Dollar En Fuego
Several months ago, we pointed out that the US dollar index relative to gold had breached long-term moving averages to the downside. After some sideways churning, sure enough, the dollar has resumed its march higher while gold moves back towards multi-year lows, keeping the ratio on the downward slope. Since the end of 2009, Gold is essentially flat while the dollar index is approximately 15% higher. Conventional wisdom has been completely turned on its head over the past four to five years. Three rounds of QE, political turmoil in Washington, and a muddle through economy had many investors convinced a significant dollar collapse was on the way and gold would outpace equities. The opposite happened, a not so atypical situation in markets. What happens going forward? Considering the intensity of the recent moves, we wouldn’t be surprised to see a short-term technical reversal. Longer-term, there’s still plenty of space to the downside on the below chart, especially in light of the massive upward move in the ratio from 2003 to 2011.
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| Source: Bloomberg and IronHorse Capital |
Inflation Expectations: Tame
Meanwhile, as always, Fed watchers gnashed their teeth over the future Fed Funds rate trajectory and the Fed statement ahead of this week’s meeting. After the meeting, the “dot chart” showing Fed members’ predictions on the future rate path showed that the median projection for 2015 has moved slightly higher, from 1.125% after the June meeting to 1.375% today, suggesting rate hikes earlier than projected in 2015. Two Fed Presidents dissented. Dallas Fed President Fisher remains preoccupied with heading off phantom inflationary pressures before they spiral out of hand. Next month should represent the final month of QR.
We remain baffled by the rush for accelerated rate hikes in the US. We pointed out early in the summer that inflation pressures are completely benign at this point and that contributors to inflationary episodes, such as labor costs, remain subdued. This week, markets received word that year-over-year CPI came in at a paltry 1.7%. Year-over-year CPI hasn’t exceeded 2.2% since early 2012. Around the world, there’s a real risk of outright deflation in Europe and Japanese economic momentum has dropped off dramatically in recent months, perhaps putting some of the price stability gains at risk there as well.
Market participants are voting. Looking at the yield spreads between Treasury bonds and TIPS, we see that market expectations for future annualized inflation are rolling over again back into sub-2% territory over the next five years. We remain of the view that it’s much easier to tame inflation after it appears than it is to reverse the insidious deflationary trends associated with sub-trend economic episodes. The US remains far below potential. The worries about “overheated” economic growth seem ridiculous. If anything, the Fed, ECB and others may be too timid when it comes to pushing economic growth back towards long-term potential.
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| Source: Bloomberg and IronHorse Capital |
Europe and Japan: The Feeling’s Gone
With recent updates to the OECD leading economic indicators for Europe and Japan, we see that the economic momentum that kept markets hopeful throughout 2013 and early-2014 has dropped off considerably. In Japan’s case, Abe may have a big problem on his hands, with the smoothed Japan LEI moving back into negative territory for the first time since the ‘08/’09 global recession, suggesting that the probability for a Japanese recession is significantly elevated. Japanese citizens may be getting the worst of all worlds: higher prices, and dim economic prospects. Europe isn’t terribly far behind in terms of entering negative economic territory. As discussed above, outright EU deflation could be in the cards; the ECB recently felt compelled to enhance monetary stimulus programs within legal bounds, though indicators this week show that some of the measures had disappointing results.
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| Source: OECD, Bloomberg and IronHorse Capital |
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| Source: OECD, Bloomberg, and IronHorse Capital |
US: P/E’s Creeping Higher:
The S&P 500 index has moved comfortably above the 2000 level again. Long-term valuation ratios have moved in lock step. As of today, the 10-year CAPE P/E, using adjusted, pro-forma earnings to satisfy those concerned about accounting changes over time, stand at approximately 22.3x, approximately 0.8 standard deviations above the norm. Valuations in the US are roughly back to levels observed in ‘06/’07 and during the mid-1960s. As we’ve mentioned in the past, we’re not suggesting that a big market maelstrom is imminent. Instead, we want to point out that valuations near these levels have regularly produced sub-median real and nominal annualized market returns over the subsequent seven to ten years. In other words, it might be a bad idea to count on double-digit US returns over the next several years when thinking through the kids’ college funds. That doesn’t mean there isn’t opportunity elsewhere around the world, however. Many individual countries/regions’ index multiples are trading in the low teens and single digits. As such, we remain convinced that longer-term equity returns will come from overseas stock markets and that the US will be a long-term laggard. In addition to the P/E chart below, we’ve included a handy-dandy rundown of markets from cheapest to most expensive across several valuation metrics produced on Mebane Faber’s World Beta website. As you can see, the US is among the five most expensive in the world. Eastern European emerging markets and peripheral European developed markets hold many of the “cheap” spots. Much of the European malaise mentioned above has already been factored into equity market outlooks.
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| Source: Bloomberg and IronHorse Capital |
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| Source: Mebane Faber World Beta Blog. mebfaber.com |
