Investment Highlights:
■ Among G7 countries, the correlation between currency performance
and Technology exposure is 95%. In a larger
universe of countries, it is 73%.
A weaker US dollar has been part of our global strategy. We
thought the dollar’s strength in 1997 and 1998 was
attributable to a global flight to quality. Investors moved
into higher quality US assets (such as T-Bonds) as the global profits
cycle decelerated, and we thought that process would reverse
and put pressure on the dollar when the global profit cycle reaccelerated.
The global profits cycle has indeed reaccelerated, but the
dollar has remained strong.
Is the strength in the dollar reflecting a renewed flight to quality,
or is it reflecting non-US investors’ enthusiasm for US Technology
stocks? It appears to be the latter.
■ Capital account vs current account
For some time, we have argued that the rally in the US dollar from
1995 to 1999 was based on the capital account rather than the current
account (monetary and capital flows rather than trade flows).
The trough in the US dollar in 1995 coincided roughly with the peak
of the global profits cycle. Markets become increasingly “Darwinistic”
when profits cycles decelerate, and investors gravitate toward
higher quality investments.
Without sounding terribly ethnocentric, US T-Bonds are perhaps
the highest quality investment in the world, and the increased
desire to purchase them as the global profits cycle decelerated
helped the dollar to appreciate. More recently, we expected the dollar
to depreciate versus other currencies because the global profits
cycle was accelerating again. Typically, investors shift from safer,
higher quality assets toward riskier, more cyclical assets when
profits cycles accelerate.
We expected investors to shift from T-Bonds to riskier assets
around the world, thus putting pressure on the dollar. However, the
US dollar has strengthened rather than weakened. In this short
report, we try to investigate why it has done so despite fundamentals
that might suggest otherwise. Clearly, we are not currency
experts. We leave formal currency forecasting to our Economics
and Currency teams. However, this study attempts to explain the
role the Technology bubble may be having on currencies. We examine
no other factors.
■ The Technology bubble is sucking capital away from non-Tech
industries as well as from non-Tech countries
■ If one is bearish on US Technology, then should one also be
bearish on the US dollar?
■ The black hole gets bigger
We include both the Canadian dollar and the Australian dollar within
our Inflation Composite Index (ICI). Because of the composition
of those countries’ GDPs, traditionally these two currencies have been
viewed as proxies for the strength in commodity markets. The two
currencies have looked more like opposites so far this year, as the
Canadian dollar has held its value versus the US dollar, while the Australian
dollar has lost about 10% versus its US counterpart.
Many have asked us what might be causing the significant difference
between the performance of the two currencies so far this year.
One client suggested that it might be related to the percent of each
country’s stock market capitalization that was in Technology stocks.
We have felt strongly that the dollar’s strength was not attributable
to a “flight to quality.” Then, upon hearing this suggestion, it suddenly
occurred to us that the Technology bubble was not only sucking capital
away from every other industry in the United States, but it was
also sucking capital away from other countries.
Our research supports the contention that flows into US Technology
stocks are influencing currencies. The currencies of countries in
which Technology comprises a greater proportion of their stock markets
are outperforming those with little Technology exposure. Our
research shows the correlation so far this year between currency performance
versus the US dollar in the first quarter among G7 countries
(plus Australia because of its dollar’s inclusion in our ICI) and
the percentage of their stock markets’ market capitalizations that are
comprised of Technology and Telecom stocks. Our studies clearly
show that the currencies of countries with greater Technology and
Telecom exposure have outperformed those with smaller exposures.
The R-squared of the regression fit among these points is 0.91
(correlation equals approximately 0.95). Further research examined
the same analysis for a broader sample of countries (24 countries versus
eight in the previous example), and the results were very similar.
Although the summary statistics are not quite as strong (R-square
of 0.54 with a correlation of about 0.73), it is clear that the relationship
still exists. In fact, only three of the twenty-four currencies
included in the study outperformed the US dollar so far this year, and
two of the three have significantly larger exposure to the Technology sector than does the US (Korea and Taiwan). The only other currency
to outperform the US in our sample was the Mexican peso,
and Mexico’s recent fortunes have been linked to those of the US.
■ Little relationship to domestic fundamentals
We find it interesting that the Australian dollar and South
African rand have performed so poorly versus the US dollar this
year because domestic fundamentals are so strong. As we have pointed
out in other reports, and as the following chart highlights, the
strongest estimate revisions in any region of the world are presently
in the Resource Markets, which we define as Australia, Canada
and South Africa. Thus, it appears that Technology weighting
rather than fundamentals is influencing currency performance. Technology
and Telecom stocks comprise only about 11% of South
Africa’s market capitalization and only about 23% of Australia’s.
Both weights are quite small compared to the US’s 50%.
■ Self-correcting mechanism may be global
We have mentioned in previous reports the self-correcting
mechanism that we feel is underway in the United States as
investors overcapitalize the Technology sector and undercapitalize
the real economy. The overcapitalization of Technology might ruin
the profit prospects for the individual companies in those industries,
but the undercapitalization of the real economy is improving the
profit potential of real economy, old-fashioned companies. We have
mentioned that Merrill Lynch Fundamental Equity Research’s
earnings forecasts show the earnings growth rates of many real economy
sectors catching up or even surpassing earnings growth in the
Technology sector. This analysis suggests that the self-correcting
mechanism might take place on a global scale. For example, we
might be overcapitalizing US Technology and Telecom, but might
be also undercapitalizing Australian Resource companies.
