- The US$ to appreciate further over time, we would suggest going long on a the trade-weighted dollar and via the yen
- The US economy is going to recover further in the second half of 2013 and well into 2014
- QE will be reduced in the early parts of 2014, but Treasury markets will begin pricing this ahead of time
- For all the same reasons that the US$ will gain strength we should see pressure on gold
- US Equities still look good, until margin over-extension becomes very extreme and equities correct
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We thought it worthwhile to look at the best-performing economy in the western world in some more detail:
The USA is actually improving at a rapid pace.
Firstly, her housing market is expanding and we are for the first time seeing that housing demand is going to outpace supply for a while into the future. With population growth of around 1 million households and with demolitions adding up to around 200-300 thousand houses there are just not enough new housing starts (around 1 million) to replenish demand at the moment. Housing stocks also need replenishing and the combined effect is an environment where we would expect housing prices to rise and related industries to flourish further.
Housing in the US has special significance and it is not only an important part for the US economy due to its size of GDP but additionally due to the wealth effect. Since home ownership in the US is one of the highest in the world, any change in house price has a significant wealth effect upon the population and in turn upon their spending behaviour. Higher house prices mean that the population feels wealthier, that they can borrow against their asset more freely and that they are inclined to spend more. Overall a substantial assistance to the US economic recovery.
Secondly, we find of tremendous interest is bank lending which we have been commenting on, to our investors, even before this note began in November of 2012. Banks have started a long while ago to lend more to small and medium-sized businesses which make up the bulk of the US economic growth (these companies also have limited or no access to capital markets). Low interest rates have made it easy for larger companies to raise capital via bond issuance and we see that the 'grab for yield' by investors has reduced spreads of high yield bonds (junk included) to near historic lows. And all this with default rates at near historic lows too - this is one of the side effects of easy money and it has meant that companies can finance themselves readily and sufficiently. Part of the US economic growth story is indeed that the transmission mechanism within the economy has begun to work better and this will over time enhance liquidity to companies and boost the economy further.
Thirdly, companies have also become very lean over the last years, boosting efficiency to a maximum. There is a high level of unemployment but some of that may be here to stay, as lower skilled labour is structurally less needed. Efficiency has been gained by automating low skilled labour tasks and it will be some time before the unskilled labour force can be re-educated towards other employment. In short, skilled labour is in demand while unskilled labour is suffering. We see the potential of segmented wage push inflation feeding into the system over time.
We do not, however, expect a sudden rise in overall inflation, as commodity prices fall ("I have too much energy" or "Is there Method in Market Madness" Tuesday, April 23, 2013) should give enough deflationary impulses to give the Fed scope to keep QE for another 9-12 months. But we do expect that the interest rate markets will increasingly price this higher wage scenario into the longer end of the bond market ahead of time (see "There is treasure in them Treasuries" Thursday, April 4, 2013).
The one big drag on the US economy is the substantial fiscal burden that the government has imposed upon its population which is in effect a tax on the consumer and diminishes disposable income economy wide. However, there are currents at work to offset this extra load on the economy: In essence they are the mentioned wealth effect via both housing and the equity markets (and till now the bond markets) and the lowering of commodity prices, which assist companies via lower input costs but also help the consumer directly via lowering of gasoline and heating costs (in effect is a lowering of taxes). This has a substantial positive impact on the now famous 'animal spirits' of consumption. Combined with demand increasing for higher skilled labour we should see the US economic recovery gaining momentum despite headwinds being forced upon it.
What this means for investors:
As we discussed in the past we favour the US Dollar and much more strongly since Japan has embarked on its massive monetisation policy, other emerging markets have explicitly or implicitly targeted their strong currency for weakness (like Australia, New Zealand and Europe) and the Fed is talking about their exit strategy for QE. Essentially, the whole world is enhancing its monetary stimulus and thereby assisting economic growth in their regions, while the US is closer to reducing its QE programme, rather than enhancing it. This should go a long way to protect the world economy from substantial loss of momentum in the medium term and enhance the US$ due to capital flows and better overall economic performance. We believe a stronger US$ would need a long time frame to have any detrimental effects on the US economic growth developments and hence should be an acceptable consequence of economic recovery for the US authorities.
As we discussed in the past we favour the US Dollar and much more strongly since Japan has embarked on its massive monetisation policy, other emerging markets have explicitly or implicitly targeted their strong currency for weakness (like Australia, New Zealand and Europe) and the Fed is talking about their exit strategy for QE. Essentially, the whole world is enhancing its monetary stimulus and thereby assisting economic growth in their regions, while the US is closer to reducing its QE programme, rather than enhancing it. This should go a long way to protect the world economy from substantial loss of momentum in the medium term and enhance the US$ due to capital flows and better overall economic performance. We believe a stronger US$ would need a long time frame to have any detrimental effects on the US economic growth developments and hence should be an acceptable consequence of economic recovery for the US authorities.
One way to think about this process is to identify who the main beneficiaries of US QE were and to imagine the opposite effect as QE is slowly exited. A lot of emerging markets spring to mind, where the same flows that have once assisted their capital markets and currencies should now be reversed. Essentially, in the first instance as US QE diminishes we should see the US$ strengthen further and the biggest losers to be the EMs as monies will flow back to the USA.
Overall, we see a lot of things falling in place for a dollar strengthening scenario and would like to add how much more helpful and attractive this makes the yen-US$ play. But also being long the US$ on a trade-weighted basis or against Emerging Market currencies.
Finally, there is also another nice part about being long the US$ which is that it is the reserve currency of the world and the place everyone flees to if there should be a real crisis along the way. So an economic meltdown in Europe or a crash in China or even a war in the world would mean that the US$ will appreciate on such an occurrance due to 'safe haven' flows. So an extreme outlier event is also covered via this trade.
We have been asked by a few of our readers to again comment about gold. Though we have no formal interests in the material at the moment we perceive the real potential for QE reduction in the US and for real interest rates to become more neutral after their extended stint in negative territory to be dampeners on the gold price and would not advise long positions in the yellow metal (especially not in US$ terms) (see article "Is there Method in the Market Madness?" Tuesday, April 23, 2013.
We have been asked by a few of our readers to again comment about gold. Though we have no formal interests in the material at the moment we perceive the real potential for QE reduction in the US and for real interest rates to become more neutral after their extended stint in negative territory to be dampeners on the gold price and would not advise long positions in the yellow metal (especially not in US$ terms) (see article "Is there Method in the Market Madness?" Tuesday, April 23, 2013.
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