U.S. Dollar: The Only Game In Town

Turmoil in Russia and emerging markets is leading to a “safe haven” demand for U.S. dollars. Historically, the Japanese yen and the Swiss franc have also been safe haven currencies, but this is not the case today:


The main support for the Japanese yen during times of risk aversion came from the behavior of domestic investors. The recycling of the current account surplus stops and foreign assets get repatriated, which work to push the yen higher. At the moment, Japan is no longer running a current account surplus and the public pension fund is aggressively buying overseas assets. Also, the BoJ has tended to respond slowly during crises. The BoJ is currently in the midst of an aggressive expansion of its balance sheet.

Switzerland has been viewed as a safe haven for hundreds of years. The country may continue to attract capital inflows, but it won’t translate into a stronger currency. The SNB remains steadfast in its commitment to prevent EUR/CHF from trading below 1.20. Indeed, the central bank introduced a negative deposit rate this week and stands ready to undertake FX intervention in potentially unlimited amounts.

Bottom Line: The U.S. dollar looks invincible. The Fed is intent on raising interest rates next year and there are no safe haven competitors. We are long the dollar against sterling, the Japanese yen and a basket of regional Asian currencies. The euro poses the greatest risk to the dollar bullish consensus. As highlighted in previous Insights, a €1 trillion expansion in the ECB’s balance sheet is already discounted and the technicals are very one-sided.

Euro: Window Of Upside?

Our FX strategists see asymmetric risks to the euro over the next 1-3 months.DIN-20141212-173326

The relationship between the euro and the ECB’s balance sheet broke down in the middle of the year. This could be a sign of currency traders front-running the ECB. The ECB has promised a lot and traders have aggressively shorted the euro. With the TLTROs and covered bond/ABS purchases having a muted effect (the take up for the ECB’s second TLTRO auction last week was underwhelming), traders are betting on an imminent sovereign QE. If the ECB fails to meet these expectations, currency speculators could begin to take profits on their short euro positions.

The sharp drop in oil prices further increases the importance of the ECB policy for the euro. The eurozone’s current account stood in a record surplus of €250 bn in the last twelve months. This has occurred even as oil imports have been steadily increasing. The eurozone’s oil import bill totaled over €300 bn over the last year. As this declines with lower oil prices, it will push the current account surplus to new record highs and exert greater upward pressure on the euro.

The way the ECB views the drop in oil prices will be vital. With headline CPI rising just 0.3% yoy, there is a reasonable chance that inflation could turn negative. If the ECB sees this as a temporary outcome and does not react with more monetary accommodation, the euro will be pulled higher by the growing current account surplus.

Our FX strategists are long the euro against a basket of the U.S. dollar and British pound.

Fed Outlook: Near-Term Versus Medium-Term

BCA’s medium-term House View is that the Fed will not be able to tighten much in 2015, and may even have to postpone rate hikes into 2016. But, robust job creation will sustain Fed talk of a mid-2015 rate hike in the near term.


According to BCA’s medium-term House View, both economic growth and inflation will likely fall short of the FOMC’s expectations, causing the central bank to postpone rate hikes into early 2016. In part, this is because the biggest boost from the most cyclical parts of the economy (housing and consumer durables) is behind us. We also believe wages will be well behaved through 2015. At the same time, there are few signs of any positive momentum outside the U.S.

The world needs U.S. spending to be robust until demand elsewhere is on firmer footing. Until that happens, we fear that any attempt by the Fed to normalize interest rates in 2015 will be met by a surge in the dollar and possibly a rally at the long-end of the Treasury curve.

Nonetheless, in the near term, there is enough economic momentum at the moment to sustain upward pressure on the front end of the Treasury curve. Leading indicators suggest that job gains will remain solid over at least the next several months. Thus, FOMC officials may try to ‘talk’ market rates higher to close the gap between market expectations for the fed funds rate and the Fed’s outlook (i.e. the median dots). Also, there is a good chance that “considerable time” is removed next week.

Bottom Line: The FOMC is ignoring extremely low long-term inflation expectations in the face of a buoyant labor market. Robust job creation will sustain Fed talk of a mid-2015 rate hike in the near term.

On Offer: Long-Term Value In European Equities

The five favorite structural valuation metrics of our European strategists – the CAPE, price to peak earnings, price to sales, market cap to GDP, and Tobin’s Q – all give the same reassuring message. European equities are at fair value, or even slightly cheap.


Based on this fair starting valuation, the FTSE100 and Eurostoxx should generate a 10-year nominal return of 10-12% a year, using the very close inverse relationship between the cyclically-adjusted price to earnings multiple (CAPE) and the subsequent 10-year nominal return.

True, since the 1980s, equity market earnings per share have benefited from a structural uptrend in profit margins. Such a tailwind may have added around 1.5% points a year to equity market returns. This boost will not last indefinitely, so a more prudent assumption would be that the 1.5% tailwind becomes a 1.5% headwind, lowering the prospective 10-year return to around 7% a year.

Compared to this conservative 7% prospective annual return from European equities, we know for certain that 10-year government bonds will return 2% in the U.K. and 1.7% in the euro area. Therefore, current valuations are discounting a prospective 10-year equity risk premium (ERP) of 5%.

Estimates vary for what a fair ERP should be, but in the U.K. the realized ERP over the past 40 years is around 3.5%. On this basis, Europe’s 5% equity risk premium appears attractive. It is also much greater than that available in either the U.S. or Japan.

Bottom Line: European equities are priced to generate very respectable 10-year nominal returns.

Are Australian Equities A Buy?

The performance of Australian equities has been dismal: Aussie share prices have lagged the global benchmark by over 30% since 2010. According to our Global Investment Strategy service, relative valuations have not cheapened enough to sufficiently compensate for pending economic headwinds.


The monetary conditions index for Australia is tightening due to the waning effect of previous interest rate cuts and currency depreciation. Granted, AUD/USD has weakened of late but the trade-weighted Aussie dollar is slightly up for the year. In addition, there is clear evidence that the Australian economy will weaken further, with deflationary pressures becoming the dominant economic force:

  • The leading economic indicator has fallen sharply, predicting that growth will slow next year.
  • Consumer sentiment has plummeted, while wage growth has dropped sharply.
  • 10-year inflation expectations have also declined to five-year lows.
  • Capital investment, which boomed last decade, has stalled. It is possible that a large divestment cycle is progressing, especially if commodity prices stay weak.

To make matters worse, the current government is committed to slashing the budget deficit in 2015, despite the recent hit to fiscal revenues from falling commodity prices and a weakening economy. Fiscal austerity at a time of tightening monetary conditions is the wrong antidote for an economy going through a negative terms-of-trade shock. This mix has and will continue to constrain aggregate demand, and will keep the Australian dollar from falling enough to jumpstart economic growth. Hence, it is unlikely that the Australian economy will suddenly spring back to life. Odds are that the stock market will continue to underperform.