■ As goes tech, so goes the US dollar?
If one is bearish on Technology, should one be bearish on the US
dollar? If it deflates rapidly, then the US dollar might stay strong.
Technology and Telecom stocks dominate many markets, and a sudden
fall in those stocks might foster an all-out “flight to quality” to
the T-Bond similar to 1998’s. However, if the deflation of the bubble
is orderly and gradual, then the US dollar might indeed decline
as investors begin to appreciate the improving fundamentals of out-
of-favor sectors, industries, and countries.
US investment strategy
■ The combination of a ‘one-theme’ market with very poor
breadth, an economy that is growing well in excess of what is sustainable
over the medium term, and a Central Bank in tightening
mode is not ideal for equities. It seems prudent to keep an above-
average weighting in cash.
■ However, the momentum of corporate earnings remains
robust against a background of vigorous domestic demand
growth. Moreover, we have been impressed by the way that the
broad markets have performed well in the face of a correction
in the NASDAQ.
■ Market breadth continues to deteriorate, and we have yet to
identify the catalyst that may cause the market to broaden. Historically,
falling bond yields have tended to be associated with
improving breadth.
■ However, it still strikes us as premature to rotate into bonds and
bond-sensitive sectors. The rally in the US long bond is clearly
supply distorted, corporate bond yields have failed to perform,
and global indicators remain consistent with stronger, not
weaker, activity. The sharp rally in financials over the past month
looks more like a bounce from oversold levels than any fundamental
shift.
■ Given our neutral stance on the Technology sector, our sector
strategy continues to favor the Energy and Basic Industries sectors,
rather than Consumer Defensives and Financials.
What’s changed?
Despite two 25bp tightenings by the Fed, the US economy continues
to gather momentum, with the consensus of US economists
now forecasting almost 4.5% growth in 2000, well in excess of the
Fed’s desired target range. Over the quarter the long bond yield fell
some 50bp, but more on supply concerns than on any sense that the
Fed had tightened sufficiently to slow the economy. This may have
exaggerated the flattening in the yield curve. By contrast, corporate
bond yields (Baa) ended the quarter stubbornly high at 8.3%.
According to VB/EIS, prospective earnings for the S&P Composite
are up 15% on a year ago and rising. Against a background of 5%+
domestic-demand growth, the earnings outlook for the S&P universe
looks well supported at least for this year. For the first two months
of the quarter, sector rotation was brutally in favor of technology.
However, the past month has seen an aggressive shift not only into
basic industries and resource stocks, but also into financials.
What to Look Out For
The combination of a ‘one-theme’ market with very poor
breadth, an economy that is growing well in excess of what is sustainable
over the medium term, and a Central Bank in tightening
mode is not one for the faint-hearted. Add to that a global economy
that is experiencing the strongest industrial upswing since
1994 and the strongest prospective GDP growth for over a decade
(3.2%) and you have an environment where it seems prudent
to maintain an above-average weighting in cash. The phrase
“don’t fight the Fed” – much quoted when interest rates were
being cut in 1998’s Asia crisis – is notable by its absence now.
One of our major concerns is the deterioration in market breadth that
is apparent on both the NYSE and also on the NASDAQ. Over the past
twelve months, around half of the constituents of the S&P Composite are
more than 25% off their highs. One of the key issues is to identify the
catalyst that will trigger a broadening of the market and the next
major sector rotation. Indeed, one fundamental issue is whether a broadening
of the market can occur without some further correction in tech.
Over the past 15 years a broadening of the US equity market has tended
to occur against a backdrop of falling bond yields and declining
prospective nominal GDP growth. There is little to suggest at present
that the Fed’s tightening to date has prompted any downgrading of
growth expectations.
The Fed will continue to tighten until growth expectations start to
be revised lower. At that point bonds and the more defensive sectors
may start to perform again. However, given the strength of the global
economy and the momentum of US domestic demand, the process
could take a while. For that reason we maintain our bias towards
the economic sensitives, including the “old economy” basic industries.
In the event of a further sharp correction on NASDAQ, the interest-rate outlook could improve significantly as fears of a Fed tightening
wane. Currently the futures market is discounting a 60bp rise
in 3-month Euros to just under 7% in six months’ time, in which case
the knee-jerk reaction of investors might be to downgrade both
growth and interest-rate expectations on the back of potential negative
wealth effects and rush to the defensives. But this could end up
only being a transitional phase. The strength of US domestic demand
coupled with a broadening economic recovery in Europe and Japan
should not be underestimated. Even if the global growth rate peaks
this summer, we expect growth to remain firm going into 2001. For
many fund managers who have adopted a neutral weight in technology,
the crux of the matter is how best to hedge the portfolio. The
longer the Fed’s tightening is perceived as insufficient to return
growth to the 3.25% to 3.75% corridor, the more cyclical value looks
attractive and a move into bond-sensitives premature. However,
there is a well-established inverse correlation between technology and
consumer staples, and a sudden correction in tech might be more likely
to prompt a defensive shift. Indeed, such a correction could be interpreted
as bond-positive to the benefit of the financials in so far as a
tech sell-off might make the Fed’s monetary stance look more convincing.
It is too soon to count growth out yet. We think the recent rally
in financials reflects the correction of an oversold condition rather than
the start of a bull run.
