“Markets have been making history lately,” says David Woo, head of rates and currencies research at Bank of America Merrill Lynch. Between late August and early October, he notes, US equities outperformed world equities for seven consecutive weeks for the first time since 1995.
Meanwhile, over the same period the dollar also went up seven weeks in a row, something that has only happened on one other occasion since 1995. “The length of the simultaneous outperformance of US equities and the USD has no parallel over the past 20 years,” says Woo.
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The prevailing investment case for the US hinges on the assumption that the US can decouple from the rest of the world and grow while other economies are stagnating. The disparity between the MSCI's US and global indices is the biggest it has been since the early 2000s when the Bric economies accounted for less than 20% of global GDP. This demonstrates the extreme divergence in expectation between US and global growth.
It all looks reminiscent of the last years of the 20th century. Then, as now, investors flocked to US assets in the belief that they would outperform global assets as the US decoupled from faltering economies elsewhere.
“We saw a similar set of circumstances between 1995 and 2000, when US equities outperformed at the same time as dollar strengthening,” says Nick Beecroft, chairman and senior market analyst at Saxo Capital Markets UK. “That was a similar period to now; we had the US standing out economically, with the dotcom boom fuelling hopes for the internet's growing contribution to growth.”
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The 1997-99 emerging markets crisis was also the last real example of US decoupling, says Woo, when “reduced inflation expectations drove down borrowing costs while a collapse of oil prices boosted real household purchasing power.”
It was also a time when the dollar-equity correlation held up in both rising and falling markets, with both falling following the Russian default. However, this correction was not representative of the broader market trend of the period. From the eve of the Asian crisis to the Russian default, emerging market equities lost nearly 60% of their value, but US equities rose by 20% during the period, says Woo.
Today's market presents a very different case to what was seen in the 1990s, says Woo. “The USD was bolstered in the late 1990s by the IT revolution which started in the US, the Asian crisis which spread to most emerging economies, and the peace dividend. The US was at the peak of its power both politically and economically then.”
Few would describe the US as at the peak of its political and economic power now. That the market seems to be treating today as a rerun of the late 1990s demonstrates the difference between what the market perceives and reality, says Woo.
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“In the late 90s there were tangible factors that worked in favour of the US,” he says. “Today the rest of the world looks terrible and the US only looks good by comparison. Today 25% of US corporate earnings come from overseas, compared with only 15% in the late 90s. The US will not decouple from the rest of the world easily.”
What is most interesting about the recent correlation between the dollar and the equity market is that usually where there has been a correlation between the two asset classes it has been an inverse one. The dollar is seen as a safe-haven investment when risk aversion is high, while equities tend to outperform when risk appetite increases.
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A stronger dollar also depresses overseas earnings, so should be a negative for US equities, says Beecroft. “Yet exports account for only 13% of the US economy,” he adds. “The proportion of S&P earnings generated abroad is also relatively modest, so the dollar does not have a big impact on growth.”
But the fickleness of these currency correlations with other assets is nothing new. James Wood-Collins, CEO at Record Currency Management, says correlations between currencies and other assets are constantly changing, but he believes there have been more marked correlations since 2008.
Keeping on top of these constantly changing correlations presents a real challenge for currency hedging, he adds. “It is impossible to say whether correlations that exist today will be sustained or may already be in the process of breaking down,” he says.
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It serves as a reminder that nothing can be taken for granted when hedging or constructing a portfolio. “It is interesting to note that two weeks ago when we saw a bout of risk aversion in the markets and yields on treasuries dropped 30bp in a day, the best currency performer on the day was NZD, a currency usually associated with risk on,” says Wood-Collins. “A lot of that was short covering but it still shows that these correlations are not as persistent or consistent as we sometimes like to think they are.”
The conclusion to draw is that the dollar and equity outperformance is unlikely to last too long. In fact, the very premise driving this correlation – that the US economy is capable of decoupling from the rest of the world despite the increasing interconnectedness of the global economy – is probably flawed.
“I’m a dollar bull but in the short term I think market sentiment may have overshot and the dollar has limited immediate upside from here,” says Woo. “Even though I am bullish the USD long-term, the idea of parity with euros is ridiculous. Global growth is increasingly a zero sum game. Another 20% appreciation of the USD against the EUR will turn the table on the relative competitiveness of the US and Europe.”
A safer way to play the decoupling theme, says Woo, is to invest in US small caps, which offer lower exposure to both the US dollar and overseas growth. “Foreign sales account for only19% of small cap sales, versus 35% for the S&P 500,” he says.