The recent dollar rally has triggered sharp declines in emerging-market stocks. They’re cheap at the moment, and an end-of-year rally could pay investors in multiple ways.
As if volatility, geopolitics, and worries over slowing economic growth weren’t enough, now we have to keep an eye—like we’ve got one to spare—on currencies.
I’d argue that over the last two weeks to a month, the rising dollar has been the most underappreciated driver of stock prices. And the weeks ahead are setting up the dollar, the euro, the Chinese renminbi, and the Brazilian real as big market movers. The reversals and rallies of the next month are likely to be signaled by, related to and amplified by currency moves.
Watch carefully if you want to catch the next rally—and avoid getting blindsided by the next reversal.
Dollar Gaining Strength
Witness the dollar’s climb against global currencies from August 30 to September 27. During those four weeks, the dollar gained 7.7% against the euro, 8.8% against the Australian dollar, 9% against the Norwegian krone, and a whopping 15.4% against the Brazilian real.
Even the Chinese renminbi lost ground to the dollar, as Beijing let the currency slide to a 3.6% decline versus the US currency.
The “why?” is pretty simple to answer. When the world gets riskier—or investors and traders perceive it as getting riskier—the world buys dollars.
Now, this might not make sense to you if you have a long-term view of the world, and are worried about little things like the US budget deficit, soaring government costs for health care, and slow economic growth. But if your time frame is days, weeks, or months instead of years, the US dollar is a great haven.
US markets are very liquid, so it’s easy to get in and out, and the Federal Reserve has promised no interest-rate increases until mid-2013, so there’s no risk that higher rates will bite into the value of your dollar assets.
And, again, hard as this may be to believe, US macroeconomics and politics are more stable in the short run than those of the Eurozone (well, duh!) or Brazil (runaway inflation), to take two examples.
The effect of dollar appreciation would have been significant if the gains in the US currency had been spread over a year or 18 months. Taking place over just the course of a month, dollar appreciation has moved markets big time.
A rising dollar sent commodity prices falling—as if they needed any help, given the fears the global economy (read China) was slowing. (See my Sept. 27 column on why only China matters.) The price of copper, for example, fell by 17.6% from Aug. 30 to Sept. 27.
A rising dollar and falling commodity prices sent commodity stock prices plunging. For example, shares of copper and gold miner Freeport McMoRan Copper & Gold (FCX), a Jubak’s Pick, dropped by 25.3% during this same four-week period.
That put significant negative pressure on emerging stock markets, as currencies pushed share prices down and commodity prices pushed commodity-intensive economies and their stock markets down. Commodity stocks, often among the stocks with the largest market capitalization in these markets, piled on the downward pressure.
No wonder the Brazilian stock market, as measured by the iShares MSCI Brazil Index (EWZ), which was already down 21.6% from its April 1 high to August 30, tumbled an additional 13.3% by September 27.
The wonder, actually, was why it wasn’t down more. This is all history.
NEXT: Where Do We Go From Here?
|pagebreak|Where Do We Go from Here?
So much in the currency markets depends on the Euro debt crisis, as William Carlos Williams might have written.
If the financial markets feel that the Eurozone hasn’t so much ended its crisis as reached a truce with it, the euro will at least stabilize against the dollar. That will last at least until the crisis next rears its head in December or so, when Greece has to make big payments to bondholders.
Currencies that are fundamentally stronger than either the dollar or the euro would climb in any truce, because cash wouldn’t be quite so single-minded in its search for safety. Commodities and commodity stocks would get a dual boost from a lower fear quotient and from any decline in the dollar.
But you can’t reduce the moves ahead in the currency markets to one all-dollar/euro, all-the-time cause.
For example, there’s the question of whether China will freeze the dollar-to-renminbi exchange rate again, as it did in July 2008. Beijing took the step then to give its financial markets and economy shelter from the global market chaos.
With 2011 reminding a number of people of 2008 and the threat to the global financial system in that year, another renminbi/dollar freeze would seem reasonably likely.
An appreciating renminbi against the US dollar would give some boost to the US economic recovery, because it would make US products cheaper in China. A frozen exchange rate would remove that boost.
A renminbi pegged against an appreciating dollar would actually make China’s exports more expensive in non-dollar countries and give those countries an edge in exporting to China. That would be a plus for a country like Brazil.
China might well be willing to pay such costs, though, to gain insulation from the global financial chaos, especially with Beijing already worried about the balance sheets of its own big banks.
What About Brazil?
As for Brazil, the value of the real is more likely to be set by internal developments than by what happens with the dollar or renminbi.
The Banco Central do Brasil lowered its benchmark Selic interest rate to 12% from 12.5% in August, before it saw a drop in inflation that hit an annual rate of 7.33% in September. It was placing a huge bet on the global economic slowdown cutting the prices of imports and commodities enough to get inflation in early 2012 below the central bank’s upper range of 6.5%.
I don’t think that’s going to happen. Much of what’s driving Brazilian inflation now is internal wage pressure.
For example, on September 27, the country’s bank workers staged a strike over pay. In their strike, which followed strikes from postal workers and metalworkers earlier in September, bank workers were demanding a 13% pay increase. Workers feel squeezed by the country’s current 7.33% inflation, and the drop in the value of the real just makes the pain worse, because it increases the cost of imports.
