Let’s Hope For Continued Dollar Strength
FinGraphs.com | Apr 21, 2015 13:36
We last contributed before spring-break, to be precise on the 27th of March. We were arguing that this time was different, that markets differed from the 2000 and 2007 tops. Cyclicals stocks (e.g. the SPDR XLY Consumer Discretionary ETF) had indeed been leading the way up (unlike in 2000 and 2007) and a combination of a very strong Dollar and subdued oil prices were “fueling” a positive wealth effect for consumers or for 70% of the US economy (not the case in the aftermaths of the Internet Bubble or the Subprime Crisis). The current FinGraphs’ Daily Mosaic below still reflects this situation (Daily charts usually deliver an investment perspective over the next few months):
In the first chart above, although it has had to brush off two consolidation periods since early December, SPY (or the SPDR S&P500 ETF) is back near its consolidation highs. Our trend analysis still shows a potential “Bull” and price targets do extend further. Our second chart is the relative performance of Consumer Discretionary Select Sector SPDR (ARCA:XLY) (the SPDR Consumer Discretionary ETF) vs SPDR S&P 500 (ARCA:SPY). It has led the market up, has reached our Impulsive targets up (“I up done”), but is still showing a “Bull” (possibly pointing to an intermediate consolidation before moving higher). Our third chart is the Dollar Index, it has reached extended Impulsive 2 targets up (“I2 Up done”).
We argued in our contribution mid March that this situation was exceptional and that although this trend seemed overextended, given its speed and strength, it could continue up following several weeks of correction into early April. There is a lot of talk about the US Dollar being the main culprit for US markets underperformance vs other international markets.
We, on the contrary, believe that it is the other markets which are on steroids and that the Dollar strength actually has a net positive effect on the US economy. It cheapens imports and keeps a negative pressure on the price of commodities. Sure it’s disinflationary, sure it impacts earnings generated abroad, but the net wealth effect to US consumers remains positive. This leads us to our fourth chart above or the Daily chart of Brent Oil. The drastic fall in Oil price in the 2ndhalf of last year is equivalent to a huge tax break for US consumers.
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The correction up, although significant, is well within what could be expected (our grey oval corrective up targets “C up” are between circa $62 and $72). We believe the longer term downtrend remains intact for now as we will see when we consider the Weekly chart of Brent Oil later on in this paper.
So three weeks ago, we were quite positive. We believed that the March correction presented an interesting “buy the dips” opportunity and that the uptrend on SPY although climbing a wall of “Dollar strength worry” was still in place. Indeed, over the last couple of weeks, SPY did move back up to flirt with its consolidation highs.
Yet, last week, the upside breakout was rejected and SPY corrected down strongly on Friday. We feel that the market internals over the last week offer interesting insight into the dynamics at play. No trend is linear and such set-backs, as long as they do not turn into outright reversals, often provide valuable guidance as to what to watch out for in the future.
For this purpose, let’s consider the FinGraphs Hourly Mosaic below featuring the same set of instruments (Hourly charts usually deliver an investment perspective over the next few weeks):
Last week, as you can see from the first Hourly chart above, SPY did attempt to continue its advance towards previous highs. Yet on Friday, the idea of a possible breakout was rejected as US markets corrected circa 1.5% to close down for the week (followed by a decent snapback today). One can notice that market internals were indeed quite different last week from the ones in the previous two weeks. In the second chart above, Consumer Discretionary (the XLY SPDR ETF) corrected quite significantly vs the general market (SPY).
Was it due to a new correction down on the USD (third chart featuring the Dollar index DXY) or an upside breakup on Oil (fourth chart featuring Brent Oil)? Both are probably related anyway. Our conclusion looking at last week’s events, is that investors really need to understand what they are wishing for. Indeed, a weaker Dollar would probably help the Oil countertrend rally to continue. More generally, the price of imports would also be adjusted up.
