Dollar Weakness on the Horizon

Wed, Oct 23, 2019 - 10:21am

A strange brew of economic conditions may be coming together to produce some contrarian outcomes, including a strengthening global economy and a potential reversal in the dollar. Craig Johnson and Marc Chandler joined the Financial Sense Newshour to discuss their views on where the market and dollar is headed.

See Craig Johnson on Value vs. FAANG Stocks; Also, Marc Chandler Says Dollar Topping Out for audio.

Equities Set to See Influx of Capital

Craig Johnson, a certified market technician, certified financial analyst and frequent guest on Financial Sense Newshour noted that he sees U.S. equities likely to strengthen in the near-term.

His company’s 40-week technique has started to broaden, which is a positive sign of increased participation in markets. He’s also starting to see his Moving Average Cyclical Evaluation (MACE) indicators improve, providing signs that market breadth is picking up.

Another key factor leaving Johnson with an expectation for a pickup in equities is the world’s $17 trillion negative-yielding debt, which will eventually shift out of fixed income and move into equity markets.

In his last trip to Europe, for example, he heard from several fixed income managers at various pension funds that they are handing money to those in the equity parts of their funds.

“We have a structural shift happening in this market, taking money from fixed income to equities,” Johnson said. “That's going to last for a while. A third [factor] is, there's so much pessimism out in the marketplace at this point in time that it's very difficult to see a market really sell off when it’s as pessimistic as it is right now.”

Caution Warranted as Leadership Shifts

Though Johnson has revised his call for the S&P 500 up to 3125, he sees market leadership shifting. Some market indicators are signaling caution, and this is how we should be thinking about this market, he noted.

At the sector level, he is beginning to see inflection points in some industrial companies, with relative strength picking up in this space, and also in transportation.

Juxtaposed against this, he’s seeing the opposite effect playing out in the FAANG stocks, which have a massive amount of capital tied up in them. These large-cap names are not breaking out to new highs, and have been in multi-year uptrends. As profit taking takes over, we should expect to see some capital leak out of the FAANG stocks and into other sectors and into mid- and small-cap stocks.

There is some improvement in the financial sector as well, Johnson noted, and overall it appears that markets are beginning to see rotation in leadership.

“From my perspective, I think this is probably something that's going to last for a while,” Johnson said. “But let me be clear. I don't think this means happy days are here again and it's time to come up with some sort of new major call on the market. I think this is, again, a signal to proceed with caution, bump up our year-end objective from 2725 to 3125 on the S&P, and tactically pick our spots at this point in time. There still are a lot of concerns and a lot of challenges that continue to overhang this market that we need to very much pay attention to.”

Playing Growth Versus Value

This all points to a shift toward growth over value in the markets, Johnson said. Fixed income is effectively dead right now, and capital is flowing to equities in a search for yield.

Increasingly money is shifting out of bonds and into higher yielding stocks and dividend-oriented portfolios, Johnson stated. Some investors are looking for growth, while others are focusing on dividends in this market.

Both types of stocks should do well, as a natural balance unfolds between investors seeking to fulfill different needs. The way to trade this setup is to watch simple indicators such as the VIX, put a 200-day moving average on it, and whenever you start to see the VIX break below its 200-day moving average, take that as a signal we have shifted to the risk-on trade.

“Some of that money starts to shift over toward that growth side of your portfolio,” Johnson said. “When you see that VIX start to break above the 200-day moving average, which is more of a risk off, you take a slice of that portfolio and you shift it more over toward the dividend- and income-paying part of the portfolio. So you can be tactical and still keep your feet on both sides of this very difficult market to be trading with all the uncertainty out there. I think that can be a winning strategy for investors.”

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Where Is the Dollar Headed?

While it may be politically expedient to hope for dollar weakness in the United States, the trend indicates recent moves lower in the dollar are leading to oversold conditions, Johnson noted. He suspects we’ll see a relief rally in the dollar around support at its 200-day moving average.

The longer-term trend is still up, Johnson stated, but if we break below the 200-day moving average, that may change. In such an environment, however, international stocks and multi-nationals will probably catch a bid. Johnson is not ready to call for a change in the dollar’s direction. The long-term trend is still intact, he noted.

“The trend is still up for now,” Johnson said. “Yes, it's sold off, but the trend is still higher. I think you need more time and the evidence to say that the dollar is going to break out. You get a lot of support also at about a 95 on the trade weighted dollar index, too.”

U.S. Macro Outlook

This leads us to consider the big picture in the U.S., and Marc Chandler of Bannockburn Global Forex, shared his thoughts on the direction of the U.S. economy.

Recent retail sales figures hinted at potential problems coming from the U.S. consumer, but it’s too early to jump to any conclusions, Chandler noted. We’re currently in the longest expansion in U.S. economic history, he added. The reason this expansion has been able to last for so long is because it has proceeded so slowly. Chandler is seeing several indicators that point to late cycle activity.

