The consensus for a strong dollar is more fragile than it appears
Our asset allocation models have been significantly dislocated by the strength of the US dollar. Our previous note – Currency First Is Second Best – showed that we had a model for working round the problem, even if it was difficult to know when to use it. This note introduces our G7 currency model, which we have been live-running for about two years. We don’t use it to make trade recommendations because we think the risk-adjusted returns are normally unattractive compared to those in other models, but it is occasionally useful in times of extreme market stress. The model itself is based on a mean-reversion approach and it is now close to its largest underweight position in USD over the last two years. This time last year, it was close to a two-year maximum overweight, when the consensus view was the dollar would be weak in 2021. If we were forced to commit capital, we would position for a weaker USD, but we think the right time to do this is January, not December.
Even the strong dollar is not as important as you think
Clients often ask whether they should incorporate a currency view into their asset allocation process, to which the short answer is No. Although we don’t normally publish it, we have a model which prioritises currency selection over asset class selection. There are times when it outperforms our standard model (and now is one of them), but over the long run it produces lower returns, with higher volatility and deeper and longer drawdowns. Two conditions are required for the Currency-First model to outperform – a global bull market in risk assets and easy monetary policy in the US. Neither one, on its own, is sufficient. If you believe the latest FOMC minutes, our standard asset class model should start to outperform again, sometime in the first half of 2022.
EM ex China has begun an interesting rally
We think it is time to take China out of the main EM equity indices. Some of the arguments made for its inclusion are no longer valid. It doesn’t make sense to have separate benchmarks for companies listed in China and Hong Kong. Separate indices for China plus Hong Kong and the rest of Emerging Markets would increase flexibility for all investors, not just those who no longer wish to have passive exposure to the current regime in China. Once we make the split, we can see that EM ex China has already begun an interesting rally.
Cause for concern in Technology and Financials
China’s stock market is always subject to official intervention, so the signals need to be interpreted carefully. However, there are two new red flags in our equity sector model, relating to Technology and Financials. Technology has suddenly started to deteriorate, which has historically been a good lead indicator for the US Tech sector. Financials are heading for a multi-year low relative to the index, which could have important implications for China’s FX policy regime.
Time to look at European Energy equities
Generating an adequate income from euro-denominated bonds is next to impossible, so investors should abandon the attempt. They should embrace currency risk – not try to hedge it away. They should enjoy the fact that US dollar yields are structurally higher than those in the Eurozone. This means owning long-dated Treasuries and dollar-denominated EM sovereign bonds. Finally, they should consider the source currency of their equity dividends and take another look at the Energy sector.
EM equity weakness may cause FX volatility to surge
So far, most of the damage inflicted by US/China trade tensions has been on EM Equities. Our models suggest they peaked over a month ago and there is no support until we get well into underweight territory. The danger is that equity weakness turns into FX volatility, affecting EMs and DMs. We know this is always dangerous for risk assets in general.