Such events would have an immediate impact on consumers and as we have seen above on our Daily charts, it is precisely the more cyclical Consumer Discretionary sector (XLY) which has been one of the key forces behind this year’s positive US market performance.
Follow me through, the USD started to rally from mid last year. It was reacting to the termination of Quantitative Easing 3 in the US and to prospects for an acceleration in US economic growth (and a related pick-up in inflation and possible US rate rises from mid this year). Abenomics and Europe’s own quantitative easing program provided an additional push. Yet, interestingly enough, the USD rise is actually having a disinflationary effect in the US. It probably exacerbated the drop in oil prices and it is keeping the cost of imports as well as the price of commodities under pressure. The benefits for US consumers are significant and we believe they outweigh the competitive disadvantage the strong USD imposes on US corporations.
Last week’s price action may highlight the new dynamic. Unlike in February, when US markets and XLY vs SPY rallied on the back of a consolidating USD (almost a relief rally), the recent price action saw the Dollar, the general market and XLY vs SPY correcting down. If these corrections were to accelerate, oil and other commodities would probably continue/start to rally on the back of a weakening USD. The positive wealth effect for US consumers could gradually disappear. Domestic Consumption and economic growth could slow, resulting in further Dollar declines (a negative feedback loop).
To sum it up, in a predominantly domestic and import focused economy, which is trying to get going, such as the US right now, a strong currency with decent growth and low inflation is probably the best one can hope for. Sure, at some point, as economic expansion matures, commodity prices will rally on the back of increased demand, inflation will start ticking up, rates will rises, bonds will correct. However, it feels widely premature to wish for such events today, especially given that we are still working through a large government and private debt overhang.
It is also interesting to consider last week price action in other international markets. Indeed, as we have argued in previous contributions, the US cannot be the only motor of growth in the world’s economy. With China slowing structurally, an economic upturn would definitely need growth in Europe and Japan to continue their recovery. The Hourly Mosaic below highlights what we would not want to see happen:
On the back of a renewed EUR/USD correction up (first chart) and some concern about GREXIT, the Dow Jones EuroSTOXX 600 dived last week (second chart). Similarly, as the correction down on USD/JPY resumed (third chart), the Nikkei 225 Index started to consolidate (fourth chart). These correlations were confirmed earlier this week as the Dollar rebounded.
h3 To sum it up again:/h3Continued Dollar strength is essential to keep the momentum in European and Japanese equity markets going. Yet, it is also a net positive for US markets and this despite concerns about the translation of foreign earnings and the competitive disadvantage of US corporates abroad. Indeed, it keeps commodity prices under pressure (oil especially) and by doing so generates the equivalent of an instantaneous tax break for US consumers.
On the contrary, we believe that if the USD started to correct down, it could trigger a very negative string of events: the oil correction up would gain further momentum putting pressure on the US consumer and more generally on the cyclical market sectors. The general market would correct and non-US markets would only make it worse.
Commodity led inflation would tick up, discussions about rate hikes would take centre stage, the bond market would start correcting and more generally volatility would accelerate up. In turn, these events would put a brake on US growth prospects resulting in a negative feedback loop as further Dollar declines take their toll.
h3 Let’s quickly review our Weekly and Daily trends on our key drivers mentioned above:/h3 h3 Weekly Mosaic (DXY, XLY vs SPY, SPY, SXXE): perspective over the next few quarters/h3Although some of them may be nearing exhaustion, all of them are still in potential “Bull” trends.
In the case of Brent Oil, we remain negative on a Weekly basis as it would be farfetched to consider the current Daily countertrend move up as anything but a correction for now (see Investor’s View chart below).
h3 Brent Oil – Investor’s View (a combination of a Weekly, Daily and Hourly chart)/h3In this context, we would consider the last week’s negative Hourly dynamics as transitory for now. What they do seem to reveal, however, is that the market as a whole is vulnerable to US Dollar weakness. This could serve as valuable information in future corrections to come.
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