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USD REDUX: 3 WAYS THE DOLLAR WINS

Takeaway: We continue to think Strong Dollar = Strong America and believe the USD can continue to win in 3 ways.

Summary: 3 Ways the USD Wins

  1. Fiscal Consolidation:  After a multi-decade run of federal fiscal profligacy,any manner of budgetary restraint is dollar supportive on the margin. 
  2. Taro Aso being Taro Aso:  With the dovish actors in place (Aso/Kuroda), the political will supportive, and the appetite there for increasingly aggressive policy initiatives we think the Yen is poised to return to ¥100+ per USD.   
  3. U.S. Growth Stabilizing:  Economic fundamentals are USD supportive, on balance, with Housing, Labor Market & Manufacturing activity data all stable to improving.  Further Economic weakness across G7 economies should support a relative bid for the dollar also.     
  4. Positioning:  Short Yen, Short Basic Materials, Long Consumption

 


“Why is broad commodity deflation a bullish setup?” – we’ve been fielding some version of that question with greater frequency over the last few weeks as market prices have continued to offer positive confirmation of our strong dollar - strong consumption view, a key underpinning of  our #GrowthStabilizing investment theme.   

 

Below we provide a summary recap of our view on the dollar-growth connection, our bullish view on the dollar and why we think there is further upside in the immediate/intermediate term.

 

THE THINKING: 

The Strong Dollar = Strong America mantra continues to anchor our view on sustainable, real GDP growth both domestically and globally.  Central to the view is the fact that a stronger dollar drives commodity & energy deflation, serving as a real-time tax cut to consumers and an input cost reduction for business with a flow-through benefit to earnings on a lag. 

 

Because most global commodity transactions settle in dollars, the USD-Commodity Price relationship is rather direct, and the impacts of commodity deflation are felt globally as share of wallet occupied by food and energy declines.  The cost deflation and purchasing power impacts are further pronounced for economies with some measure of a currency peg to the U.S. Dollar – fundamentally, we continue to like Hong Kong, China, and Singapore, in part, for that reason.  

 

Persistent central bank policy intervention with the explicit goal of devaluing the currency to drive (financial) asset price re-flation has been a discrete headwind to sustainable dollar strength over the last five years.  Investors, on balance, have bought into the policy regime with a primary follow-on effect being that equity and commodity price correlations to the dollar have been strongly and inversely correlated over that same time.   

 

While policy initiatives supported equity valuations (via lower discount rates & a lower dollar) and provided some measure of economic stimulation, commodities and inflation hedge assets generally outperformed other asset classes.  With repeated rounds of easing, the investor response became pavlovian with commodity and energy price inflation and lower real, inflation adjusted growth on the other side of those policy initiatives.

 

As we’ve stated repeatedly, big government policy intervention and the perpetuation of the temporal,  Dollar Down --> commodity Inflation Up --> Real Growth down, dynamic has served to:   

 

1. Shorten Economic Cycles, and

2. Amplify Market Volatility. 

 

As a result, we’ve been beholden to compressed economic oscillations and fleeting, episodic periods of growth, while real, sustainable, demand growth has remained elusive. 

 

Can we break the cycle as Bernanke's last Bubble (commodities) deflates?

 

With QE-infinity on the table, the capacity & appetite for further Fed balance sheet acceleration declining, and domestic growth stabilizing, the potential to break free of the prevailing, policy-inflation-growth cycle that has characterized the better part of the last five years is increasing – with the prospects for sustained USD appreciation gaining concomitantly. 

 

Indeed, at present, intermediate term dollar correlations to the S&P500 are positive while holding negative across the larger commodity basket.  Dollar Up, Stocks Up, Commodities Down is the relationship dynamic we’d like to continue to see perpetuate itself with respect to sustainable end demand.

 

Mother Nature likes redundant systems and we feel comfortable taking an anti-fragile cue from one whose traversed a global cycle or two.  Currently, we think the strong dollar thesis can win in 3 ways.

