Weekly Closer Look: U.S. Dollar, Free fall or finding a floor?
The aggressive and prolonged dollar decline appears at odds with the economic backdrop, yet signs of a recovery remain elusive. Digging deeper into the drop, we remain optimistic that conditions are supportive of a modest dollar recovery through 2018.
A tight U.S. labor market with the unemployment rate sitting near a two-decade low, a lift to economic growth from recent tax cuts, and an economy nearing capacity constraints bode well for an uptick in inflationary pressures in 2018, in our view. We are already seeing signs that price pressures are starting to escalate with the 10-year breakeven rate—a gauge of inflation expectations—recently rising above 2%. This should ultimately help the dollar bottom and work its way moderately higher in 2018.
An unexpected, hawkish shift in Fed policy could also lift the dollar. If commodity prices remain high and import prices strengthen, stoking inflationary pressures further, this could prompt the Fed to surprise markets by raising rates to a greater extent than current expectations. With central banks in other developed economies poised to keep policy rates unchanged in such a scenario, the dollar would likely benefit, as would exporters in the eurozone and Japan, which have been held back by currency strength in their regions.
Beyond potential central bank policy shifts, there remain risks to the global growth outlook that are broadly dollar positive. A modest correction in equity markets could result in portfolio assets flying back to the safety of Treasuries and other dollar-denominated assets. Also, geopolitical tensions have not gone away. Given that dollar short positioning is significantly overstretched, an unwinding of these positions would further bolster a dollar recovery.
The pain for the dollar persists, yet some combination of the scenarios above, particularly continued strengthening of the U.S. economy and normalization of inflation rates, should see the dollar on the mend in 2018.
- The U.S. equity market wobbled for the first time in months as the Dow Industrials dropped 539 points (-2.0%) in the first two sessions of the week amid rising U.S. interest rates, concerns about health care profit margins, and accounting issues at insurer MetLife. But the latter two issues seemed more like excuses than the cause. The mild selloff was long overdue as the market had marched persistently higher since mid-November. It’s not yet clear if the market is out of the woods, but two bellwether groups, transportation and semiconductor stocks, actually held up a bit better than the market during the selloff. Regardless, we think investors should expect more turbulence in coming months.
- While the equity market attempted to regain its footing in subsequent sessions, Treasuries continued to sell off and yields climbed further with the 10-year closing near 2.78% on Thursday, up almost 38 basis points since the start of the year. The Federal Reserve’s slightly more hawkish meeting statement, including greater recognition of inflation risks, helped push yields higher.
- After outperforming in January, the Health Care sector has been weak recently as two issues have reinjected concerns about industry profit margins: (1) Three corporate heavyweights outside of the industry, JPMorgan Chase, Amazon, and Berkshire Hathaway, will pool resources in an attempt to collectively lower their health care costs. (2) President Trump restated his goal to significantly reduce prescription drug prices. RBC Capital Markets’ drug distributors analyst wrote, “… we do not see how the companies disrupt the healthcare status quo immediately. We believe that the power to drive change at a rapid pace resides only in Washington, where we see little chance of regulatory directed change emerging in the near term.”
- Despite the recent equity wobbles, fundamentals remain strong. S&P 500 Q4 earnings growth is pacing at 14.9% y/y, well above the 11.9% consensus forecast one month ago. Due to tax cuts, the 2018 consensus estimate has shot up to $154.66 per share, nearly matching our forecast.
- Following the Bank of Canada’s January rate hike, the market is pricing in two to three additional hikes of 25 basis points (bps) in 2018. We believe two hikes may be more likely as NAFTA uncertainty and the reaction of debt-burdened households to higher interest rates may slow the pace of tightening. We expect higher government bond yields, led by longer-term maturities, as the Canadian economy is operating close to capacity and signs of inflation are beginning to appear. We prefer short- and intermediate-term bonds until we see higher longer-term yields or a steeper curve. Many discounted 3- to 6-year bonds offer attractive after-tax yields.
