still consistent with an ongoing rally. As we said about his first piece on tech stocks last month, let’s hope he’s right.
— Isabelle Lee
If you want a great comedy that will delight all the family, I’ve just caught up with a gem from 2007 called Hot Fuzz. Starring Simon Pegg, it features even more British character actors than the average Harry Potter movie. The premise is to parody and lampoon standard US action movies. What would happen if a classic cops movie played out in a sleepy, rural town? “Hot Fuzz” has the answer. Without giving away too much of the plot, this is the final shootout. It’s really good. More From Other Writers at Bloomberg Opinion:
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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
John Authers is a senior editor for markets and Bloomberg Opinion columnist. A former chief markets commentator and editor of the Lex column at the Financial Times, he is author of “The Fearful Rise of Markets.”
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