As the legendary Soros declares above: investing is never about making predictions, it is about making probability-adjusted bets. Hence global macro investors tend to map out scenarios and devise action plans to deal with uncertainty in the financial markets.
The US Dollar is a mega trend that has to be observed closely by virtue of the fact that most of the real world’s trade is conducted via the USD and it is the world’s reserve currency. For these reasons, when the greenback surges strongly (and unexpectedly), it tends to have a deflationary effect across the entire world akin to tightening liquidity conditions.
Since the start of 2016, the USD has been weakening year-to-date against many currencies, and that has led to easier monetary conditions across emerging markets, sparking a rally in commodities and emerging market equities. For an idea of how and where the markets could move in the fourth quarter, I’m monitoring the trend in the US Dollar for various possible scenarios to play.
A look at the chart of the US Dollar Index (DXY) tells us that it has been literally sideways for some time since mid-2015. Year-to-date, price action of the DXY has been in a triangle on higher time-frames and has spent more than 50% of the time below its 200-day moving average.
At this current juncture despite the Fed holding its trigger in September, it could go both ways, breaking above its 200 DMA and the triangle pattern or breaking below. And when it does move and break from its current tight range, it could move in a sudden and drastic manner, given the market’s current positioning.
I suspect that it could break below, given the tendency of mean-reversion effects seen in mega currency moves during long term trends. The USD could be ‘pulled’ back to its 200-week moving average before it resumes its advance. The greenback also has the tendency to give off ‘bear traps’. During the previous bull market cycle in the USD from late 1994 to 2000, the greenback rose steadily until 1998 after the emerging markets crisis, and weakened heftily before resuming its bull trend (falling to its 200-week moving average). This can be seen in the chart below:
If the USD indeeds weaken for whatever reason, we could expect the following to happen:
- commodities continue to rally (crude oil, natural gas, softs)
- precious metals may continue to perform well (although the consensus view may lead to more muted returns)
- commodity-related equities will rally for a few months (energy-related equities could be a good near-term play)
- emerging market equities will continue to rally (Turkey, Russia, Indonesia, Thailand, India, etc)
- commodity-related FX may strengthen against the USD (Aussie, Kiwi, Norwegian Krone, etc)
I’m inclined to go long the Norwegian Krone (NOK), the Russian Rouble (RUB) and the Aussie (AUD) against the USD to play a commodity-reflation story. Playing this theme out via the currency markets also allows you to ride the tailwind of positive interest rate differentials.
I’m also messing around with certain emerging market equities in order to play this theme.
Additionally, the US equity market may perform well until the Presidential Elections in November or until the Fed’s next meeting in December (depending on how risk sentiment changes). At this moment, semiconductors have already rallied strongly since the start of 3Q 2016 (see chart of the Philadelphia Semiconductor Index below). The sector has seen some form of consolidation in 2015, and with recent inventory adjustment, this sector could be leading indicator for the months ahead. Thus, tech-related stocks could well lead the market’s performance, and the small and micro-cap segments as well as high beta cyclical areas could lead the way given that many investors are positioned in the stable, low-beta segments.
However, a second scenario is if the USD breaks above the triangle pattern and strengthens for whatever reason, and if so, we could expect that:
- risk sentiment could be more muted, capping the performance of high-beta / cyclical-orientated equities
- Emerging markets would see a reversal in its year-to-date rebound and rally (we probably need to monitor how economic data and forward looking indicators trend to have an idea)
- commodity-related currencies would suffer and reverse their strong rebounds year-to-date
- commodity-related equities would be great short plays
This 2 scenarios above would be the dominant story for the quarter (and even into 2017). I’ll be going with this playbook depending on what happens to the USD, and watching price action for cues.
Some risks that could spook markets and derail the reflation theme that I think is probable include concerns regarding Europe’s banking sector and if concerns over China materialise again (or both happening at the same time). However, with liquidity conditions abundant and the high yield credit markets still holding up well, sentiment and risk appetite is still strong at this moment…