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Why a weaker dollar matters for risk

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There were signs of a shifting market tide on Tuesday, with a softer US dollar helping bolster sentiment. Such is the bombed out state across equities and credit, that these markets are rallying hard, even after dire purchasing manager surveys for the service sector arrived.

There was certainly quite a risk asset bounce, reflecting market sentiment that the US Congress was close to passing a massive spending bill, on the third attempt. So now some good news is priced into equities and it remains to be seen how long that can run. Importantly, measures of implied volatility are retreating further from recent peaks.

But as Marc Chandler at Bannockburn Global Forex reminds us:

“It is important to remember that among the biggest rallies take place in bear markets.”

If you are looking for a sustained recovery from here, the key factor is Covid-19 abating. Evidence of the virus curve flattening in the US holds the key for markets finding solid bedrock in the coming weeks. Until then, the scope for bear market rallies and renewed bouts of selling pressure are not hard to anticipate. 

In market terms, the vast efforts of the US Federal Reserve ahead of Congress injecting hefty stimulus into the mix are designed to buy time until the spread of the pandemic is halted. 

Market sentiment runs on the basis of being ahead of events and in this respect, plenty rests on the US dollar easing from elevated levels versus rivals. This is where a burgeoning tide of Federal Reserve easing (and through the buying of bonds, injecting more dollars into the financial system) and Congressional pump priming is seen weighing on the reserve currency.

Analysts at Jefferies argue:

“Escaping the dollar vortex may be better dealt with through a massive fiscal response. In our opinion the US must convince the financial markets that any fiscal package will be enough to contain US corporate solvency concerns thereby preventing credit spreads widening any further.”

Running against this is scope for further shocks as lockdowns and containment measures in Europe (where thankfully there are signs of the virus curve flattening in Italy), the UK and US are likely to prevail for at least another four weeks and longer.

This certainly complicates the task of assessing market signals and discerning say for example, whether a sub-50 reading in S&P 500 implied volatility is a signal to start adding to your equity holdings. There’s no shortage of commentary focusing on how once volatility subsides, it should spark investors having to rebalance portfolios in favour of equities versus government bonds. The big rally in sovereign debt and large losses in equities means the value of bonds has risen sharply within portfolios.

Mark McCormick at TD Securities says they “expect markets to remain defensive, underscoring more pain across equities and pro-cyclical currencies”.

This entails some relief for the euro, yen, Swiss franc and perhaps the pound in the wake of the Fed going all-in on the monetary policy front.

Mark says: “These alternative reserve currencies seem best-poised to benefit from the Fed’s uber-dovishness,” while in contrast: 

“We don’t think the Fed moves will usher in a rush to buy the pro-cyclical currencies like EM and the dollar bloc, as the spread of Covid-19 over the coming weeks keep the growth story too fluid to reprice even if the kitchen sinks and bazooka coming rolling out.”

Longer-term, another key issue revolves around whether US equities can maintain their “premium” over the rest of the world. Global equities have fallen harder than Wall Street and one clue resides in how some US technology companies have benefited from the upheaval of people working from home and spending their time connected via social media, or watching streaming services. As I type this at home, the other two family members stuck at the homestead are also online, with junior racing through the homework set by his teachers.

Another way of looking at this comes from Nick Colas at DataTrek, who notes that the scale of the S&P 500’s recent slide indicates a lot of faith in the capacity for an earnings recovery for large companies. The broad market has fallen back at a level seen in late 2016 and Nick estimates the S&P currently trades about 19 times “normalised (cross-cycle) earnings”, and he adds:

“As wrenching as the recent declines have been, markets have not given up on the idea that normalised corporate earnings power remains intact.”

Still he counsels patience for investors “as they wait for an earnings recovery post COVID-19. The costs (wages, overhead, etc) will come back quickly. Demand will take longer to build.”

One important long-term consequence of the pandemic is whether it crushes the future prospects of various sectors such as airlines, energy and retailers, among others. There is a template for this from the financial crisis in the form of banks, as Ben Inker, head of GMO’s asset allocation team, explains via the following chart. 

“The combination of substantial dilution (16 per cent net issuance by global banks from 2007-2011 versus net buybacks of 2 per cent for the overall market in the same period) and the unique damage to bank business models stemming from regulatory change and monetary policy does give us a template of how fair value can be destroyed.”

The concern from here is whether a number of sectors feeling the brunt of the pandemic shock to the economy and their business models are destined to experience a long-lasting hit. Government led bailouts and infusions of capital stand to help some, but this also means investors need to assess the winners and losers over a considerable period of time. 

As for banks, sustained low rates via central banks capping long-dated bond yields only compounds the pressure they face too. 

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Quick Hits — What’s on the markets radar

Plenty of eyes are watching China as the country slowly returns from the virus. Here’s one red flag fluttering via FT reporters: “China’s $43tn property sector, the backbone of the economy, is showing signs of deterioration even as Beijing attempts to kick-start growth after the coronavirus outbreak.”

Watch the aftershocks in areas like property, which in China is estimated to account for a quarter of the country’s gross domestic product.

Here’s another big buyer of global fixed income. Japan’s Government Pension Investment Fund will bolster its portfolio allocation to foreign bonds by 10 percentage points to one-quarter, via Nikkei. 

RJ O’Brien believe this “represents a swing of about $170bn” and observe that “it is not intervention, but it will represent” sales of euros and yen versus the dollar over time.

Given the recent acceleration in Japanese data covering foreign bond purchases, GPIF and others have likely jumped ahead of the gun.

The main conclusion from a dismal array of purchasing managers’ indices for March is that the hit to the service sector for Japan, Germany, France, the UK and the US lagged expected estimates. This highlights the enormity of the coming shock with economies under greater quarantine of late, while also making it very difficult to assess just how bad things will get.

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I’d love to hear from you. You can email me on michael.mackenzie@ft.com and follow me on Twitter at @michaellachlan.

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