The strong US dollar and global equities.
The most important theme in the world financial market since August has been th82dramatic rise in the US dollar against the world's major currencies, notably the Euro (economic contraction in Germany due to Russia sanctions and the subsequent Bundesbank/ECB "shock and awe" monetary easing), sterling (risk premium on the Scots referendum), Japanese yen (spike in US Treasury bond yields on strong economic data and Abenomics reforms) and the Australian dollar (collapse of LNG, crude oil and iron ore prices). Since the Euro has a 57 per cent weight in the US Dollar Index and the Euro has fallen from 1.39 to 1.29 in 2014, the US dollar is now sharply rising against global currencies. This has seismic implications for every major asset class.
The US economic supertanker is finally accelerating six years after the fall of Lehman Brothers and the epic $3bn expansion in the Federal Reserve's balance sheet. Second quarter GDP was 4.3 per cent. Consumer confidence is on a roll. Car sales are at 17 million units, above 2006 levels. The ISM manufacturing and services indices are both 59, indicating expansion. The shale oil boom, residential property investment and technology capex can easily mean that US economic growth accelerates to 3.4 per cent at a time when Europe's Big Three economies (Germany, France, Italy) face recession. The Yellen Fed will have to respond to accelerating US growth data with a shift in its language on interest rates. This means the US Treasury ten year note could well rise to three per cent, a scenario that could well take the US dollar higher to 1.25 Euro and 110 yen. This means while corporate earnings will be stronger in US, valuation multiples will also be compressed by higher interest rates.
The US equities market is not cheap at 16 times earnings. I am afraid that the surge in the US dollar and recession in Europe are both negative for earnings growth in large cap multinational who dominate the US indices this winter. Moreover, the end of the US central bank's bond buying program (the taper) could mean a rise in volatility in both the stock and bond markets. Wall Street has not had a 10 per cent correction since August 2011. The macro tea leaves suggest a 10 per cent correction is all too possible in winter 2014. The stratospheric levels of leverage in the debt markets and Dodd Frank/Volcker Rule related fall in bank capital dedicated to market making means that the spike in the US Treasury bond yields could become chaotic in illiquid markets. A sell off in bond markets could easily lead a fall in the S&P 500 to the 1840 - 1860 level, an optimal reentry price.
Unlike 2013, nimble sector rotation alone will enable investors to deliver superior performance in US equities. For instance, health care has been a stellar performer in the past two years, up 42 per cent in 2013 and 16 per cent in 2014. I believe US money centre banks, who benefit form both accelerating economic growth and a steeper US Treasury bond yield curve, will benefit most from the macro milieu
of late 2014 and 2015. For instance, I would use any sell off in New York to accumulate positions in Citigroup at 48 or 25 per cent below tangible book value. General Motors also offers a 3.5 per cent dividend yield, investment grade upgrade potential, 20 per cent EPS growth, a 8.5 times forward earnings valuation, new product launches and a superior product mix now that the Saturn, Pontiac and Hummer assembly lines have been discounted.
Stay away from European equities
I believe investors should reduce their exposure to European equities. As US economic growth accelerates while Europe is stagnant/recession, the growth and earnings outlook between the US and Europe will increase. This means an exodus of offshore capital from Europe and a fall in the Euro to as low as 1.20 next year. GCC investors will face steep currency losses if they buy European equities but do not hedge Euro risk. The geopolitics of Ukraine/Russia is also a sword of Damocles for European equities, as is the anti-Euro, anti-capitalism, xenophobic National Front's political success in France now that President Hollande's approval ratings have fallen to 15 per cent, the lowest in the history of the Fifth Republic.
While German luxury auto manufacturer Daimler AG will hugely benefit from the fall of the Euro, the strength in the North American truck market and the new $5bn corporate restructuring plan, its shares should only be bought if Gulf investors hedge currency risk. Daimler AG offers an almost five per cent forward dividend. The ECB's policy action reflects a grim economic growth and inflation outlook for the Old World. This means German Bunds will outperform US Treasury bonds as the ECB opts for easy money while the Federal Reserve is forced to "tighten". However, European equities will underperform US or Japanese equities since recession could lead to a fall in analyst earnings growth estimates this winter will mean a fall in crude oil and metal prices, making energy and mining shares a disaster on Wall Street even while the world scrambles to buy technology shares as capex spending plans accelerate in Silicon Valley. This sector rotation began on Wall Street in September.
A strong US dollar and higher US interest rates are negative for emerging markets currencies dependent on offshore funding for current account deficit. This means investors should expect major currency sell offs in Turkey, Indonesia, South Africa, Brazil. In Asia, Taiwan has the highest current account surplus and earnings momentum. Japan is still attractive at 12 times forward earnings and 1.5 times book value as Abenomics redefines the Empire of the Rising Sun-and Sinking Yen!
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|Publication:||Oman Economic Review (OER)|
|Date:||Oct 28, 2014|
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