This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article features Tyler Mordy, president and chief investment officer of Toronto-based Forstrong Global.
German philosopher Arthur Schopenhauer once observed that every truth passes through three stages before it is recognized: “In the first it is ridiculed; in the second it is opposed; in the third it is regarded as self-evident.”
Bull markets follow a similar evolution. In the early phase, nonconsensus ideas are swiftly dismissed as fringe-dwelling lunacy. But, slowly over time, roots grow on tiny seeds of skepticism, scale along a trellis of complacency and, finally, bloom into full-scale, radiant bull markets. Suddenly, investors wake up to discover the world has changed.
The Healthy Dollar
Consider the U.S. dollar’s recent path. Those not prone to revisionist history will marvel at the transformation in popular perception.
In the aftermath of the global financial crisis, it was almost universally believed that the largesse of central bank responses (with the Fed as the leading monetary polluter) would create high and sustained inflation, simultaneously hammering the value of the dollar. A persistent flood of ink was spilled warning of the coming “death of the dollar.”
While investors luxuriated in the polemics of many well-known bears, money poured into commodity products (not least, resource-tracking ETFs) and other inflation-fighting assets. Clearly, that was not a winning strategy. Inflation has remained stubbornly low and the dollar has been on an unstoppable seven-year rise.
The Dollar’s ‘Self-Evident’ Stage
But all of that is history. Now, perceptions of the U.S. dollar are firmly in Schopenhauer’s third, “self-evident” stage. Being long dollars has become an extremely comfortable consensus.
We, too, have been in this cozy camp. Since 2008, we have argued that post-financial crisis periods typically produce a chronically strong senior currency (in today’s world, the U.S. remains the monetary hegemon). Investors, still carrying crisis-made scar tissue, tend to cling close to shore.
Endless financial crisis fears prevail. And each time volatility erupts, capital quickly flows back to the perceived safety of the U.S., creating a persistently conservative posturing.
An Aging 7-Year Bull Market
Where to next? This is where financial markets depart from Schopenhauerian theory. Truths are universal and, importantly, durable. Their permanency doesn’t fade. Conversely, financial markets—much to the chagrin of those still carrying the torch for the efficient market hypothesis—are driven by ephemeral opinions.
“True” financial value is itself a suspect notion. What’s right in one regime will be wrong in the next.
Looking ahead, it is the consensus view that the U.S. Fed will finally hike rates in December. It is also consensus that the chief beneficiary of the long-awaited liftoff will be the U.S. dollar. What is not obvious is if the consensus is right about all of this.
We recently wrote about factors driving currency returns. A critical component of successful analysis involves investor sentiment. Anytime a strongly unified consensus surfaces, investors should take notice, as there may be an opportunity to position differently and outperform.
‘Policy Divergence’ Consensus
Today “policy divergence” is the buzz. Global central banks will soon be traveling very different monetary pathways from the Fed. The consensus-held corollary is that higher interest rates will push the dollar to loftier heights.
If only it were that simple. Interest rate differentials are hardly the only factor driving currency returns. In fact, once upon a time, higher rates were viewed as a negative for currencies—an indication that the country was forced to pay higher funding costs because of inflation or other some other illness of the currency.
What’s more, history disagrees with the consensus here. The last two episodes of Fed tightening (starting in February 1994 and June 2004) actually produced a weak dollar in the following six-month period, staying suppressed for the following three years.
What other factors are important at this juncture? Consider at least four big ones, all suggesting a weakening U.S. dollar directly ahead:
1. “Escape velocity” may be elusive, but the post-crisis climate is fading. One of the primary contributors to a rising U.S. dollar has been an economy saddled with high debt. By definition, high indebtedness is deflationary. As households deleverage, less credit means less supply of currency in circulation, and therefore a strong dollar.
Yet we are now quickly approaching an inflection point. On a world scale, the U.S. has arguably most successfully deleveraged. Household debt has fallen to its lowest point relative to incomes in more than a decade. Credit growth is also expanding. Excess capacity is no longer an issue. And encouragingly, incomes are finally picking up. These are not the conditions for a disinflationary backdrop or a strong dollar. A weaker-than-expected U.S. dollar would have enormous investment implications, not least for emerging markets, where a strong dollar has contributed to widespread credit crunch fears and slumping stock markets.
2. “Policy convergence.” To be sure, global central bankers no longer perceive American-style post-crisis policies as avant garde. Whether or not we agree with these approaches, they are now standard operating procedure. The U.S. economy has become a leading indicator of what other central banks will do. In fact, the more the U.S. moves away from stall speed, the more pressure will be on other central banks to “converge” and do more so they, too, will be successful like America.
The above may explain the euro’s recent stability. On the surface, recent news from the ECB (notably, intensifying its QE program to unprecedented levels) should have produced a weaker euro. That has not been the case. What’s happening? Very likely, capital is rewarding the best macro stories—nations with ongoing ultra-stimulative monetary policy and growth moving in the right direction. Combine that with equity valuations that are much better than the U.S., and there is a strong argument for lasting outperformance in both Europe and Asia. All of this is dollar bearish.
3. Dollar valuation somewhere in the stratosphere. Markets are arenas of action and reaction, dialectics of suppositions, beliefs and, yes, flawed assumptions. In Soros-speak, markets are “reflexive”: perceptions of reality—whether accurate or not—often distort underlying fundamentals themselves.
The U.S. dollar is today’s reflexive case in point. So positive has been the opinion toward the U.S. dollar that its value has been bid up to dangerous levels (see chart below). Now, like Icarus soaring too close to the sun, the dollar’s wings are melting. This has been especially problematic for corporate America. The strong dollar was a leading contributor to a fall in S&P 500 profits (ex-financials) of 3.6% year-on-year. Expect continued head winds.
4. Fed hawkishness priced in. Investors should commit and recommit to memory that Mr. Market is very good at discounting future events. What is already well known? That the actions of central banks have become predictable, even boring. Most importantly, investors know that the ECB and Bank of Japan will continue to aggressively expand their balance sheets. That explains the near 14-year high in the U.S. dollar and the nearly unprecedented cheapness of the Japanese yen.
This leaves the U.S. dollar highly vulnerable. Any hint of dovishness is likely to lead to a sell-off. The Fed can soften its tone in two key ways. First, communicating the speed and duration of its tightening cycle, along with its end point. The gradualism of the Fed and commitment to “lower for longer” is still underappreciated. The recent long bond rally is forecasting this trend. Second, any sell-off in global capital markets or economic slowdown (as we saw this summer) will cause the Fed to hit pause on further hikes. Either scenario is highly probable, but both dollar bearish.
The dollar has quietly displaced gold as the world’s new cult currency. But is this aging bull market logical and sustainable? Among 19th-century philosophers, Schopenhauer was among the first to contend that, at its core, the universe is not a rational place. With high overvaluation, negative momentum and capital outflows increasing, the rationality of an ultra-long U.S. dollar position should be held in question.
Like other asset classes, currencies have a history of heading into extremes. The U.S. dollar could certainly move higher from here. But it is a crowded place and the stakes are enormously high.
Tyler Mordy, president and chief investment officer of Forstrong Global, is a recognized innovator in the design and application of global macro ETF managed portfolios. He is widely interviewed by the financial media for his global investment strategy views, as well as ETF trends. CNBC has called him one of the “best independent ETF experts.”