As the first quarter comes to a close, there were two significant developments in financial markets that very few people have recognized or are discussing. These shifts in prevailing relationships will be the critical few drivers of asset prices over the next 3-6 months.
US Divergence Trade Shifting
The US divergence theme, which I have been discussing since last Summer, may have started to shift.
Beginning late last Summer, the divergence theme that had the US economy as the healthiest of everyone in the sick ward, produced a cycle where the USD and US equities rallied together and left all of the other major currency and equity markets in their wake. In addition to the expected relative outperformance of the US economy, the other component of the US divergence theme was the fact that the US Fed was the only central bank to begin to tighten post-Crisis, while the rest of the world’s central banks continue to utilize easing policies to help spur economic growth.
The central banking component of the divergence theme did not disappoint. Through the first 3 months, no less than 23 central banks announced easing policies, the most significant of which was China. In fact, there were several banks that weren’t expected to join the free for all, that surprised and cut rates, including: Thailand and South Korea.
Despite a lot of recent speculation to the contrary, the Fed continues to point to an interest rate hike in June or September. Despite downward revisions to the Fed’s growth forecasts, Yellen has noted that it still anticipates above trend growth.
Although there is greater attention on the USD's rise from the Fed, it does not appear to be overshadowing other factors. Nor does the USD seem to have risen to a point that poses an obstacle to the beginning of the normalization of US monetary policy.
However, the high correlation between US equities and the USD as well as the outperformance of US equities over the rest of the world, has begun to breakdown and reverse.
The USD finished Q1 on a strong note, outperforming every major currency except for the Swiss France, which was the strongest of the major currencies following the SNB's decision to lift the currency cap, gaining 2.2% against the USD.
On the opposite end of the spectrum, the Euro posted its worst three-month performance since it began, declining 11.3%. The USD’s continued strength has raised concern about the robustness and sustainability of US corporate earnings. This concern coupled with negative interest rates in Europe and the ECB's policy response has created a powerful incentive to move into European equities.
A significant portion of European bonds have negative yields further propelling investors into European Equities. During some weeks, the flow of funds out of US equity funds into European equity funds matched up almost dollar for dollar. All of this has led to European equities, FEZ, outperform US equities, SPY, by 660 basis points so far this year. The Eurozone isn’t the only equity market outperforming the US year-to-date. Capital has been flowing into the emerging markets as well.
This capital flow has led to 600 basis point outperformance by a number of equity markets including: China, South Africa, Taiwan, South Korea, and Russia. Russia’s equity market is outperforming the US by a gaudy 2,500 basis points.
The continued strength of the USD and the relative weakness of US equities has caused a shift in the correlation between these two markets. The implication of these shifting correlations reflects changing drivers for asset prices and is one of the most important developments in 2015.
US Economic Growth Expectations Shifting
Readers of TWR know that I have a couple of proprietary indices that help me to get a good grasp on trajectory of US growth moving forward over the short-term. The first of these indices is my US Slow Growth Index, which is made up of assets that outperform on a relative basis when the US economy is slowing, or decelerating.
The other index is my US High Growth Index, which consists of assets that outperform, on a relative basis, when the US economy is exhibiting strong or accelerating growth.
Monitoring these two indices allows me to know, in real-time, whether market participants believe that the US economy is going to see growth accelerate higher in the next few quarters or will growth begin (or continue) to slow over the next 3-6 months.
Last year, my US Slow Growth Index doubled the return of the US High Growth Index and beat the S&P 500 by over 300 basis points. However, during the first 2 months of this year, that tide had turned. The US High Growth Index was outpacing the S&P 500 by 100 basis points and the US Slow Growth Index by 400 basis points. It should be noted that the US Slow Growth Index declined 2% through the first 2 months of the year.
But just as the sands are shifting with the relationship between the USD and US equities, so too, there is a shift occurring the market’s outlook for US growth. Over the last month, US Slow Growth assets are outperforming their High Growth counterpart by 320 basis points and the broader US equity market by 470 basis points.
Investors began the year with high hopes of US growth despite the bleak growth picture throughout the rest of the world. Clearly, market participants have not been impressed by recent US data and are pessimistic that any robust data lay in front of us. This shifting of the sands on the US growth front is the other significant development during the first quarter of this year.
I manage money based on the belief that markets are a dynamic interplay between history, math and human psychology.
The key word being dynamic.
Markets are like ecosystems, it evolves and shifts for its own survival. Most people believe that either markets are random and unpredictable or deterministic and foreseeable. The truth is that markets are both. The key to outsized returns with lower volatility is the ability to identify the subtle shifts in capital markets before everyone else and position yourself accordingly. Attain a position from which you can exploit the market’s inevitable imbalance.