 

 

THE FACTORS & HOW TO POSITION: 

 

1. Fiscal Consolidation:  After a multi-decade run of debt financed consumption and federal profligacy, Sequestration, or any manner of fiscal restraint & consolidation, on the fiscal policy side is dollar favorable on the margin.  Further, given the diminishing return of fed policy action and the reduced appetite for further QE initiatives, QE now appears rearview as a discrete bearish catalyst for the dollar in the near-term.

 

2. Taro Aso being Taro Aso:  We’ve detailed our Short Yen case via our #QUADRILL-YEN 1Q13 Investment theme and on our recent best ideas call (email us if you would like a copy of the presentations).  In short, with the dovish actors in place (Aso/Kuroda), the political will supportive, and the appetite there for increasingly aggressive policy initiatives we think the Yen is poised to return to ¥100+ per USD.   A weak Yen with an explicit and comparatively dovish policy outlook for Japan vs the U.S. is supportive of dollar strength.  

  • Positioning:  We continue to like the short Yen position on the other side of the long dollar call.  

3. U.S. Growth Stabilizing:  Economic fundamentals are USD supportive, on balance, with Housing, Labor Market & Manufacturing activity data all stable to improving.  Further Economic weakness across G7 economies, particularly across the EU, UK & Japan, should support a relative bid for the dollar in the immediate/intermediate term as well.     

  • Positioning: 
    • Short Basic Materials:  Materials is the worst looking sector across the S&P from a quantitative perspective and has direct negative leverage to commodity deflation
    • Long Consumption:  A Real-time tax cut via energy deflation is positive for real earnings growth and discretionary income.  We like Consumption oriented/Consumer Facing equities in the U.S.  and select Asian equity markets (China, Hong Kong)
    • Short Gold:  To the extent that U.S. dollar strength is reflective of growth and interest rate expectations (or just the expectation for a cessation in easing) we think gold holds further downside over the intermediate term. 

 4. Quant:  The USD remains bullish and is breaking out from a quantitative perspective. TRADE & TREND Support sit lower at $80.65 and $80.12, respectively.

 

 

Christian B. Drake

Senior Analyst 

 

 

USD REDUX: 3 WAYS THE DOLLAR WINS - USD Levels

 

USD REDUX: 3 WAYS THE DOLLAR WINS - USD vs CRB 030113

 

USD REDUX: 3 WAYS THE DOLLAR WINS - Inflation vs Real Earnings Feb

 

USD REDUX: 3 WAYS THE DOLLAR WINS - Bearish Yen 1

 

USD REDUX: 3 WAYS THE DOLLAR WINS - Bearish Yen 2

 



LAND HO!: “ESCAPE VELOCITY” ON THE HORIZON?

Takeaway: A continued breakdown of investors’ perception of tail risk bodes well for domestic capital markets and economic growth.

SUMMARY CONCLUSIONS:

 

  • With spot VIX itself having broke down to new post-crisis lows in recent weeks (and still bearish-TREND on our quantitative factoring), we are encouraged to see that the rolling premium for 6M-forward VIX is also breaking down hard from its recent post-crisis peak.
  • To the extent this trend does continue as we navigate the confluence of near-term domestic fiscal policy catalysts, we could be looking at a scenario six months from now where the ever-elusive “escape velocity” becomes a probable scenario to risk manage. 
  • By “escape velocity”, we are referring to a rather bullish environment where implied volatility across domestic capital markets trades sustainably lower (a la 2003-07) amid a commensurate pickup in economic activity and the velocity of money.
  • At any rate, hope remains no investment process and we definitely need to see more data to support this narrative.

 

Shortly after our morning call yesterday, a very astute client and equally-shrewd investor asked us: “Can you explain to me what the implication of the ‘term structure of the VIX’ coming down means versus the spot VIX index coming down?”

 

Simply put, investors paying up less for perceived tail risk is a bullish indicator for US equities, as it would indicate that investors are beginning the process of closing the book on the 2008-09 financial crisis once and for all – implying that they may be increasingly comfortable with taking on more risk.

 

To the extent these signals are being driven by requests from their clients or as a result of improved corporate sentiment, the recent breakdown in the term structure of the VIX curve may turn out to be a favorable signal for the domestic economy as a whole.