Maybe the central bank will get lucky, but I think that breaking inflation in Brazil now is going to require painful cuts in government spending and a return to a policy of interest-rate increases.
NEXT: A Ruble Crisis Coming?
|pagebreak|A Ruble Crisis Coming?
The great currency wild card, one that you probably haven’t thought about in a while, is Russia’s ruble.
The nation’s central bank has been active in the currency markets lately. It bought $2 billion in rubles on September 26 alone.
The problem is that Russia’s finances are a mess, especially after the government upped spending to increase the military budget and to put more cash into social programs. (It’s called buying off social protest.)
With the new spending, the Russian budget, which is heavily dependent on oil revenues, doesn’t balance unless oil sells for $120 a barrel. That’s not likely in 2012. (West Texas Intermediate crude closed at $81 a barrel, and Brent at $103 a barrel, on September 28.)
I think there’s a real chance of a cut to Russia’s credit rating in 2012, and an outside chance of a ruble crisis.
My conclusion from all this: While I can make a case for a short-term decline in the US dollar against the euro and other currencies (such as the Norwegian krone and the Australian and Canadian dollars) over the rest of 2011, if the euro crisis continues to move from a rolling boil to a simmer, I find it very hard to make a case that the dollar won’t regain its safe-haven boost in at least the first half of 2012.
Nothing coming out of Europe convinces me that we’re going to see a real solution to the debt crisis there this month—or even the creation of a credible firebreak to prevent the crisis from moving to Italy.
Without that solution and firebreak, financial markets could take a breather from the Greek crisis that could be long enough to fit in an end-of-the-year rally. But investors can expect a return to the crisis in December, when Greece needs another cash infusion (this time to pay bondholders).
I don’t see a way out of the crisis, except through the creation of a financial guarantee fund of a size that looks to be politically impossible in Germany, Finland and the Netherlands—or through a default by Greece.
Even the expansion passed by Germany today would not be large enough. The existing 400-billion euro fund is too small to do the job, and there’s no support in these countries for increasing the size of the fund.
Where the Pain Will Be Felt
I think it’s safe to assume that a return to the debt crisis—with a Greek default as a likely part of the end game—would not be good for the euro, and would cause cash to flow into the dollar.
That won’t be good for global commodity prices, for the currencies of emerging economies, or for developed economies with either actual or merely geographical ties to the euro. This trend will be especially tough on developing economies and emerging markets, such as Brazil and Russia, that are facing big, internally generated problems as well.
Will there be any place to hide from this dollar-up/everybody-else-down current trend? Maybe in what I’d call the China currency block.
There are a group of global currencies so linked to the Chinese economy—the Australian and Singapore dollars come to mind (sorry Canada, but too much of your economy is linked to that of the United States)—that cash flows in and out of the US dollar are less important for the value of their currencies than the growth rate of the Chinese economy.
As long as investors aren’t sure what China’s growth rate will be when it bottoms in 2012, it will be hard for these currencies to detach themselves from the global dollar trend. But as soon as it is clear—maybe in mid-2012—how slow China will go, then I think these currencies and economies will wind up, with China, dancing to their own tunes, and not that of the global trend.
If and when that happens, those will be the best-performing currencies (except for the dollar-pegged renminbi) and stock markets in the world.
NEXT: So What Do You Do?
|pagebreak|So What Do You Do?
- Profit from the end-of-the-year rally—if we get one—by picking commodity-related stocks that have been crushed recently.
(I have recommended Jubak’s Picks member Freeport McMoRan Copper & Gold for this purpose.) Add a dose of crushed technology shares, such as my recent Jubak’s Pick of F5 Networks (FFIV).
And consider a dollop of stocks outside the Eurozone that have been killed along with the euro. Take a look at Norwegian fertilizer company Yara International (YARIY), for example.
We should have a better sense of the chances for a year-end rally when we see, in coming days, how financial markets react to the newest temporary fix in the Greek crisis, and to the earnings season that starts on October 11.
- Sell into the rally in order to raise cash for the first half of 2012 (roughly).
The goal here is to have a supply of dry powder, so that sometime in the first half of the year, if the dollar rally resumes, you’ll have the cash to pick up the fundamental bargains that the dollar rally will create in commodities and commodity-related stocks, and in assets denominated in temporarily depressed currencies.
It’s OK if you keep your powder dry by investing in gold (if the yellow metal stabilizes) or less-volatile high-yield stocks until then.
I’d love to pick up Australian stocks if I can pay for them in temporarily overvalued US dollars. Over time, I’ll get not just the appreciation in the underlying stock, but in the currency, too.
- Wait patiently (or impatiently, but just wait) for evidence that the market is starting to see a bottom in China’s growth rate.
You don’t need to pick the absolute moment in 2012 when the market psychology changes. You’d just like to avoid taking too much punishment while you wait for a turn.
Will executing any one part of this strategy—let alone all three—be easy? No way. It will demand more patience that I usually can muster.
But from all I can see, managing your market exposure and your cash (or cash surrogate) positions will be the key to investing in the rest of 2011 and the first half of 2012.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund did own shares of Freeport McMoRan Copper & Gold and Yara International as of the end of June. For a full list of the stocks in the fund as of the end of June, see the fund’s portfolio here.
