THEMATIC INVESTMENT CONCLUSIONS
Long Ideas/Overweight Recommendations
- Consumer Staples Select Sector SPDR Fund (XLP)
- iShares U.S. Home Construction ETF (ITB)
- Health Care Select Sector SPDR Fund (XLV)
- PowerShares DB U.S. Dollar Index Bullish Fund (UUP)
- iShares 20+ Year Treasury Bond ETF (TLT)
- LONG BENCH: Vanguard REIT ETF (VNQ), Utilities Select Sector SPDR Fund (XLU), Vanguard Extended Duration Treasury ETF (EDV)
Short Ideas/Underweight Recommendations
- iShares TIPS Bond ETF (TIP)
- CurrencyShares Japanese Yen Trust (FXY)
- iShares MSCI Emerging Markets ETF (EEM)
- SPDR Barclays High Yield Bond ETF (JNK)
- Industrial Select Sector SPDR Fund (XLI)
- SHORT BENCH: SPDR Oil & Gas Exploration & Production ETF (XOP), CurrencyShares Euro Trust (FXE), WisdomTree Emerging Currency Fund (CEW)
QUANT SIGNALS & RESEARCH CONTEXT
The U.S. Dollar Is Crushing Naysayers: Those of you who are familiar with our work know that core to our research and risk management processes is a behavioral finance overlay that centers mostly on sentiment. Specifically, we believe there are three states of sentiment that investors must attempt to contextualize prior to taking a position in or formulating a view on a specific security or market:
- Not enough of either
In that context, we continue to believe that consensus is not in the area code of being Bullish Enough on the U.S. dollar.
As you know, we’ve been dollar bulls for nearly six months now in conjunction with our #Quad4 theme and what continues to amaze us about the strength in the U.S. Dollar Index is the level of disbelief among investors with respect to the velocity of its appreciation.
Anecdotally speaking, I can count on one hand the number of institutional clients that expect parity in the EUR/USD cross and/or reversion to the August ’98 highs of ~147 on the USD/JPY cross.
But why use anecdotes when you can use math?
Specifically, the sell-side (i.e. Bloomberg consensus) expects the U.S. Dollar Index (DXY) to appreciate +1.3% to 95.68 by EOY ’15 based on our weighted amalgamation of all the constituent currency forecasts.
That sounds reasonable, but not in the context of them expecting it to appreciate +2.2% to 92.27 by EOY ’15 at the end of last year. It’s worth noting that 92.27 is a full -2.5% lower than where the DXY is trading today – just four weeks later!
In line with their institutionalized processes, sell-side forecasts for key USD crosses are likely to continue chasing trending price momentum – within one sigma of the median forecast, of course! Can’t risk being isolated from the herd…
What about the buy-side? Have institutional investors been any better at forecasting where the dollar has been headed? Absolutely not. Far from it actually.
For example, let’s review how buy-side consensus was positioned ahead of the ECB smoking the EUR/USD cross to ~12yr lows with the announcement of its QE program last week. At the end of last year, the most probable spot price range for January 22nd was 1.2131-1.2162 according to Bloomberg’s FX Rate Forecast Model. The left tail of the 95% confidence interval band was 1.1526. The EUR/USD cross closed at 1.1366, a 0.24% probability just some ~3 weeks earlier!
Why was the precipitous YTD decline of -6.6% on the EUR/USD cross considered such a low probability among investors?
Anecdotally, some investors were myopically focused on the hawkish commentary emanating from the Bundesbank – Wolfgang Schaeuble in particular – in their relatively hawkish handicapping of ECB QE risk(s). Other investors were myopically focused on the Fed and what a deteriorating outlook for growth and/or inflation would do to the FOMC “dot plot” and, ultimately, the U.S. dollar.
While both views can be considered to be well within reason at the time(s), the fact of the matter is that both views were ultimately proved wrong by the market. Fortuitously, our team has been on the right side of the long-dollar trade all along.
