US Dollar Vs. Junk Bonds, Commodities, And Emerging Market Stocks by Evergreen Gavekal

For those properly prepared, the bear market is not a calamity but an opportunity.” — Sir John Templeton


  • Stocks have rallied over the past couple weeks as (1) China drew down its foreign exchange reserves to stabilize its currency, (2) the Fed decided to delay its second rate hike, and (3) the Bank of Japan surprised the world with a negative interest rate policy.
  • Some investors see these events as cause for celebration, but we see them as reason to be worried about global economic and financial stability. From that perspective, we believe the latest up-move in stocks is nothing more than a bear market bounce.
  • We believe the US dollar will ultimately weaken if fears of a US recession continue to rise and the Fed is forced to reverse course. However, history suggests the dollar can run a bit longer if foreign central banks ease aggressively, China’s currency free floats, and/or global risk aversion takes over in a powerful way. In that event, we would expect financial markets around the world to sell off significantly.
  • With Japan’s unexpected move to negative interest rates last week, 23% of global GDP is now governed by central banks charging sub-zero rates on bank reserves. While it will undoubtedly lead to more misallocation and more financial system instability over the coming years, it also increases the risk of a Chinese currency shock, widespread competitive devaluation, and another surge in the US dollar in the short-term.
  • Financial markets are likely to remain under pressure barring a sharp reversal in the US dollar. While it could be a head-fake, the greenback has softened considerably in recent days.

Bear Market Bounce?

The following commentary is from the Evergreen Investment Team:

After falling roughly 10% in the first few weeks of 2016, US stocks melted up starting on January 20. Among the drivers of this rally were: (1) China deploying its limited foreign exchange reserves to temporarily stabilize its currency, (2) the Federal Reserve’s deciding to delay its second rate hike on fears of global stability, and (3) the Bank of Japan unexpectedly following Europe, Denmark, and Sweden into a negative interest rate policy.

Some Wall Street commentators interpreted this news and the subsequent bounce in global asset prices as a sign that the worst was over. They said that global growth jitters were somehow calming and that the US equity bull market would bounce back to new highs.

However, the Evergreen investment committee just looked on with skepticism. Yes, the stock market was clearly oversold, but we are not day traders. We are fundamental investors with a longer term outlook. Our view is that a bear market is already underway for most US stocks and recent events are more a cause for concern than for celebration.

As you can see in the chart on the next page, it didn’t take long for the excitement to fade. This kind of volatility is a classic symptom of bear market sell-offs in which stocks tend to put in lower highs and lower lows all the way to the bottom.

S&P 500 Since 2015

US Dollar Vs. Junk Bonds, Commodities, And Emerging Market Stocks

Source: Evergreen Gavekal, Bloomberg

The question is: what happens next?

As we’ve outlined in recent EVAs, Evergreen believes the Fed has been tightening for far longer than most people realize and that the resulting rise in the US dollar, fall in commodity prices, and tightening in credit conditions is pushing global markets to a breaking point.

If that’s true, it also means that the trade-weighted US dollar could continue its volatile rally even as US economic growth softens and the stock market crashes… just like 2001.

Trade-Weighted US Dollar Index And S&P 500

US Dollar Vs. Junk Bonds, Commodities, And Emerging Market Stocks

Source: Evergreen Gavekal, Bloomberg

We’re not saying the dollar can run forever. US recession risks are clearly rising and we believe an eventual turn from Fed tightening to Fed easing will ultimately lead to a reversal in this powerful trend. But it’s important to note that—just like the stock market—dollar bull markets can dramatically outstrip their underlying fundamentals as we saw in the mid-1980s and in the early 2000s.

Over the last week, though, the US dollar has fallen sharply, a bit over 3%. That may not seem like much compared to the wild gyrations of the stock market this year but in currency terms, it’s quite significant. Our partners at Gavekal Research are wondering if this might mark the top of the buck’s incredible run since the summer of 2014. As they concede, it’s a huge “if” but the futures market is now implying a mere 10% chance of Fed rate hike in March.

In fact, a growing number of pundits are shifting to our view that Fed easing is more likely later this year than additional tightening. Should this perception become main stream, it undercuts the primary reason for the dollar to rise. Aside from the up-lift due to potential rate hikes—and the related, but now fading belief, the US economy is an island of economic strength—the dollar is extremely expensive against almost every other currency. In other words, it is over-priced and vulnerable to a deeper correction. You don’t need to look any further than Mexico and Canada to see how cheap their products and services have become compared to those in the US.

As you can see below, the dollar started to go postal in the summer of 2014. This is almost precisely when nearly every asset class on the planet began to crack.

US Dollar Vs. Junk Bonds, Commodities, And Emerging Market Stocks

US Dollar Vs. Junk Bonds, Commodities, And Emerging Market Stocks

Source: Evergreen Gavekal, Bloomberg

We believe mid-2014 will go down in the history books as the pivot point for this up-cycle in financial markets. Yes, the S&P rose a bit higher after that, strictly as a function of a handful of stocks like the infamous FANGs—Facebook, Amazon, Netflix, and Google (you may have noticed the FANGs* have been biting their holders so far this year). But most stocks essentially topped out during that fateful summer. And for asset classes like commodities, emerging market stocks, and the junkiest junk bonds, it’s been nightmare conditions ever since.

Consequently, if the dollar is truly in break-down mode, that should be very good news for the biggest victims of its spike. The fact that the yen is now higher than it was before Japan announced its negative interest rate policy gives some credence to the theory the dollar is topping. Also, the euro is higher versus the buck despite the European Central Bank’s head, Mario Draghi, promising to do whatever it takes to elevate inflation (central banker-speak for trashing its currency). The totally nuked energy sector would be among the most obvious beneficiaries if the dollar is actually reversing course.

Despite the hopeful scenario outlined above, we need to be realistic. And the reality is there is a lengthy list of negative developments occurring simultaneously around the world. One we don’t feel is getting the

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