 

Technically speaking, “history” (i.e. we only have data going back to 2004) shows us that the premium investors are willing to pay for 6M-forward VIX relative to spot VIX should oscillate around +20%, with any major drawdowns in that premium typically being accompanied by a melt-up in spot prices. Looking at the data through the prism of a 3M moving average (to smooth out the inevitable S/T outliers), we’ve seen that premium widen to as high as a double (i.e. +40%) in the post-crisis era.

 

With spot VIX itself having broke down to new post-crisis lows in recent weeks (and still bearish-TREND on our quantitative factoring), we are encouraged to see that the rolling premium for 6M-forward VIX is also breaking down hard from its recent post-crisis peak.

 

LAND HO!: “ESCAPE VELOCITY” ON THE HORIZON? - 1

 

LAND HO!: “ESCAPE VELOCITY” ON THE HORIZON? - 2

 

LAND HO!: “ESCAPE VELOCITY” ON THE HORIZON? - 3

 

To the extent this trend does continue as we navigate the confluence of near-term domestic fiscal policy catalysts, we could be looking at a scenario six months from now where the ever-elusive “escape velocity” becomes a probable scenario to risk manage. By “escape velocity”, we are referring to a rather bullish environment where implied volatility across domestic capital markets trades sustainably lower (a la 2003-07) amid a commensurate pickup in economic activity and the velocity of money.

 

LAND HO!: “ESCAPE VELOCITY” ON THE HORIZON? - 4

 

At any rate, hope remains no investment process and we definitely need to see more data to support this narrative. Still, it’s always fun to dream…

                                                                                                                                                                                                                   

Happy Friday,

 

Darius Dale

Senior Analyst


THE BAD NEWS IS OUT OF THE WAY IN CHINA

Takeaway: While this latest round of tightening measures is definitely impactful, they are not nearly as negative as we initially feared.

SUMMARY CONCLUSIONS:

 

  • China’s official Manufacturing PMI report was particularly bad “underneath the hood” (New Orders, New Export Orders and Purchasing of Inputs all down over 1ppt). As we have mentioned many times before, however, any sequential readings in Chinese (and, by extension, Asian) growth data from JAN to FEB will be distorted by the timing of the Lunar New Year festival, which was entirely in FEB this year after being a JAN event last year. We reiterate that the MAR growth figures will be the first true test of our Asian #GrowthStabilizing thesis (click here for the latest update).
  • Also announced overnight was the central government’s official response to the momentum of property price appreciation in China. On balance, this latest round of macroprudential tightening measures is definitely impactful, but not nearly as aggressive as the “hammer” we feared in our worst-case scenario.
  • All told, we still like Chinese equities on the long side w/ respect to the intermediate-term TREND duration. Encouragingly, our TREND and TAIL quantitative support levels are still intact after the recent round of policy-induced weakness. A recapture of the Shanghai Composite’s immediate-term TRADE line (2,385) would be an explicit signal that we’re going to continue to be right on China.
  • If you don’t want to take our word for it, that’s fine; Australia (both equities and currency) and CAT are two short ideas you can use to hedge, or to outright express any bearish view on China from here – which we obviously would be on the other side of (email us for our latest work on either).

 

PMI DATA DISAPPOINTS, BUT DOESN’T MATTER

This morning brought forth a great deal of PMI data out of Asia, obviously headlined by China’s manufacturing indices: FEB NFLP Manufacturing PMI: 50.1 from 50.4 vs. Bloomberg Consensus of 50.5; and FEB HSBC Manufacturing PMI: 50.4 from 52.3 vs. Bloomberg Consensus of 50.6.

 

China’s official Manufacturing PMI report was particularly bad “underneath the hood” (New Orders, New Export Orders and Purchasing of Inputs all down over 1ppt). As we have mentioned many times before, however, any sequential readings in Chinese (and, by extension, Asian) growth data from JAN to FEB will be distorted by the timing of the Lunar New Year festival, which was entirely in FEB this year after being a JAN event last year. We reiterate that the MAR growth figures will be the first true test of our Asian #GrowthStabilizing thesis (click here for the latest update).