With respect to the Fed in particular, the “dots” continue to get punted at every interval yet the dollar continues to ascend to new heights.
Specifically, according to the Fed Funds futures curve, the probability of “liftoff” (i.e. a rate hike) by the December 2016 FOMC meeting at the May 6th 52-week low in the DXY was 90.8% (100% less a 1.4% probability of 0% less a 7.8% probability of 0.25%). It regressed to 86.1% by the end of last year and further to 65.3% currently.
With long-duration Treasury bonds continuing their moonshot higher (yes, we’ve been bullish on those too), the rates market clearly gets this dynamic.
What the currency market is failing to appropriately price in is the global monetary policy divergence we have identified and continue to view as supportive of the USD over the intermediate term and potentially over the long term if the 2016 election cycle portends a structurally hawkish shift in monetary and fiscal policy.
In short: the ECB and BoJ are simply more dovish than the Fed at the current juncture and that is likely to continue at least until a clear trend of deteriorating labor market fundamentals takes hold in the U.S.
We repeat: the ECB and BoJ will likely remain more dovish than the Fed until a clear TREND of deteriorating labor market fundamentals takes hold in the U.S. We are simply not there yet according to how the Fed analyzes labor data.
Hopefully by now we’ve done a good job using our #process trifecta of History, Math & Behavioral Finance to make a compelling case for material U.S. dollar appreciation from here. Our bearish call on commodities, emerging market financial assets and dollar-denominated high-yield corporate debt is an easy call to continue to make in light of that.
How will that impact equity portfolios, however? Based on historical return patterns, a continued strengthening of the USD vis-à-vis peer currencies is likely to continue to perpetuate a performance divergence between the “haves” (i.e. high domestic revenue exposure) and the “have nots” (i.e. high international revenue exposure) in the domestic equity market.
Email us if you have questions on how to replicate this equity screen or if you have any other questions we may be able to help with. Best of luck out there.
***CLICK HERE to download the full TACRM presentation.***
TRACKING OUR ACTIVE MACRO THEMES
Global #Deflation: Amidst a backdrop of secular stagnation across developed economies, we continue to think cyclical forces (namely #StrongDollar driven commodity price deflation) will drag down reported inflation readings globally over the intermediate term. That is likely to weigh heavily upon long-term interest rates in the developed world, underpinning our bullish outlook for U.S. Treasury bonds.
#Quad414: After DEC and Q4 (2014) data slows, in Q1 of 2015 we think growth in the US is likely to accelerate from 4Q, aided by base effects and a broad-based pickup in real discretionary income. We do not, however, think such a pickup is sustainable, as we foresee another #Quad4 setup for the 2nd quarter. Risk managing these turns at the sector and style factor level will be the key to generating alpha in the U.S. equity market in 1H15.
The Hedgeye Macro Playbook (1/23)
Long #Housing?: The collective impact of rising rates, severe weather, waning investor interest, decelerating HPI, and tighter credit capsized housing in 2014. 2015 is setting up as the obverse with demand improving, the credit box opening and 2nd derivative price and volume trends beginning to inflect positively against progressively easier comps. We'll review the current dynamics and discuss whether the stage is set for a transition from under to outperformance for the complex.
Best of luck out there,
Associate: Macro Team
About the Hedgeye Macro Playbook
The Hedgeye Macro Playbook aspires to present investors with the robust quantitative signals, well-researched investment themes and actionable ETF recommendations required to dynamically allocate assets and front-run regime changes across global financial markets. The securities highlighted above represent our top ten investment recommendations based on our active macro themes, which themselves stem from our proprietary four-quadrant Growth/Inflation/Policy (GIP) framework. The securities are ranked according to our calculus of the immediate-term risk/reward of going long or short at the prior closing price, which itself is based on our proprietary analysis of price, volume and volatility trends. Effectively, it is a dynamic ranking of the order in which we’d buy or sell the securities today – keeping in mind that we have equal conviction in each security from an intermediate-term absolute return perspective.