When looking at the 12-month moving average of nonfarm payrolls, and the 12-month moving average of auto sales, both peaked a couple of years ago.

Core retail sales are up four percent, which is still healthy, but consumption is apparently being driven with credit, Chandler said. These factors all point to a slowing U.S. economy, he added. Coupled with recent phrasing from the Fed, Chandler believes this implies we will see the Federal Reserve cut rates in October, and possibly three more times in total.

“There’s about an 80 percent chance of that October cut priced into the market,” Chandler said. “Because the economy is so old, and this cycle is so old, and these late cycles are already taking place, I think we should anticipate further slowing next year. I think that's probably the signal that the World Bank and the IMF gave in recent days, cutting their world growth outlook including the U.S. forecast.”

Chandler on Interest Rates and the Dollar

On a longer time horizon, Chandler sees interest rates in the U.S. remaining lower for a longer period of time. Negative-yielding bonds are the culprit.

We still see people buying bonds, Chandler noted, not for the yield, but for capital appreciation. Something similar is playing out in equities, as well, as people are buying stocks not for capital gains, but for dividend yield. In addition, Chandler noted, he does not believe recent dollar weakness is transitory. Instead, he thinks the 10-year-long rally in the dollar is coming to an end.

The dollar is currently in the process of topping out, he added. The relevant pattern to watch for is that of tight monetary policy combined with loose fiscal policy. This produces the best mix for a country's currency, Chandler said.

That's the setup we saw last year, but the opposite conditions are now taking hold, as looser monetary and tighter fiscal policy spell trouble for the dollar on a structural basis. In the last stage of a dollar rally, interest rate differentials move against the dollar, Chandler stated. Since last November, the German two-year yield has been rising against the U.S. two-year yield. The same setup is happening with the U.K. and Japan.

“The U.S. is no longer the high-yield country,” Chandler said. “Because of our need for capital imports, because of trillion-dollar budget deficits, because of uncertainty about trade policy, foreign investors require a greater premium to hold onto U.S. rates, and to hold onto U.S. assets. I'm looking at the dollar to gradually wind down and come off. But so far to really solidify that we need to see better news out of Europe and Japan, and frankly we're not seeing that.”

Signals May Point to World Recovery

It might be that the world economy is poised to avoid a recession, potentially triggering the improving conditions Chandler expects to suggest the dollar rally is coming to an end.

Chris Puplava, chief investment officer of Financial Sense Wealth Management, noted that, while he has been positioning clients’ assets defensively based on a global growth slowdown he saw taking root a year ago, the setup may be changing. The U.S. is showing signs of deceleration now, and while global signs of slowdown persist, it may be that the world is going to begin coming out of this and return to growth.

We're getting to the latter stage of the global slow down, Puplava said. We will start to see stabilization internationally in economic reports and even some improvement, he added. Meanwhile, signs of slowdown in the U.S. are strengthening with retail sales growth and industrial production both slowing down. The wildcard is the ongoing problems with the U.S.-China trade war with the outcome remaining unclear despite somewhat easing tensions.

There is potential for a bearish outcome to have a muted effect, as everyone seems to be positioned for this already. Instead, if we see a positive catalyst surprise markets, we could see a significant reaction to the upside.

On the flip side, if we get positive catalysts—for example, if earnings in the U.S. come out on the positive side and surprise, if we continue to see progress with the trade war with China, and if economic growth comes in on the plus side—then I think you could see a significant increase and reaction to the market because people are positioned for the other outcome.

“This is a very asymmetric current setup right now in the markets, where everyone's positioned for the bearish outcome,” Puplava said. “If we hit the bullish outcome, I think the markets could surprise on the upside.”

Dollar Weakness on the Horizon

We're probably nearing a trough in global growth, Puplava stated, and when we see global growth accelerate, at the same time the U.S. slowdown is likely to persist, as the U.S. entered the slowdown later than the rest of the world. This is likely to create a setup where the U.S. dollar continues to weaken. The dollar outlook for the next six to nine months is bearish, Puplava stated.

One indicator Puplava tracks is a global M1 money supply index, where he pays attention to the aggregate money supply for the global economy. This has turned up, further strengthening the case that we should see a bottom in global growth.

“We're probably going to see international assets outperform U.S. markets,” Puplava said. “This really would be a complete reversal of last year when the global economy was decelerating, while the U.S. economy was accelerating. What we saw from that was strength in the dollar compared to world currencies. Now I think we're going to see the complete opposite of that, where the global economy strengthens while the U.S. weakens. … I'm not just seeing the dollar weaken against one currency. I'm looking for the dollar to weaken against most global currencies. … Weakness in the dollar relative to world currencies near-term is probably going to broaden out and extend into an intermediate term viewpoint.”

To listen to this podcast, see Craig Johnson on Value vs. FAANG Stocks; Also, Marc Chandler Says Dollar Topping Out, or for a full archive of past shows, visit our Financial Sense Newshour page.

By Ethan Mizer

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