- Looking ahead, credit fundamentals remain fairly healthy, but we see limited scope for additional credit spread tightening from current levels given many credit spreads are at the narrowest level in a decade. Aging expansions tend to engender more aggressive actions from corporate borrowers, and we are seeing some evidence of this. Upgrading quality remains a theme for us in 2018.
- The TSX Preferred Share Index is up 1.2% YTD and sits just slightly lower than the high reached on January 9. Since then, we have seen five new issues come to market, totalling CA$1.325B. Despite the significant new supply, the preferred share market has remained resilient, supported by an increase in rates, with the 5-year Government of Canada yield up 21 bps YTD. We believe the preferred share market remains well positioned to deliver a mid-single-digit annual return, with a chance of overshooting if market conditions remain strong.
- The European labour market continues to improve, with 140,000 fewer unemployed, though December’s 8.7% unemployment rate was unchanged. Core inflation crept up to 1% y/y in January from 0.9% in December, and is now sitting just above its three-year average. Despite robust 0.6% q/q GDP growth in Q4, it looks as though the European Central Bank (ECB) will hold back from being too hawkish.
- In the UK, our long standing dislike of domestic stocks is being vindicated. Our position has been predicated on: the slowdown in the economy due to Brexit uncertainty; ongoing fiscal austerity which can weigh on public sector facing companies; and worries regarding potential nationalisation, political intervention, or regulatory change should Labour gain power, which would afflict sectors such as Utilities and Transport. Domestically focused FTSE 350 stocks have underperformed their peers with international exposure, and are now trading at a significant discount of close to 15% to their historical average on a forward price-to-earnings basis. Yet, with most of these factors unlikely to lift in the short term, we believe it is too early to step back into domestic stocks. While we believe there is value emerging, the risk to earnings suggests caution is still warranted. We would wait for an improved domestic backdrop and more attractive valuations before changing our view.
- The rise in government bond yields in the largest developed markets in January put the Bank of Japan (BoJ) in an interesting position. The BoJ has targeted a 10-year yield of around 0% as part of its ultra-loose monetary policy to stimulate inflation—a goal which has been met with some degree of success over the past several years, although inflation remains below the 2% target.
- With low bond yields elsewhere in 2017, the BoJ was able to take its foot off the pedal in terms of its asset purchases. The recent surge in yields caused BoJ Governor Haruhiko Kuroda to reaffirm that Japan remains committed to its monetary policy to achieve its inflation target. This is in contrast to other major central banks and may prove a headwind for the yen. Some investors had been expecting some degree of reduction in stimulus, which would have been bullish for the currency.
- Industrial production in Japan for December rose to its highest level since 2008. The employment situation is at its tightest level in over 25 years. The unemployment rate is 2.8% while the jobs-to-applicants ratio, the number of jobs available relative to the number of applicants, continues to move higher and is now at 1.59. Japanese stocks are at their highest level since the early 1990s.
- China reported mixed Purchasing Managers’ Index (PMI) data in January. The official manufacturing PMI softened to 51.3 (forecast: 51.6). A stronger currency has caused some concerns about export demand. The yuan continued to move higher during the week and touched USDRMB6.3, the strongest level since China’s mini-devaluation in August 2015. The non-manufacturing, or services, PMI improved to 55.3 and remains at robust levels, as has been the case for years.
- China’s NASDAQ-style ChiNext Index fell after several major companies reported disappointing results. Leshi Internet Information & Technology Corp. (300104 CH), the second-largest index member, said it expects to post a loss of about RMB11.6B for 2017, reversing an RMB555M profit in 2016. Having fallen 11% in 2017, the ChiNext Index is still trading at a price-to-earnings ratio close to 40x.
Article Editor：Ray Li, MBA, CFA
RBC Wealth Management | RBC Dominion Securities
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