 

THE BAD NEWS IS OUT OF THE WAY IN CHINA - 1

 

HOUSING’S “HAMMER”?

According to data from SouFun Holdings Ltd., the country’s largest real estate brokerage, Chinese home prices rose for the ninth consecutive month in FEB: +0.8% MoM from +1% MoM in JAN. This string of sequential  momentum is generally consistent with the property price data we track that comes out on a lag.

 

Also announced overnight was the central government’s official response to the momentum of property price appreciation in China:

 

  1. Increase down-payment requirements and interest rates for second-home mortgages in cities with “excessively fast” price gains;
  2. Ban real estate companies found to be engaged in hoarding land or collaborating to push up home prices from getting new development loans or raising funds from the capital markets;
  3. Implement a 20% capital gains tax whenever the original purchase price is available; and
  4. “Quicken” the expansion of the nationwide property-tax trials (authorities also imposed a property tax for the first time in the cities of Shanghai and Chongqing).

 

The first two measures are not particularly corrective and generally target only the obvious and unwanted speculative activity in the market. The second two measures, however, are indeed punitive in the sense that they may ultimately impact first-time homebuyers. Relative to our expectations as outlined on Wednesday’s Best Ideas call (email us for the replay info), this confluence of macroprudential tightening measures is somewhat aggressive.

 

They could’ve been far, far worse, however; any further outright restrictions on sales and purchases would’ve slowed overall construction-related activity and would have been very bearish for prices in the sense that price-insensitive buyers would’ve been incrementally forced out of the market(s).

 

Moreover, on the bright side of the property tax implementation, an expedient rollout backed by “unswerving” enforcement may help shore up local government finances to the extent they are still facing cash flow difficulties – which is among the core tenets of the stale China-bear thesis. Per the latest Ministry of Finance analysis, 53% of LGFV debt – which totaled 9.2 trillion CNY at the end of 2012 – will come due by year’s end. If 2012 was an indication, however, loans will continue to be rolled over. Trust us – Chinese state banks know exactly where their bread is buttered.

 

All told, we still like Chinese equities on the long side w/ respect to the intermediate-term TREND duration. Encouragingly, our TREND and TAIL quantitative support levels are still intact after the recent round of policy-induced weakness. A recapture of the Shanghai Composite’s immediate-term TRADE line (2,385) would be an explicit signal that we’re going to continue to be right on China. If you don’t want to take our word for it, that’s fine; Australia (both equities and currency) and CAT are two short ideas you can use to hedge or to outright express any bearish view on China from here – which we obviously would be on the other side of (email us for our latest work on either).

 

THE BAD NEWS IS OUT OF THE WAY IN CHINA - 2

 

As a reminder, the 12th National People’s Congress commences on MAR 5. Moreover, we expect to see a fair amount of positive headlines in the way of meaningful economic reforms. For the associated prep notes, please refer to our 2/26 note titled: “RISK MANAGING CHINA”.

 

Darius Dale

Senior Analyst


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Financials Take Hold

Over the last year, the S&P 500 has returned +9.55%, which is impressive for anyone who had index funds in their portfolio. But the real gains can be seen in individual S&P sector ETFs. Financials (XLF) are leading the pack, up +17.16% over a one-year period, while Tech (XLK) and Energy (XLE) are up +1.24% and +2.08%, respectively. The recovery in the housing market and the uptick in mortgages and housing prices has no doubt given a boost to the banks and other financial institutions as growth continues to stabilize.

 

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Can We Fix It?

While the US stock market is looking good, America's political class is looking ugly, today. Automatic spending cuts aka The Great Sequester are set to kick in at midnight. Can Congress come to an agreement? Fat chance of that happening. So the question is, will it really hurt the stock market? In a sense: no. We may see a down day or two, but we are bullish on consumption. Consumption helps drive growth and with oil prices hitting 2013 lows this morning, we're liking the consumption game. Remember: strong dollar = strong America. 

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