Overview:
- Weakness in the USD continues as world’s most crowded trade unwinds
- Long-term government interest rates moving higher, following inflation trends
- Global growth prospects improving as well as for US
- Earnings estimates for S&P 500 look to have bottomed and may be catalyst to propel markets out of trading range
Back on May 1st I penned an article showing that we were facing an important inflection point in the markets with a simultaneous peak in the dollar and a bottom in global growth that would have widespread investment implications. Chief beneficiaries cited were foreign currencies, foreign equities, and commodities while the bond market would likely be the greatest casualty.
The trends mentioned above have certainly been in play recently and are being powerfully demonstrated as I write. Of the 30 world currencies I track relative to the US dollar, not a single one is down relative to the USD at present and the majority have advanced over the last month as the following USD currency (and precious metals) pair table shows.
Foreign Currency Relative Performance to USD
Source: Bloomberg
The USD Index is at its lowest level since February and over the last month has wiped out the bulk of its gains this year. Weakness in the dollar is powering commodities higher today with silver back above /oz and a close above its 200-day moving average for the first time since January while gold has also firmed, testing its long-term 200-day moving average.
Though today's action in gold and silver is causing some excitement among metals investors, the big move strategists have been watching is in the bond market where we've seen yields spike. If you didn't read my piece published on May 1st, here's why I explained this was likely to occur:
Another trend we are likely to see in the coming weeks and months is that a bottom in global growth will arrest the deflationary trend of falling inflation rates and falling interest rates that we’ve seen over the last several years. The pickup in global growth predicted by the relative performance of early- to late-stage cyclicals argues that long-term interest rates should move higher as shown below where both US and German long-term yields should be heading higher for much of the rest of the year. As long as the rise in interest rates is orderly we could see global capital move out of the bond market and help lift equity markets higher.
Market participants are now making adjustments to their inflationary outlook, especially with the biggest global reflationary effort by central banks we've seen since 2008/2009 underway (see story). Nearly every major developed nation is seeing a rising trend in inflation rates this year and outside of Europe most government bond yields bottomed in January-February shown by the red shaded bar in the image below (top panel shows inflation rates and bottom panel shows government interest rates).
Source: Bloomberg
Confirming this trend, the Economic Cycle Research Institute (ECRI) shows that we are now seeing measures of future inflation hitting 3½ year highs. See Euro Zone Inflationary Pressures Rising:
Inflation pressures in the euro zone have risen, suggesting the European Central Bank's 1-trillion-euro bond buying program may be working, an indicator designed to predict cyclical trends showed on Friday.
The Eurozone Future Inflation Gauge (EZFIG), a measure of the outlook for inflation published by the Economic Cycle Research Institute, climbed to 98.7 in March from February's 97.6.
"With the EZFIG climbing to a three-and-a-half year high in March, euro zone inflation is poised to rise further in the coming months," said Lakshman Achuthan, ECRI's chief operations officer.
Turning towards the US economy, ECRI took on the recent crowd of those calling for a recession in their report, A Two-Speed Economy, where they state:
A whiff of panic is in the air. So much so that, with economic surprise indexes falling to their most negative readings in years, the “R” word has begun to pop up again, with some observers warning of a 1937-like relapse – into a depression, no less.
To put the state of the economy in perspective, Chart 1 presents the growth rate of ECRI’s US Coincident Index (USCI), which subsumes the key indicators of output, employment, income and sales used to determine official US recession dates. The chart goes back to 1919, to include not only the 1937-38 depression, but also the 1929-33 one, as well as the less well-known 1920-21 depression. Sure, USCI growth has dipped lately, but this is nothing like its 1937 plunge.
Meanwhile, the consensus view is that the economy is pulling out of an “air pocket,” on its way to “escape velocity.” Both views are mistaken.
So what’s really going on? Chart 2 clues us in.
While growth in ECRI’s US Coincident Manufacturing Index (bottom line) has indeed dropped to its worst reading in more than a year, growth in the US Coincident Services Index (top line), despite a small dip, remains near a ten-year high. This means that manufacturing growth is in a cyclical downturn that ECRI saw coming (USCO Essentials, November 2014) – not an unexpected “soft patch.” But service sector growth is holding up, following the strength in our service sector leading indexes.
Bottom line, this is no recession and certainly nothing like a depression. It’s a two-speed economy, featuring a clear downturn in manufacturing growth, but not in services. As for where we go from here, we’re keeping a close eye on our full array of leading indexes.
Speaking of those leading indexes, ECRI’s Weekly Leading Index (WLI) for the US continues to advance and, after bottoming in January, it is now back into positive territory and suggests the weak Q1 GDP print was a temporary decline in growth and the risk of slipping into a recession right here is slim to none.
Source: ECRI
The turnaround in global growth and the expected bottoming in the US economy should be favorable for the equity markets in the months ahead and the no-man’s-land that the US markets have been stuck in since November will likely be resolved to the upside. One of the things I predicted would occur associated with a top in the USD would be a rise in earnings estimates for the S&P 500 which would likely lift stocks higher. As shown below, there has been an inverse correlation between the earnings estimates for the S&P 500 for this year with the USD Index (shown inverted for directional similarity) and the recent top in the USD has correlated with a bottom in earnings estimates which have just started to trend higher recently.
Source: Bloomberg
As I showed in my last article, the US dollar tends to move inversely to global growth and given an expected pickup based on global early- to late-stage cyclical relative performance, the USD should remain flat to down heading into the fall and continue to elevate earnings estimates for the S&P 500 this year.
Source: Bloomberg
I think the decline in the dollar is becoming overdone in the near-term and we could see the USD stabilize; however, given the lack of capitulation by dollar bulls (red line below) I think the trend in the USD remains sideways to down for several more months. When viewing futures positioning, we are a long ways away from reaching bearish sentiment suggestive of a strong bottom in the dollar, which should support a further move in commodities, inflation and interest rates and allow for further improvement in S&P 500 earnings estimates.
Source: Bloomberg
Summary:
The turning point in global growth and a top in the dollar continue to influence global financial markets and these trends are likely to remain in place for much of the year. Thus, the recent rise in interest rates recently will likely continue as economic and inflation rates trend higher in the present global reflationary wave. Under this backdrop, commodities, foreign equities, foreign currencies, and equities with a global footprint are likely to do well ahead.
As always, investors will have to grapple with Fed uncertainty as our central bank appears bent on beginning to raise interest rates this year which is sure to play on markets and needs to be monitored.
