Markets and the Dollar
Stocks rallied in recent weeks, until the looming “Brexit” vote in England stopped the upward momentum in its tracks. Markets participants had assumed the British would vote to remain in the EU, so they had simply shrugged off the vote until last Thursday when the polls show the “exit” side ahead. European stocks got crushed, more so on the continent than in Britain itself. Investors figure an exit would mean uncertainty in England but ultimately they wouldn’t suffer too much. The real worry is that a British exit would prompt calls for an exit vote in other nations, hastening the end of the Union. Political scientists will tell you that the failure to effectively deal with crises in Greece and Cyprus, coupled with the “every-country-for-himself” response to the Syrian and Libyan refugee crisis, has showed everyone that halfway integration does not work. The fact that savers in many of these countries receive nothing (or less!!) on their deposits just adds to the sense of “there has got to be a better answer than this” that pervades Europe right now. No government wants to give their people a vote at this point.
The stock rally had been primarily due to weakness in the US dollar. When the dollar weakens relative to other currencies, it reduces the burden on countries that have debt denominated in dollars. This primarily means emerging markets, and that is why emerging market performance has improved this year relative to their disastrous declines from 2011 through 2015. Latin America has been the biggest beneficiary of the suddenly-weaker dollar, since a rebound in commodities has coincided with the decline in the dollar. Lately when the dollar falls, the market displays “risk-on” behavior – meaning economically sensitive and/or more leveraged companies & industries tend to perform better, as do higher interest rate countries. On the other hand, when the dollar rises, the ”risk-off” winners are much fewer -typically only utilities, real estate and consumer staples, and also usually the Japanese yen.
Gold has been a huge beneficiary of the change in expectations regarding the dollar. 2015 basically saw gold in a death spiral. Prices were falling due to the strong dollar, and mining firms had little or no access to capital since nobody likes to finance companies they expect to go out of business. Valuations understandably became dirt cheap. With the recent dollar weakness, investor demand has improved considerably – which also reopens the capital spigot. The Gold Miner ETF (Ticker:GDX) is up roughly 95% so far this year. See Chart 1. However, even with that incredible year to date performance gold miners aren’t even close to break-even on a five year basis. The point being that gold mining stocks are EXCEPTIONALLY volatile, but even after 95% gains are not necessarily expensive. ETFs that invest in gold bullion (Ticker: GLD) are up roughly 20% so far this year, but their five year annualized losses are less than half that of miners. See Chart 2.
Chart 1 – YTD
Chart 2 – 5 Year
Yesterday’s Federal Reserve decision to keep rates unchanged was completely expected. The only surprise was the forward guidance. After the last meeting, six governors expected two rate increases before the end of 2016. After this meeting that number was down to one. I interpret this as the Fed has seen more data than just the shockingly poor May unemployment report to conclude that the economic expansion is not accelerating, and therefore they are loathe to do anything to put it at risk. The behavior of the bond market continues to suggest that desire for safe, positive yield is overwhelming greater than fear of inflation. Stocks should continue to see this as a net positive[i]. So should gold investors.
Perhaps yesterday’s biggest loser was the Bank of Japan. The yen just keeps rising, increasing the deflationary pressure. I think you just have to avoid Japan right now from an investment standpoint.
[i] That doesn’t change my feelings about stock prices being well above what their earnings can justify in most cases, but valuation is a very poor timing tool in the short and intermediate term. In the long run, however, it is an excellent tool.